LIFE INSURANCE, THE DEVIL, AND THE DETAILS

Transcription

1 LIFE INSURANCE, THE DEVIL, AND THE DETAILS I. INTRODUCTION A. This outline presents taxation rules for life insurance (primarily income tax) and highlights some tax traps and solutions. It is not enough to know the rules. The prudent planner should be able to see and solve tax issues in real-world planning situations. B. There are a number of sections in the Internal Revenue Code that affect the income taxation of life insurance and certain transactions involving life insurance. 1. Section 7702 defines life insurance. 2. Section 7702A defines a modified endowment contract (MEC). 3. Section 72 controls the taxation of distributions from life insurance contracts during the life of the insured. 4. Section 83 determines the amount of income reportable when a life insurance policy is transferred as compensation. 5. Section 101 controls the taxation of death proceeds of life insurance contracts. 6. Section 162 establishes the rules for deducting premiums as a business expense for services rendered. 7. Section 264 provides rules that generally deny deductions for premiums and interest paid or accrued on life insurance contracts. 8. Section 1035 governs tax-free exchanges of life insurance contracts. C. SOME BASIC TERMS AND CONCEPTS FOR INCOME TAXATION OF LIFE INSURANCE 1 1 For additional defined terms and concepts, see Income Tax Basics of Life Insurance (F.O ). 1

2 1. A withdrawal is intended to broadly describe the taking of cash from the policy. For purposes of this outline, withdrawals from insurance policies include surrender of additions, dividends received in cash, partial surrenders, and policy loans. The tax consequences of these withdrawals will be discussed in further detail in this outline. 2. For purposes of this outline, the tax basis of an insurance policy is typically the investment in the contract, generally defined as premiums plus other consideration paid on or for the policy, less amounts received from the policy which are excluded from the policyowner s income (e.g., dividends). 2 a. Note, however, that a contract s basis might not always equal investment in the contract under I.R.C. 72(e). (1) In Revenue Ruling , 3 the I.R.S. ruled that a policyholder is governed by I.R.C. 72 and thus taxed on amounts received in excess of investment in the contract when receiving money from the insurance company. But the I.R.S. also ruled that, when a policyholder sells the life insurance contract to a person unrelated to [the insured] and who would suffer no economic loss upon [the insured s] death (e.g., a life settlement company), the transaction does not fall under I.R.C. 72, but instead under I.R.C. 1001, and the policyholder is taxed on amounts received in excess of adjusted basis. (2) Importantly, Revenue Ruling also instructed that the basis of the contract for purposes of these sales is found by subtracting the cost of insurance from the cumulative premiums (i.e., from the investment in the contract). It also ruled that the cost of insurance amount is taxed at capital gains rates. It did not tell us how we are supposed to determine the cost of insurance (3) This ruling does not appear to apply to most of the transactions described in this outline where basis is relevant because those transactions contemplate a 2 I.R.C. 72(e). 3 Rev. Rul , I.R.B (May 1, 2009). 2

3 transfer to a related party. Therefore, this outline assumes that basis and investment in the contract are determined in the same manner. Practitioners should realize, however, that sales to unrelated parties may be subject to the ruling and that, in those cases, the basis may not include the cost of insurance and the tax on the sale may be higher. 4 b. Basis can also differ from investment in the contract for other, noncontroversial reasons. For example, when an existing policy is purchased from a policyowner, the purchaser s initial tax basis is the cost (i.e., purchase price) of the policy. The purchaser s cost basis may be quite different from the seller s basis. On the other hand, when a policy is given away, the donee generally takes the basis of the donor (a carryover basis ). c. If the policyowner is not the insured, and the policyowner dies while the insured is still alive, does the unmatured policy receive a basis step-up? The law is unclear on this issue. A life insurance policy is property, and it is a capital asset (it s not defined as not being a capital asset under I.R.C. 1221), so there s reason to believe it receives a basis step-up under the general rules of 1014(a) (i.e., the basis of property received from a decedent is adjusted to date of death value). On the other hand, the built-in gain portion of the contract could be viewed as income in respect of a decedent (IRD), and IRD items are barred a basis step-up under I.R.C. 1014(c). 3. Gross and Net Cash Value. Gross cash value is the total cash value of a policy, without reduction for surrender charges or policy loans. Net Cash Value is actual cash value that would be received upon surrender of the policy, after reduction for surrender charges and policy loans. 4. The gain in an insurance policy (called income on the contract under 72) is generally the gross cash surrender value in excess of the policyowner s basis. This gain is taxed as ordinary income under various triggering circumstances described within this outline. 4 For more on this issue, see the A.P. Bulletin (June 2009), Ouch, My Head Hurts Treasury Rules That 'Basis' is Lower Than 'Investment in the Contract.' 3

