Chapter 15 Flashcards
Income Taxation of Life Insurance (40 cards)
Accelerated Death Benefits Paid to Terminally or Chronically Ill Insureds
Amounts received under a life insurance contract covering the life of an insured who is terminally or chronically ill are now excludible from gross income
terminally ill insured
A terminally ill insured is one who has been certified by a physician as having an illness or condition that can be expected to result in death within 24 months of the date the certification is given.
Life Insurance Withdrawals
Withdrawals of cash value from a life policy are generally taxed on a first-in first-out (FIFO) basis; that is, withdrawals are treated as a nontaxable return of capital to the extent of premiums paid. Withdrawals in excess of premiums paid are taxable.
However, it is critically important to understand that withdrawals will be taxed as income first (a last-in first-out [LIFO] treatment) if the policy is classified as a modified endowment contract (MEC).
In addition, withdrawals from a life insurance policy that are made during the first 15 policy years and are associated with a reduction in the policy’s death benefit will also be subject to LIFO tax treatment, even if the policy is not a MEC.
Gain realized upon surrender or maturity of United States Government Life Insurance (WWI) or National Service Life Insurance (WWII) is exempt from tax.12
True
Where the owner of a life insurance contract receives the lifetime maturity proceeds or cash surrender value of the policy in one lump-sum payment from the insurance company, the amount received in excess of the owner’s cost basis is taxed as ordinary income.
True
Deductions for life insurance premiums are allowed if owned by a business
Generally, premiums paid on business life insurance are not deductible. The Internal Revenue Code is explicit: “No deduction shall be allowed for . . . premiums on any life insurance policy, or endowment or annuity contract, if the taxpayer is directly or indirectly a beneficiary under the policy or contract.”
Deductibility of disability premiums
The Internal Revenue Code provides that premiums paid for personal disability income insurance are not deductible.33 Included in the definition of disability income insurance are policies that pay a weekly income payment to the insured while hospitalized.
Deductibility of health care premiums for individuals
Premiums paid for medical reimbursement insurance are considered a medical care expense under the Code35 and are deductible to the extent that they, along with other itemized medical expenses, exceed 10 percent of adjusted gross income. Different rules apply to self-employed taxpayers.
Life Insurance transfer-for-value rule
A transfer-for-value rule stipulates that, if a life insurance policy (or any interest in that policy) is transferred for something of value (money, property, etc.), a portion of the death benefit is subject to be taxed as ordinary income.
Exceptions to the transfer-for-value rule?
(1) transfers to the insured
(2) transfers to a partner of the insured
(3) transfers to a partnership in which the insured is a partner (4) transfers to a corporation in which the insured is a shareholder or an officer
(5) transfers in which the transferee’s basis in the transferred policy is determined in whole or in part by reference to the transferor’s basis. (occasionally referred to as the carryover-basis exception)
insurable interest
As a general rule, the requirement of insurable interest applies only at the time of policy inception.
What are the three types of losses deductible to an individual?
It is key to remember that three types of losses are deductible to an individual:
(1) losses incurred in a trade or business
(2) losses incurred in a transaction entered into for profit
(3) casualty or theft losses.
Section 165 of the Code generally allows deductions for such losses provided they are “not compensated by insurance or otherwise.”
Charitable Life Policies and premium deductions
Premiums paid on life insurance owned by a qualified charitable organization are deductible to the donor as a charitable contribution, subject to the charitable contributions limitations. It is important that the charity be the owner of the policy and have the exclusive right to cash in the policy, borrow on it, or change the beneficiary.
Premium payments as income for separated spouses
For divorce and separation agreements executed before January 1, 2019, premium payments by one spouse or former spouse for life insurance owned by and benefiting the other spouse are deductible as alimony.
For divorce and separation agreements executed after December 31, 2018, alimony payments are not income to the payee-spouse and not deductible by the payer-spouse.
Split Dollar Life Insurance
A well-known fringe benefit for selected employees is the split-dollar life insurance plan. Under such an arrangement, an employee and employer share or split the premium payments. In the most basic form of split-dollar, cash-value-type policies are used and the employer’s share of the annual premium is measured by each year’s increase in cash value. Correspondingly, the employee’s share of each premium payment is the difference between each year’s cash value increase and the amount of net premium due. The employer can be named beneficiary to the extent of the cash value. The employee can have the right to name his or her own beneficiary for the difference between the total death proceeds payable and the cash value.
No deduction is available to the employer for contributions to a split-dollar plan because the employer is also a beneficiary under such a policy within the meaning of Section 264(a) (1) of the Code.
True - the employee names the beneficiary for the death benefit but the employer retains interest in the cash value.
Nondeductibility of Interest Payments
The general rule is that no interest deduction is allowable with respect to indebtedness incurred in connection with a life insurance, endowment, or annuity contract issued after June 8, 1997. Exceptions to this general rule provide for limited interest deductions for loans in connection with certain business-owned contracts, as discussed in the following sections. There are complex and overlapping sets of rules regarding interest deductions for policy loans with respect to policies issued on or before June 8, 1997
Nondeductibility of Interest Payments - Key Person Exception
The “Key Person” Rule. This provision is the most significant exception to the general rule that interest deductions on policy loans are disallowed. The key person 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. The definition of a key person is an officer or 20 percent owner of the taxpayer.
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.
Interest on Policy Loans
Interest on Policy Loans
• Interest is deductible only if the business-owned policy insures a “key person”.
• A key person is either an officer or 20 percent owner of taxpayer/business.
• No business can have more than 20 “key persons”.
• Interest is deductible only to extent of $50,000 of loan principal.
• Moody’s rates must be used.
If the transfer of a life insurance policy falls within one of the enumerated exceptions to the transfer-for-value rule, the entire death proceeds will be received income tax free by the beneficiary.
True
Interest deductions for loans from business-owned single-premium life insurance policies are limited to $1,000 annually.
False
Interest on loans from single-premium life insurance policies cannot be deducted.
An individual who transfers a policy on his or her life to a qualified charity and continues to pay the premiums may deduct the amount of the premium payments each year as a charitable contribution only if the charity is the owner of the policy and has exclusive rights as owner.
True
A surviving spouse may exclude all interest income payable under any settlement option for a matured life insurance policy.
False
If the amount is received with respect to a death occurring on or before October 22, 1986, the interest will be included in the gross income.
TA corporation may take a deduction for premium payments made for insurance on the life of an officer of the corporation if the beneficiary is the corporation.
False
IRC Sec. 264 prohibits a deduction by any taxpayer for premiums paid on life insurance contracts if the taxpayer is directly or indirectly a beneficiary.
