Taxation of Life Insurance and Annuities

1
Taxation of Life Insurance and Annuities

• Al Kingan, JD, LLM, CLU, ChFC
• Director, Estate Business Planning

University of Nebraska School of Law 2006 Estate
Business Planning Program May 12, 2006
078730-000
2
Disclosure
This presentation is not written or intended as
specific tax or legal advice and cannot be relied
upon for purposes of avoiding any federal tax
penalties. MassMutual, its employees and
representatives are not authorized to give tax or
legal advice. You are encouraged to seek advice
from a qualified tax or legal advisor.
3
Life Insurance Tax Basics

• Premiums are not tax deductible
• Death benefits are income tax exempt
• Cash values are tax-deferred

Life Insurance
4
No Deduction for Premiums

• IRC 264 life insurance premiums are not tax
  deductible expenses.
• John cannot deduct the premiums he pays on his
  personal life insurance policy.
• Johns business or employer cannot deduct the
  premiums it pays on an insurance policy it owns
  on his life (e.g., key person insurance).

Life Insurance
5
Tax-Free Death Benefits

• IRC 101(a) gross income does not include
  amounts received under a life insurance contract,
  if such amounts are paid by reason of the death
  of the insured.
• Must be a life insurance policy
• Must be paid because the insured died
• Any type of policy (Term, WL, UL, etc.)
• To any beneficiary (individual, trust, business)

Life Insurance
6
IRC 7702 Definition of Life Insurance

• Product must meet Sec. 7702
• Must be a life insurance contract under
  applicable law (state or foreign), and
• Must meet either of two tests
• Cash Value Accumulation Test
• Guideline Premium Test
• Also, Mortality Expense charges must be
  reasonable

Life Insurance
7
IRC 7702 Failure

• If a policy is a life insurance contract under
  state or foreign law, but does not qualify under
  IRC 7702
• Investment gain on failed contracts are taxable
  each year as ordinary income
• Otherwise, Investment gain is tax deferred
• Income tax-free if received as death proceeds

Life Insurance
8
Taxation of Life Insurance (non-MECs) Policy
Distributions

• Favorable taxation - generally, return of basis
  first
• Dividend distributions - reduce investment in
  the contract
• Special Rule for Withdrawals/Partial Surrenders
  During 1st 15 Years
• Pre-7702 (pre-January 1, 1985)
• reduce investment in the contract
• 7702 Contracts
• Distribution may be treated as income on contract
• Separate formulas for years 1-5, 6-10 and 11-15

Life Insurance
9
Taxation of Life Insurance (non-MECs) Policy
Distributions (cont.)

• Policy loans
• Not a distribution
• Loan can be repaid out of death proceeds with No
  tax
• Policy lapse with loan in excess of basis is
  taxable
• Full Surrenders
• Amount received (including loan forgiveness) in
  excess of basis is taxable ordinary income
• Distributions in excess of basis
• Taxable as ordinary income

Life Insurance
10
Taxation of Life Insurance Modified Endowment
Contracts (MECs)

• Section 7702A -(applies on or after June 21,
  1988)
• Policy that fails the 7-pay test (but passes
  definition of life insurance test of Section
  7702)
• Policys total premiums exceed the premium limits
  defined in the legislation
• During first 7 years
• At the date of a material change, or
• At the date of loss of grandfather status

Life Insurance
11
Taxation of Life Insurance Modified Endowment
Contracts (MECs)

• Material Changes
• Term rider attachments
• Conversion of Dividend Accumulations to Paid-up
  Additions
• Death Benefit Increases
• Certain Universal Life corridor increases

Life Insurance
12
Taxation of Life Insurance Modified Endowment
Contracts (MECs)

• Policy Distributions - Section 72(e)
• Dividends/Withdrawals/Partial Surrenders
• Taxed Income out first
• Full Surrenders
• Amount received (not including loan forgiveness)
  in excess of basis is taxable ordinary income
• Loans and Collateral Assignments
• Taxed same as a surrender or withdrawal
• Repayment of loan increases investment in the
  contract

Life Insurance
13
Taxation of Life Insurance Modified Endowment
Contracts (MECs)

• Policy Distributions (cont.)
• Premature Distributions
• Additional 10 penalty tax applies to taxable
  income on distributions from a MEC
• Exceptions
• Policyowner has attained age 59 1/2
• Policyowner has become disabled
• Distributions taken as a series of substantially
  equal periodic payments (at least annually) over
  life expectancy of owner and owners beneficiary