4 5. Valuation of Life Insurance. For purposes of this outline, the fair market value of a life insurance policy is generally assumed to be equal to its net cash value. Keep in mind, however, that true fair market value might be greater than the net cash value. What s more, even though Revenue Ruling generally instructed that a life insurance policy s value should be the same regardless of whether the transaction involves income tax (e.g., transfer of policy from employer to employee) or gift tax (e.g., transfer of policy from insured to irrevocable trust), the valuation formulas offered by various Treasury Regulations seem to differ slightly depending on whether it is a gift tax transaction or an income tax transaction. a. Generally, Treasury Regulations provide that the gift tax value of a life insurance contract is found through the sale of comparable contracts. 6 To approximate this value, the regulation further provides: (1) If a policy is purchased for the benefit of another, the value is the cost of the contract (i.e., the premium paid). 7 Practitioners generally use this premium paid value when a contract is transferred within the first year of purchase. (2) If the policy has no more premiums owed (e.g., paid-up or single premium) the value is the single premium needed to buy a policy of the same specified amount on someone the same age as the insured. 8 (3) If the policy still has premiums being paid, the value is the interpolated terminal reserve, plus unearned premium, minus loans. 9 The reserve value generally takes into account the expiration date of a surrender charge. b. For income taxable transactions, a policy s fair market value is generally articulated as policy cash value and all other rights under such contract Rev. Rul , C.B Treas. Reg (a). 7 Treas. Reg (a), Example (1). 8 Treas. Reg (a), Example (3). 9 Treas. Reg (a), Example (4). 10 See Treas. Reg (e) and 1.402(a)-1(a)(1)(iii). 4

5 (1) Before 2005, vague and inconsistent Treasury Regulations had inadvertently encouraged valuation schemes in the employment contexts of transfers of contracts from employers to employees (I.R.C. 83), transfers from qualified plans to employees (I.R.C. 402), and group insurance plans funded with permanent policies (I.R.C. 79). (2) In 2005, however, final Treasury Regulations issued under those Code sections, along with safe-harbor formulas, have made the income tax valuation rules more uniform and less susceptible to abuse. 11 Under the safe harbor formula, a permanent policy s value is generally the higher of Premiums plus Earnings minus Reasonable Charges (PERC) or Interpolated Terminal Reserve plus pro-rated expected dividends (ITR). 12 c. For term policies, the unearned premium approximates the policy s value Life insurance is defined in I.R.C. 7702, which applies to contracts issued after December 31, a. The definition includes two alternative tests that companies use to qualify their policies as life insurance. One test is generally applied to traditional policies and the other is applied to universal life policies. (1) If a contract fails to satisfy the definition, the policyowner must include in gross income the income on the contract, as defined in 7702(g)(1)(B). This definition of income on the contract can trigger tax even though the policy does not yet have a gain as defined under the 72 definition of income on the contract. 11 See Treas. Reg (d)(3), (e), and 1.402(a)-1(a)(1)(iii); also see Rev. Proc , C.B. 962; Rev. Rul , C.B. 821; and Rev. Rul , C.B For more complete information about these rules, see the following: In Confusion There's Profit The Tax Valuation of Life Insurance; A.P. Bulletin (May 2005), I.R.S. Issues New Life Insurance Valuation Safe-Harbor: Revenue Procedure , I.R.B. (April 8, 2005); and A.P. Bulletin (September 2005), I.R.S. Issues Final Regulations on Valuation of Life Insurance: Treas. Reg , and 1.402(a)-1 Treasury Decision 9223 (August 25, 2005). 13 See Rev. Rul , C.B. 300 (a group term policy given away a day before the monthly premium was due had no ascertainable value). 5

