Income Taxation

1. Income Taxation Chapters 16 and 17: Income Taxation of Life Insurance and Modified Endowment Contracts

2. Life Insurance Proceeds Generally, life insurance death benefits payable by reason of the death of the insured are excludible from the gross income of the beneficiary.

3. Accelerated Death Benefits Must be paid by insurer or licensed viatical settlement provider �Terminally ill� means death is expected within 24 months of physician�s certification Payments to �Chronically ill� insured must be made pursuant to qualified LTC rider

4. Taxation of Policy Benefit Options Policy in Force: Dividends treated as return of capital; withdrawals generally taxed on FIFO basis Lump-Sum Payments: Gain taxed as ordinary income Interest-Only Option: Interest taxable Installment Options: Interest portion of payment taxable Contingent beneficiary taxed in generally the same way as primary beneficiary Consider �60-Day Rule� for surrendered policies

5. Surrender of Policy Face Amount of Policy: $50,000 Cash Surrender Value: $8,000 Premiums Paid: $9,000 Dividends Paid on Policy: $2,000 Amount Taxable: $1,000 --$8,000 � ($9,000 - $2,000) = $1,000

6. �5-15� Withdrawals Taxed on LIFO basis if associated with a reduction in policy benefits during first 15 policy years Greater taxable amount during first 5 policy years �Ceiling� applies to taxable amount Typically associated with universal life policies

7. Transfer-for-Value Rule A tax law providing that where a policy transferred by assignment or otherwise for a valuable consideration matures by reason of death, the transferee will be liable for income tax on the amount of death proceeds in excess of the actual value of the consideration paid for the contract plus the total of net premiums and other amounts subsequently paid by the transferee.

8. Example Face amount of policy: $100,000 Amount paid for policy by transferee: $20,000 Premiums subsequently paid by transferee: $10,000 Amount taxable to transferee upon death of insured: $70,000 --$100,000 � ($20,000 + $10,000) = $70,000

9. Transfer For Value EXCEPTIONS Transfers to the insured Transfers to a partner of the insured Transfers to a partnership in which the insured is a partner Transfers to a corporation in which the insured is a shareholder or officer Transfers to which carryover basis rules apply (i.e., tax-free exchange)

10. Transfer For ValueNON-EXCEPTION Transfers from one shareholder in a corporation to a fellow shareholder!

11. Insurable Interest The legal principle that requires the policy owner under a life insurance policy to have a sufficient business or personal relationship with the insured at the time of policy inception.

12. Premium Payments Premium payments by one spouse or former spouse for life insurance owned by and benefiting the other spouse are deductible as alimony, if the following occurs: Payments are made in cash and terminate at the death of the payee-spouse. Payments are made under a divorce decree or separation agreement. The parties are not members of the same household and do not file joint tax returns. Payments are not for child support. Payments must be made for at least 3 years unless either spouse dies or the payee-spouse remarries.

13. Nondeductibility of Premiums NEVER deductible if taxpayer paying premiums is directly or indirectly a policy beneficiary If payor is NOT a policy beneficiary, premiums are deductible only if they qualify under a specific rule of tax law (e.g., Alimony, Compensation, or Charitable Contribution)

14. Key Person Rule For purposes of determining the deductibility of interest payments on a loan from an insurance contract, an individual insured who is an officer or 20 percent owner of the taxpayer. Rule provides that interest on loan amounts not in excess of $50,000 per insured person is deductible if the insured or other covered person under the contract is a key person.

15. Key Person Rule There are further restrictions on the definition of a key person. The total number of key persons per business taxpayer may not exceed the GREATER of: five individuals or the LESSER of 5 percent of the total number of officers and employees of the business taxpayer, or 20 individuals

16. Result: Interest on Policy Loans Interest is deductible only if business-owned policy insures �Key Person� Key person must be either an officer or 20 percent owner of taxpayer/business No business can have more than 20 �Key Persons� Interest deductible only to extent of $50,000 of loan principal per insured �Moody�s� rates must be used

17. MECs MEC is a life insurance policy that has failed the �7-Pay Test� (post June 20,1988) Partial withdrawals, loans and collateralizations subject to LIFO (�Last �in, First-out) taxation 10 Percent penalty, if applicable, applies only to taxable portion of transaction with policy 7-Pay Test applies again if policy experiences a �Material Change�

18. MECs The �7-Pay Test� -- A test to determine if a particular life insurance contract is or is not a modified endowment contract. If the total premium paid into the policy in the first 7 years or in the 7 years following a material change in it exceeds the sum of the �net level premiums� that would be needed to pay up a policy in 7 years, the policy is as MEC.

19. MECs Net Level Premiums -- An artificially constructed amount based on reasonable mortality charges, an assumed interest rate, and (in some cases) reasonable insurance company expense charges, used in determining whether a life insurance contract is a MEC. See example on 17.4 (note that taxable amounts increase basis in policy)

20. MECs: Material Changes Substantial increases in death benefits due to large deposits of premium Reduction in benefits during first 7 policy years Reduction in benefits anytime for survivorship policies Term conversions (to cash value) 1035 exchanges