Life Insurance
14
Taxation of Annuities

• Inside Build-up
• Generally, Tax Deferred
• Exception, Deferred Annuities held by
  Non-natural persons
• Beginning with investment contributions after
  2/28/86 - Sec. 72(u)

Annuities
15
Taxation of Annuities

• Deferred Annuities
• Withdrawals/Partial Surrenders (Amounts not
  received as an annuity)
• Taxed as distribution of income on the contract
  first
• Full Surrender/Loans/Collateral Assignments
• Amount received in excess of basis is taxable
  ordinary income
• Gifts of Annuity Contract
• Treated as a disposition triggering tax on gain
• Except between spouses or incident to a divorce

Annuities
16
Taxation of Annuities

• Deferred Annuity Distributions (cont.)
• Premature Distributions
• Additional 10 penalty tax applies to taxable
  income on distributions from a Deferred Annuity
• Exceptions
• Contract holder has attained age 59 1/2
• Contract holder has become disabled
• Distributions taken as a series of substantially
  equal periodic payments (at least annually) over
  life expectancy of owner and owners beneficiary

Annuities
17
Taxation of AnnuitiesDeath of Contract Holder -
Sec. 72(s)

• If Surviving Spouse named as Beneficiary
• Spouse replaces Contract holder
• Mandatory distributions
• Before Annuity Starting Date
• Distribute entire amount within 5 years
• Over life of beneficiary (beginning w/in 1 year)
• On or After Annuity Starting Date
• At least as rapidly as method of distributions
  prior to holders death

Annuities
18
Exchanges of Insurance and Annuity Contracts -
Section 1035

• No Gain or Loss Recognized
• Old Basis Carries over to new contract (unless
  exchange involves taxable boot
• Permissible Exchanges
• Life Insurance for Life Insurance, Endowment or
  Annuity
• Endowment for Endowment or Annuity
• Annuity for Annuity
• Note, Endowment Contracts are no longer available

Exchanges
19
Exchanges of Insurance and Annuity Contracts -
Section 1035

• Special Rules
• Contracts must have the same Insured or Insureds
• Generally believed that owner must be same
• Exchange may involve multiple contracts
• New Life Policy will not become a MEC as a result
  of exchange unless old policy was a MEC
• Amount transferred from old contract not treated
  as a premium payment under MEC test
• It does, however, lower premium limit that would
  otherwise apply to new policy

Exchanges
20
Exchanges of Insurance and Annuity Contracts -
Section 1035

• Life Insurance Exchanges - Boot Anomaly
• Sec. 1035 refers to 1031 for operational
  instructions
• Under Sec. 1031, any debt forgiveness is boot
• Under Sec. 72, no gain on life policy until
  distributions exceed basis
• Apparent conflict in IRC? (nah?, cant be?)
• Insurance Carriers generally take position that
  forgiven loan is taxable (preserves
  business/prevents penalties)
• Problem can be avoided by first doing a partial
  surrender that eliminates loan (step transaction?)

Exchanges
21
Life Insurance Death ProceedsTransfer for Value

• Death Proceeds Income Tax Free Unless Transfer
  for Value Rule Applies
• Transfer for Value - In the case of a transfer
  for valuable consideration by assignment or
  otherwise, of a life insurance contract or any
  interest therein, proceeds in excess of basis are
  taxable.

Life Insurance
22
Transfer for Value

• Section 101(a)(2) Transfer for Value Exceptions
• Transfer to Insured
• to Partner of Insured
• to Partnership in which Insured is a Partner
• to Corporation in which Insured is a shareholder
  or officer
• Transfer where basis in hands of transferee is
  same as in hands of transferor

Life Insurance
23
Transfer for Value

• Caution Broad application of Transfer for Value
  Rules - Examples
• A, B and C own Corp they buy policies on each
  other for Buy/Sell funding
• A dies
• B C collect death proceeds, and buy stock from
  As estate
• B buys As interest in policy on Cs life
• C buys As interest in policy on Bs life
• Transfer for Value?

Life Insurance
24
Transfer for Value

• Examples
• A and B are brothers they own XYZ Corp.
• Each owns a life insurance policy on his own life
• Each names his brother as beneficiary of his life
  insurance policy
• Transfer for Value?

Life Insurance
25
Transfer for Value

• Examples
• Mom gifts life insurance policy to daughter.
  Policy has outstanding loan.
• Premiums paid 8,000
• Outstanding loan 5,000
• Net Cash Surrender Value 10,000
• Transfer for Value?