6 (2) If a policy fails to satisfy the definition after it has been issued, the cumulative amount of the income on the contract for all prior years is included in the policyowner's gross income in the year of the failure. b. A change of insured under a policy issued prior to Northwestern Mutual s NN policy series generally causes the policy to fail the definition of life insurance because the mortality assumptions for prior policy series are not acceptable under the tax definition. A change of insured on a pre-nn contract can be completed by first changing the policy to Inforce CompLife and then completing the change of insured. 7. A modified endowment contract (MEC) is a life insurance policy that is subject to less favorable income tax rules on lifetime withdrawals. Taxable gain comes out first (and may be subject to an additional 10% penalty), rather than tax-free basis first. A MEC is nonetheless a life insurance policy, so cash values are not taxed as they grow, and the death benefit is income tax-free to the same extent as it is for other life insurance contracts. A MEC is defined in 7702A as a contract issued or materially changed after June 20, 1988 that satisfies the definition of life insurance under 7702, but fails to pass the 7-pay test of 7702A. a. The 7-pay test provides that the cumulative amount paid under the contract at any time during the first seven contract years cannot exceed the sum of the net level premiums which would have been paid on or before such time if the contract provided for a paid-up policy after the payment of seven level annual premiums. b. In theory, a 7-pay policy would pass the 7-pay test and avoid classification as a MEC, but the computational rules do not allow the use of expense charges. This results in a 7-pay limit that is lower than the premium charged for a 7- pay policy. In fact, 15-pay policies will usually exceed the 7-pay limit and be classified as MECs. 14 c. If the death benefit is reduced in the first seven years, the contract must be re-tested using the reduced death benefit 14 The Northwestern Mutual Network Illustration System (NIS) will determine whether a new policy will be treated as a MEC and whether any specific subsequent transaction will cause a contract to become a MEC in the future. To obtain help in determining whether a particular policy will be issued as or become a MEC, Northwestern Mutual financial representatives should contact the sales support area of life products. 6

7 of the policy. If the policy fails the test, it will become a MEC. 15 Second-to die policies must be re-tested if they are reduced at any time during the life of the contract. 16 d. If a policy is materially changed, it must be re-tested under a special 7-pay test called the material change test. The policy resulting from the change is treated as newly issued and a new seven year period begins. If the policy fails the material change test, it will be classified as a MEC. (1) Material changes include but are not limited to: (a) (b) (c) (d) a change of insured, a tax-free 1035 exchange, a term conversion or other change of plan, an addition of certain benefits such as disability waiver of premium, additional purchase option or accidental death benefit. (e) Most increases in death benefit are considered a material change. But increases attributable to the following are not: (i) (ii) dividend additions on fixed-premium contracts, investment performance on variable contracts, and (iii) premiums that are necessary premiums or dividends earned on those premiums on flexible contracts. (But see immediately below for a discussion of necessary premiums ). (2) Any increase in the death benefit attributable to the payment of premiums in excess of the necessary premiums is a material change. The necessary premiums are the total premiums required to 15 I.R.C. 7702A(c)(2). 16 I.R.C. 7702A(c)(6). 7

8 generate a guaranteed cash value sufficient to pay up fully the lowest death benefit payable during the first seven policy years. In other words, once the guaranteed cash value of the contract reaches the point at which it would purchase paid-up insurance equal to the lowest death benefit during the first seven years, all of the necessary premiums have been paid. With fixed premium policies, the necessary premium limit is only an issue if there is an increase in the premium. 17 II. AN OVERVIEW OF LIFE INSURANCE TAXATION A. PREMIUM PAYMENT 1. Premium payments generally are not deductible by the policyowner Nonetheless, practitioners at times colloquially state that amounts used to pay premiums are deductible premiums when the payments generate a deduction for reasons other than their status as life insurance premiums. a. When an employer pays premium on an employee-owned policy, the employer can deduct the payment to the extent it is reasonable compensation. 19 The premium effectively is paid with after-tax dollars, as the payment is included in the employee s income. 20 b. When a donor pays a premium on a policy owned by a charity, the payment is generally deductible as a charitable contribution. As with all charitable contributions, the deduction is subject to prescribed limits (e.g., limited to 30% or 50% of donor s adjusted gross income). 21 c. When a person pays a premium on a policy owned by an ex-spouse pursuant to a divorce decree, the payment may be deductible as alimony. 22 The premium ultimately is 17 With Northwestern Mutual CompLife policies, the limit could be reached with a scheduled level premium. 18 I.R.C. 264(a)(1). 19 I.R.C. 83 and I.R.C. 61 and I.R.C I.R.C

9 paid with after-tax dollars, as the payment is included in the recipient s income. 23 d. Subject to certain limits, an employer may make a deductible contribution to a qualified retirement plan, and the plan may purchase a policy on the employee. While the contribution is not currently taxed to the employee, the employee must include in income the one-year term value of insurance coverage provided. 24 B. CASH VALUE INCREASE 1. The increase in cash value is generally tax deferred One exception to this rule is that the increase in cash value may be taxed to a C corporation under the alternative minimum tax Another exception occurs when a contract is treated as life insurance under applicable state or foreign law, but does not meet the 7702 definition of life insurance. In this case, the policyowner is taxed each year on the income on the contract, which in this context means the cash value growth and cost of life insurance for the year in excess of the premiums paid during the year. 27 C. DEATH BENEFIT 1. The death benefit of a life insurance policy is generally received income tax-free. 28 a. This result holds true even if the policy is a MEC. b. A partial exception to tax-free death benefit occurs if a contract is treated as life insurance under applicable state or foreign law, but does not meet the 7702 definition of life insurance. In this case, the death benefit is tax-free under 101 only to the extent it exceeds the contract s net surrender value. 29 The effect of this might be insignificant, however, because the amount of death benefit equal to net 23 I.R.C See 72(m)(3); Treas. Reg (b), 1.402(a)-1(a)(3), 1.403(a)-1(d); and Notice , I.R.B I.R.C. 72. Cohen v. Commissioner, 39 T.C (1963); Griffith v. Commissioner, 35 T.C. 882 (1961). 26 I.R.C. 55(a). 27 I.R.C. 7702(g)(1). 28 I.R.C. 101(a)(1). 29 I.R.C. 7702(g)(2). 9

10 30 See I.R.C. 7702(g)(1). 31 I.R.C. 55(a). 32 See Notice , I.R.B for more details. 10 surrender value presumably would be tax-free for a different reason. Namely, that it represents premiums paid with after-tax dollars or income on the contract that was already taxed during the insured s life due to the failure of the contract to qualify as life insurance. 30 c. For viatical settlement transactions, amounts received during the insured s life may be income tax-free as accelerated death benefits if the insured is terminally ill or chronically ill as defined under 101(g)(2) and (3). 2. The death benefit may be taxed to a C corporation under the alternative minimum tax The death benefit may also be taxed due to other rules governing employer-owned life insurance (sometimes called COLI Best Practices rules). Under I.R.C. 101(j), if an employer purchases life insurance on the life of an employee (or an officer or director), the employer will be income taxed on the death benefit it receives in excess of basis. a. Luckily, it is possible to escape this bad outcome. To do so, the employer must provide the employee written notice of the purchase, and the employee must consent to that purchase in writing all before the policy is issued. 32 b. Presuming proper notice and consent occurs, then per I.R.C. 101(j)(2), the death benefit is tax-free (under normal rules of I.R.C. 101) if (1) The death benefit is paid to certain parties related to the insured employee (family members, estate), or is used to buy a business interest from these parties (entity buy-sell); and/or (2) The death benefit is paid to the employer, and the employee was a director or highly compensated employee at the time policy was issued. In this case, the death benefit can be received by the employer tax-free regardless of whether the insured employee dies while working there, or many years after terminating employment (e.g., quit, get fired, retire); and/or

11 (3) The death benefit is paid to the employer, and the employee was not a director or highly compensated employee at the time policy was issued. In this case, the death benefit is tax-free only if the insured employee dies while working there, or within 12 months after terminating employment (e.g., quit, get fired, retire). c. These I.R.C. 101(j) rules are effective for policies issued after Aug. 17, If a policy is issued before that date, and then 1035 exchanged after that date, the new policy is not subject to these rules unless there is a material increase in death benefit or other material change. Because of the vagueness of this standard, it s safest to assume the new policy is subject to the rules, and to get the requisite notice and consent. d. Employers are also required to annually file with the I.R.S. Form 8925, in which the employer is to reveal certain information about the insurance policies it owns on employees. 4. Transfer-for-Value Rule. The death benefit may be taxed if the policy or an interest in it has been transferred for valuable consideration. 33 This exception to the general rule of tax-free death proceeds, generally referred to as the transfer-for-value rule, can have broad applications. a. The transfer-for-value rule is concerned with income taxation of proceeds received upon the insured s death. It is not concerned with any income tax imposed at the time of the lifetime transfer that triggers the rule. b. Specifically, the statute reads as follows: In the case of a transfer for valuable consideration, by assignment or otherwise, of a life insurance contract or any interest therein, the amount excluded from gross income... shall not exceed an amount equal to the sum of the actual value of such consideration and the premiums and other amounts subsequently paid by the transferee I.R.C. 101(a)(2). 34 I.R.C. 101(a)(2). 11

12 (1) Valuable consideration means much more than just a cash payment. It includes anything of value, including a promise to do or refrain from doing something in exchange for a policy or any policy interest. To be safe, many practitioners presume the rule is triggered if the transaction is for any reason other than entirely and solely a gift. (2) Note that the rule applies to any interest therein. This includes but is not limited to: an ownership right; a beneficiary designation (at least those that are irrevocable or become so after the insured s death); and may include a policy interest in certain types of split dollar plans (e.g., an endorsement). (3) Treasury Regulations provide that the pledging or assignment of a policy for collateral security is not a transfer for a valuable consideration. 35 (a) (b) Because of this provision, it is commonly accepted by practitioners that the release of a collateral assignment on a policy is not a transfer for valuable consideration. The I.R.S. has never addressed this issue, probably because the conclusion is obvious. Although this Treasury Regulation may seem to help frequent lenders such as banks, it also provides that the tax-free treatment of death proceeds under 101 is inapplicable to any amounts received by the pledgee or assignee. 36 Presumably when a lender receives amounts from an assigned policy upon the insured s death, it is taxed to the extent the amount received exceeds the loan principal (e.g., accrued interest). c. There are several exceptions to the transfer-for-value rule. Meeting an exception preserves the income tax-free treatment of the death benefit. 35 Treas. Reg (b)(4). 36 Treas. Reg (b)(4). 12