Life Insurance
26
Transfer for Value

• Examples
• Mom gifts life insurance policy to daughter.
  Policy has outstanding loan.
• Premiums paid 20,000
• Outstanding loan 25,000
• Net Cash Surrender Value 12,000
• Transfer for Value?

Life Insurance
27
Transfer for Value

• Examples
• Policy on A owned by As Irrevocable Trust
• A, concerned about one of trust beneficiarys
  ability to handle money, wants to change trust
• Can A create new trust to buy the life insurance
  policy from old trust?

Life Insurance
28
Transfer for Value

• Examples
• Can As New Trust buy life policy from Old Trust?
• Under Grantor Trust rules, all assets of New
  Trust are treated as owned personally by A for
  income tax purposes
• The Transfer for Value Rule is an Income Tax rule
• A transfer directly to A (the Insured) is exempt
• IRS, after refusing to rule for many years, has
  issued a number of favorable letter rulings
• PLR 200228019 PLR 200247006 PLR 200606027
• PLR 200518061 PLR 200514001

IRS Private Letter Rulings are opinions rendered
by staff of the IRS relating to a specific case.
These opinions do not set legal precedent but do
provide some insight concerning the IRS attitude
toward the relevant tax issue. PLRs cannot be
relied on as can published rulings (Revenue
Rulings).
Life Insurance
29
Transfer for Value

• Examples
• Getting As Policy from As Old Trust to As New
  Trust
• Any Other Options?

Life Insurance
30
Transfer for Value

• Getting As Policy from Old Trust to New Trust
• The Super Conservative Solution
• A creates Family Limited Partnership
• A Transfers FLP interests to New Trust
• New Trust buys policy form Old Trust
• Trustee should sell for greater than cash value
• Avoid any Breach of Fiduciary Duty argument
• Results
• Partner of the Insured Exception Applies
• No Transfer for Value Problem/No Sec. 2042 Problem

Life Insurance
31
Transfer Value of a Life Insurance PolicyRev.
Proc. 2005-25 TD 9223 Regulations

• New Insurance Valuation Rules apply to Transfers
  of Life Insurance from
• Employer to Employee
• Distribution or Purchase from a Qualified Plan
• Value to be used is the Fair Market Value, not
  the
• Cash Value
• Cash Surrender Value, or
• Interpolated Terminal Reserve (gift tax value)

Life Insurance
32
Transfer Value of a Life Insurance PolicyRev.
Proc. 2005-25 TD 9223 Regulations

• Rev. Proc. 2005-25 valuation safe harbor for
  Universal Life policies is the greater of
• The Statutory Reserve
• The product of the PERC amount and the Average
  Surrender Factor (ASF)

Life Insurance
33
Transfer Value of a Life Insurance PolicyRev.
Proc. 2005-25 TD 9223 Regulations

• PERC Definition Aggregate of
• Cumulative premiums paid
• Plus earnings credited on contract
• Minus mortality charges and other reasonable
  charges actually charges
• Minus any distributions, withdrawals or
  surrenders taken prior to valuation date

Life Insurance
34
Transfer Value of a Life Insurance PolicyRev.
Proc. 2005-25 TD 9223 Regulations

• Average Surrender Factor (ASE) is an adjustment
  to account for surrender charges.
• Expressed as a number between .70 and 1.00
• Employment Based Transfers - subject to IRC 79,
  83 or 402(b), the ASE is 1.00
• Note No surrender charges can be taken into
  account in a transfer from employer to employee
• Qualified Plan Based Transfers- the ASE is
  greater of a) .70, or b) fraction of CSV/PERC as
  if surrender was on first day of policy year

Life Insurance
35
Transfer Value of a Life Insurance PolicyRev.
Proc. 2005-25 TD 9223 Regulations

• For Whole Life Type Products, the safe harbor
  value is the greater of
• Interpolated Terminal Reserve
• Plus Unearned Premium, etc.
• product of the PERC and the ASE
• (no ASE adjustment if the distribution is from
  employer to employee)

Life Insurance
36
Gift Tax Value of Life Insurance

• Gift Value is Interpolated Terminal Reserve
• In early years - close to premiums paid
• In later years, equal to Cash Surrender Value
• Probably the Account Value of a UL or VUL policy

Life Insurance
37
Estate Tax Inclusion of Life Insurance

• Section 2042
• Death Proceeds includable in Decedents Taxable
  Estate if
• Payable to Decedents Estate
• Payable to Others, and decedent possessed at his
  death any of the policys incidents of ownership,
  exercisable alone or in conjunction with any
  other person.