13 (1) The first set of exceptions is based on the transferee s relationship to the insured. Under 101(a)(2)(B), the exceptions are for transfers to: (a) (b) (c) (d) the insured; a partner of the insured (which includes a member of an LLC taxed as a partnership, but does not include a co-shareholder in a C or S Corporation); a partnership in which the insured is a partner (or LLC taxed as a partnership in which the insured is a member); or a corporation in which the insured is an officer or a shareholder (available to both C and S Corporations). (2) The other exception is where the transferee s basis in the contract is determined in whole or in part by reference to the transferor s basis in the contract, or, more simply put, where the transferor s basis carries over to the transferee. 37 (a) (b) The transferor s basis carries over in a number of situations, such as transfers to a spouse under 1041, tax-free reorganizations, incorporations, contributions to capital, contributions to and certain distributions from partnerships, and pure gifts. Transfer-for-value is often a concern when there is a part gift / part sale transaction. These generally occur whenever the amount the transferee pays the transferor for the policy (the part sale ) is lower than the policy s value (the shortfall being the part gift ). These transactions raise transfer-forvalue questions because the sale part triggers the transfer-for-value rule, but the transferor s basis carries over in only some of these transactions. More specifically, the 37 I.R.C. 101(a)(2)(A). 13

14 transferee s basis in the property is the greater of: the amount deemed paid by the transferee; or the transferor s basis. 38 (c) Frequently, the amount paid by the transferee comes in the form of the transferee taking over a policy loan (because the transferor is discharged of that debt). In such a situation, the carryover basis exception will be met only if the loan is lower than the contract s basis. (d) (e) (f) (g) For example, Mom owns a policy on herself with a value of $40,000, a basis of $30,000, and a loan of $25,000. Mom then transfers the policy to Son. Because the policy s net value is $15,000 ($40,000 less $25,000), that is the part gift. The $25,000 loan assumed by Son is the part sale, because that is what he is deemed to pay Mom. After taking ownership, Son s basis is the higher of Mom s basis ($30,000) or what he paid ($25,000). Because Son s basis is determined by reference to Mom s basis, this transaction meets the carryover basis exception. In the same example above, if Mom s basis were merely $20,000, then Son s basis would instead be determined by the amount he paid ($25,000), not Mom s lower basis ($20,000). The carry over basis exception to the transfer-for-value rule would not be met, and the death benefit in excess of what Son paid would be income taxable. To avoid this trap, Mom could (before the transfer) pay off enough of the policy loan so that it is lower than her basis. If the above example (where loan exceeds basis) is changed so that the insured is the Son, the transfer would meet the to the 38 Treas. Reg ; see also, Rev. Rul , C.B

15 insured exception, and tax-free death benefit would be preserved. Whenever the transfer-for-value rule is violated, the taint on the policy can be removed if the last transfer before the insured s death is to one of the exempt transferees listed in (1) above. 39 (3) For second-to-die contracts, the exceptions for exempt transferees apply only if both insureds are involved in the exception (e.g., a partner of the insureds). (a) (b) Deceptively, it s not clear whether a transfer of a second-to-die policy to both insureds meets the transfer-to-the-insured exception. For example, Mom and Dad buy a policy on their joint lives from Daughter and are now joint owners of the policy. The argument that this meets the to the insured exception is, naturally, that the two transferees are the two insureds. The contrary argument that the to the insured exception is not met is based on the theory that Dad has purchased a policy insuring someone in addition to himself, and that this indivisible policy interest which insures Mom was not transferred to the insured with respect to Dad. The same goes for Mom. If Mom and Dad fear this result, they could become partners in a bona fide partnership before the transfer, in which case the to a partner of the insured exception is met. D. POLICY WITHDRAWALS 1. Policy Loans a. A loan from a policy generally is not taxed, because the borrowed amount must eventually be repaid to the insurer and bears interest. 39 Treas. Reg (b)(2). 15

16 b. A loan from a MEC, however, is treated as a distribution from the MEC and is taxed to the extent of the gain in the contract at the time of the loan. 40 (1) Pledging or assigning a MEC as collateral is treated as a policy loan, and likewise is taxed to the extent of gain in the contract. 41 This includes the typical collateral assignment equity split dollar arrangement. Also, If the assigned policy is a MEC (whether relating to a split dollar arrangement or otherwise), it s possible that the equity (policy s gain) is taxed as a deemed withdrawal as the cash value grows for as long as the assignment remains on the policy. The law isn t entirely clear on the issue, and some argue that tax should be imposed only on the gain in the one year that the collateral assignment is created. To avoid this issue, do not use or immediately remove a collateral assignment on a MEC. (2) The taxpayer (normally the policyholder) is generally subject to an additional 10% tax on the income recognized upon a withdrawal from a MEC. 42 Some exceptions apply, such as being over age 59½. 43 c. A policy loan extinguished in a 1035 exchange is taxed to the extent of the gain in the contract. 44 See E.2, below. 2. Dividends, Partial Surrenders, and Policy Reductions a. Cash released in the form of a dividend, partial surrender, or reduction in a non-mec contract is generally not taxed until the cumulative withdrawals exceed the contract s basis. 45 (1) This is often called the first in, first out (FIFO) method of taxation because the investment in the contract is treated as going in first and going out first. 40 I.R.C. 72(e)(10)(A)(i). 41 I.R.C. 72(e)(4)(A)(ii). 42 I.R.C. 72(v). 43 See I.R.C. 72(v). 44 I.R.C. 1035(d)(1). 45 I.R.C. 72(e)(5). 16

17 (2) This FIFO withdrawal rule does not apply to loans; loans in excess of basis do not generate taxable income. b. Under the forced-out-gain rule of 7702(f)(7)(B), a withdrawal can cause some or all of the gain in a contract to be taxed before the basis is recovered. 46 (1) The types of withdrawals that are subject to the forced-out-gain rule include a surrender of additions and a partial surrender or reduction. (a) (b) A policy loan or assignment does not trigger the rule s application. Dividends received in cash generally do not trigger the rule s application either. (2) Gain is forced out if: (a) (b) (c) (d) the policy is a non-mec policy issued after December 31, 1984, the withdrawal is taken in the first 15 policy years, the withdrawal reduces the death benefit, and the maximum cash value allowed after the reduction per rules delineated in 7702(f)(7) is lower than the actual cash surrender value before the reduction. Forced-out-gain will be recognized on the lesser of the amount of the difference or the gain in the contract. c. MEC rules. Cash received from a dividend, partial surrender or reduction of a MEC is taxed to the extent of gain in the contract The Northwestern Mutual Network Illustration System (NIS) generally will determine whether a partial withdrawal will trigger forced out gain. To obtain help in using NIS for this purpose, Northwestern Mutual financial representatives should contact the sales support area of life products. 17

18 (1) This is often called the last in, first out (LIFO) method of taxation because the gain in the contract is treated as being the last in and the first out. (2) The types of MEC withdrawals that are subject to the LIFO method include a surrender of additions, dividends received in cash, a partial surrender or reduction, and policy loans or assignments. (a) (b) (c) Loans used to pay premiums are treated as taxable withdrawals to the extent of gain. Dividends used to pay premiums are not treated as taxable withdrawals. Additions that are surrendered to pay premiums are also generally not treated as taxable withdrawals either. 48 (3) The taxpayer (this is the policyowner, not necessarily the insured) is also subject to an additional 10% tax on the income recognized upon a distribution/withdrawal from a MEC. 49 This 10% penalty tax does not apply to any distribution: (a) made on or after the taxpayer attains age 59½. If a trust is the policyowner, the withdrawal arguably can meet this age exception if the trust is a grantor trust for income tax purposes, and the individual grantor is over age 59½. (b) attributable to the taxpayer becoming disabled. (c) which is a part of a series of substantially equal periodic payments over the life or life 47 I.R.C. 72(e)(10)(A)(i). The Northwestern Mutual Network Illustration System (NIS) generally will determine whether a policy will be issued as or become a MEC. To obtain help in using NIS for this purpose, Northwestern Mutual financial representatives should contact the sales support area of life products. 48 See Conference Committee Report to Technical and Miscellaneous Revenue Act of 1988, P.L , Act 5012 and 5014: Under these [MEC] rules, any amount in the nature of a dividend or similar distribution that is retained by the insurer as a premium or other consideration paid for the contract is not includible in gross income of the owner of the contract. (Emphasis added). 49 I.R.C. 72(v). 18