This is a summary only of the tax issues related
to federal gift and estate laws and is not
intended as tax or legal advice. Specific advice
should obtained from a qualified professional.
Life Insurance
38
Estate Tax Inclusion of Life Insurance

• Section 2035
• Death Proceeds includable in Decedents Taxable
  Estate if
• Decedent transferred or relinquished an interest
  in property (including any incidents of ownership
  in a life insurance policy on Decedents life)
  during the 3 year period ending on the date of
  decedents death.

This is a summary only of the tax issues related
to federal gift and estate laws and is not
intended as tax or legal advice. Specific advice
should obtained from a qualified professional.
Life Insurance
39
Life Insurance Tax Traps

• Goodman Triangle Problem
• Dad doesnt want to pay legal fees to create a
  trust
• He names responsible Child A as owner of his life
  insurance policy
• Child A and Child B are policy beneficiaries
• Dad dies Child A is deemed to have made a
  taxable gift of ½ of the death proceeds to Child B

This is a summary only of the tax issues related
to federal gift and estate laws and is not
intended as tax or legal advice. Specific advice
should obtained from a qualified professional.
Life Insurance
40
Life Insurance Tax Traps

• Life Insurance Owned by Multiple Individuals
  Present Interest Exclusion Issue
• Dad doesnt want to pay legal fees to create a
  trust
• He names both Child A and Child B as owners of
  his life insurance policy
• Dad pays all policy premiums
• Dads premium payments are all taxable gifts
  They do not qualify for the annual gift tax
  exclusion

This is a summary only of the tax issues related
to federal gift and estate laws and is not
intended as tax or legal advice. Specific advice
should obtained from a qualified professional.
Life Insurance
41
Life Insurance Tax Traps

• Life Insurance Owned by Multiple Individuals
  Present Interest Exclusion Issue
• Joint owners must all consent to exercise any
  policy rights
• Therefore, no individual owner is deemed to have
  a present interest in a policy gifted to multiple
  parties
• Same with the payment of premiums on a policy
  owned by multiple parties

Life Insurance
42
Life Insurance Tax Traps

• Life Insurance Owned by a Credit Shelter Trust
• Could be a Great Idea, unless
• Insured is named Trustee
• Insured is given a Limited Power of Appointment
  over the Credit Shelter Trust

Life Insurance
43
Life Insurance Tax Traps

• Corporate Owned Policy Payable to a Personal
  Beneficiary
• Death Benefit may be taxed as a dividend
• Death Benefit may be taxed as compensation
• Death Benefit will be deemed to have been
  constructively paid
• First to corporation
• Then from corporation to Deceased Employee,
• Then from Deceased Employee to named beneficiary
• Depending upon beneficiary, could also be a
  Transfer for Value

Life Insurance
44
Perspective

• Primary purpose is to provide cash to beneficiary
  at death of the insured.
• Income to help support a family, put children
  through college, pay off mortgages, pay estate
  taxes, fund a buy-sell plan, or make a charitable
  bequest.
• Secondarily, permanent life insurance policies
  also build up tax deferred cash values.
• May be used to reduce/skip premiums, help provide
  cash for emergencies, even help supplement
  retirement income.
• Congress provides certain tax benefits for life
  insurance as a public policy due to its value to
  society. Lets keep things in perspective as
  abusive uses of the tax benefits can lead to loss
  of those benefits.

45
Why Life Insurance?

• Provides funds on-time, during period of greatest
  need, regardless of when death occurs
• Income tax free death proceeds
• Potentially Estate tax free death proceeds (with
  appropriate estate planning)
• Income tax deferred cash value growth
• Favorable basis recovery of lifetime
  distributions
• Cash value loans in excess of basis also income
  tax free

Life Insurance
46
Common Uses of Life Insurance Proceeds

• Estate tax transfer costs
• State death transfer costs
• Family income maintenance
• Payment of mortgages and debts (both personal and
  business)
• Educational needs for children/grandchildren
• Equalization of inheritances
• Special Needs situations

Life Insurance
47
Uses of Life Insurance (cont.)

• Multiple marriage situations
• Income tax issues on Qualified Plans and other
  IRD items
• Wealth replacement of assets transferred directly
  (or indirectly) to charitable institutions

Life Insurance
48
MassMutual Financial Group is a marketing
designation (or fleet name) for Massachusetts
Mutual Life Insurance Company (MassMutual) and
its affiliates.
Massachusetts Mutual Life Insurance Company and
affiliates, Springfield, MA 01111-0001
www.massmutual.com