19 expectancy of the taxpayer, or joint lives or joint life expectancy of the taxpayer and a beneficiary (e.g., a lifetime annuity). E. POLICY TERMINATIONS (TAXABLE & TAX-FREE EXCHANGES) 1. Complete Surrender or Lapse a. The entire gain in the policy (gross cash value over investment in the contract) is taxed as ordinary income when the contract is completely surrendered or lapses. 50 b. The gain may be deferred by the policyholder if: (1) the policy is surrendered under an income tax-free 1035 exchange, although if the policy has both a loan and gain when carrying out a 1035 exchange, taxable income is incurred, or (2) the policyholder elects a settlement option to receive amounts as an annuity (annuitizing the contract). 51 For a policy with both a loan and gain, the law implies that taxable income is not incurred when it is annuitized (basis is reduced tax-free by the amount of the loan before annuitization). c. If the surrendered policy is a MEC, the taxpayer is subject to an additional 10% tax on the gain recognized. 52 The exceptions to this general rule are: the taxpayer is age 59½, disabled, or the distribution is part of a series of substantially equal periodic payments over the taxpayer s life. 53 d. Are losses on life insurance policies deductible? Several cases have held that policyholders cannot take an income tax deduction when the amount received upon sale or surrender of a policy is lower than the investment in the contract. 54 Most practitioners interpret these as holding that no deduction is allowed for any loss realized on the 50 I.R.C. 61 and I.R.C. 72(h) and (e). 52 I.R.C. 72(v) and 7702A. 53 I.R.C. 72(v)(2). 54 London Shoe Co., Inc. v. Comm r., 80 F.2d 230 (2d Cir. 1935); Century Wood Preserving Co., v. Comm r., 69 F.2d 967 (3d Cir. 1934); and Keystone Consolidated Publishing Co. v. Comm r., 26 BTA 1210 (1932). 19

20 surrender of a life insurance policy. Other practitioners, however, interpret these and related cases as simply holding that a loss is rarely realized upon a surrender of a life policy (under the view of these old cases that basis rarely exceeds cash value), but when a loss is in fact realized, it is deductible. 55 Nonetheless, those deducting losses on life insurance policies should be prepared for a fight with the I.R.S. 2. Section 1035 Tax-Free Exchanges a. The surrender of one policy for another is a taxable event but for b. If the transaction qualifies under 1035, no gain or loss is recognized when a life insurance contract is exchanged for another life insurance contract or for an annuity (or, starting in 2010, for a long term care insurance contract). Annuities cannot be exchanged tax-free for a life insurance policy, but can be exchanged for another annuity (or, starting in 2010, for a long term care insurance contract). c. In addition to avoiding income upon policy surrender, there are two more reasons to do a 1035 exchange. (1) After a 1035 exchange, the owner s basis in the new contract will generally be the same as the basis in the original contract. 56 Where the old policy s cash value is less than premiums paid, the new policy will have a higher basis than it would have had if the surrendered cash value had been paid into the new policy without a qualifying exchange. The higher basis means that more cash can be withdrawn from the new policy without triggering gain. (2) Large lump sums deposited in a new policy frequently result in a MEC, but 1035 exchanges often avoid this result. This is because the lump sum put into a new policy under a 1035 exchange is somewhat disregarded for MEC testing under the special material change 7-pay test. The new policy received in a 1035 exchange is not a MEC unless 55 See Cohen v. Comm r., 44 B.T.A. 709 (1941); and Fleming, PH TCM P (1945). 56 I.R.C. 1035(d)(2). 20

21 substantial new premiums are paid into the new policy. See g., below. d. In order to qualify under 1035, the life policy received in the exchange must be on the same insured or insureds as the old life policy. This means that exercising a change of insured policy option does not qualify as a tax-free exchange, but the exercise does qualify for special material change testing. See g., below. e. Different insurance carriers can be involved in the exchange and different types of policies can be used. 57 Traditional policies can be exchanged for universal life and vice versa. Likewise, portfolio based or fixed policies can be exchanged for variable policies and vice versa. 58 f. If money or other non-like kind property is received in an exchange (so-called boot ), that money or property is taxed to the extent of the policy gain. (1) Certain insurers, Northwestern Mutual included, will not issue a new policy with a loan outstanding. Any 1035 exchange to Northwestern Mutual made with a contract subject to an existing loan will result in the loan being eliminated in the exchange. (2) The elimination of a policy loan pursuant to a 1035 exchange is considered the same as the receipt of money and triggers income tax on whichever is lower: (a) (b) the loan extinguished, or the gain in the contract. g. After a 1035 exchange, the new contract may or may not be a MEC. (1) If the original contract is a MEC, this status carries over to the new contract. (2) If the original contract is not a MEC, the tax-free exchange is treated as a material change for 57 Rev. Rul , C.B Rev. Rul , C.B

22 purposes of 7702A and the new contract must be tested for MEC status. (a) (b) The special 7-pay test for material changes is applied in determining whether the new policy will be classified as a modified endowment. Even though the new contract must be tested for MEC status, a lump sum paid into a new contract via a 1035 exchange in and of itself will not cause the new contract to MEC, whereas a lump sum of the same amount being paid outside of a 1035 exchange very well can cause the new contract to be a MEC. h. After a 1035 exchange, a new 15-year period begins for purpose of determining forced-out-gain under 7702(f)(7). i. After a 1035 exchange, a new 7-year period begins for purposes of the 4 out of 7 rule under 264 (relating to deductibility of interest on amounts borrowed to purchase or carry life insurance). 3. Trade or Exchange of Policies on Different Insureds (Termination of Cross-Purchase Buy-Sells) a. Gain is recognized when parties own policies on different insureds and trade or exchange those policies (e.g., upon formation or termination of a cross purchase buy-sell agreement). Because the insureds are different, the transaction does not qualify for tax-free treatment under 1035 and is treated as a sale of the policies rather than a qualifying 1035 exchange. b. Each party s gain is determined by: (1) adding the value of the policy received to the cash (or other property) received, then (2) subtracting the sum of: (a) the basis of the policy transferred, and 22

23 (b) any cash (or other property) paid in the transaction. c. Ultimately, a party s basis in the newly acquired policy is generally the gross cash surrender value of the policy received. Any cash received in the transfer does not add to basis. 4. Change of Insured a. Exercising a change of insured option is treated as the surrender of the contract for income tax purposes and does not qualify as a 1035 exchange because the insured is not the same. This means that the entire gain in the policy is taxed as ordinary income. 59 b. When changing the insured on an older policy, it may be possible for the new policy to fail the definition of life insurance because mortality assumptions for older contracts may not be acceptable under the current definition of life insurance. F. POLICY TRANSFERS 1. There are generally three types of policy transfers. a. Transfers for valuable consideration, b. Transfers by gift, and c. Transfers that are part gift and part sale. 2. Transfers for Valuable Consideration a. Transfers for valuable consideration include the following: (1) The sale of a policy. (a) (b) If the amount received exceeds the seller s basis in the policy, the seller generally recognizes income under 1001(a). The buyer s initial basis generally will be the amount paid to the seller I.R.C. 1035; Rev. Rul , C.B I.R.C. 1011(a) and

24 (2) The transfer of a policy in exchange for services performed (e.g., employer to employee). (a) (b) (c) (d) The transferor-employer generally recognizes income on the gain in the policy. 61 The transferor-employer is also entitled to an offsetting deduction for the fair market value (often roughly equal to net cash value) of the policy if the compensation is reasonable. 62 the transferee-employee recognizes income in an amount equal to the value of the policy (i.e., the net cash value). 63 The amount recognized by the transfereeemployee generally will be the transferee s new basis in the policy, regardless of what the transferor s basis was in the policy. b. The transferor-employer s current recognition of gain has little to do with whether the transfer meets an exception to the transfer-for-value rule, which instead deals with whether income tax will ultimately be imposed on the death benefit. In fact, the policy may be surrendered well before the insured dies. c. If the sale is to an unrelated party who would suffer no economic loss upon the insured s death, the parties to the sale should carefully consider whether and how Revenue Ruling would apply to the transaction. See definition of basis in section I.C.2. on p. 2 of this outline. 3. Transfers By Gift a. A gift of a policy generally results in no current income tax on the gain in the contract. b. The transferee does not include the value of the gift in income I.R.C. 1001(a). 62 I.R.C. 83 and 162(a); Treas. Reg (b); United States v. Davis, 370 US 65 (1962); International Freighting Corp. v. Comm r., 135 F.2d 310 (2d Cir. 1943). 63 I.R.C

25 c. The transferee generally has a carryover basis in the policy. 1015(a). The transferee s basis is increased by gift taxes paid on the gift. 65 d. A gift of a policy generally results in no transfer-for-value problem because it is a purely gratuitous transfer instead of a transfer for valuable consideration. Moreover, because gifts result in a carryover basis, the transferee s basis in the contract is determined in reference to the transferor s basis an exception to the rule. 66 e. A gift of a policy is subject to gift tax. 67 (1) The gift tax value of the policy is generally determined by whether the policy is newly issued, paid-up, or still in need of premiums. See I.C.5.c., above. (2) For gifts to charity, the donor s deduction is generally limited to the lower of the policy s value or the donor s basis in the policy. 68 f. If the policy is subject to an outstanding loan, income can be recognized on the transfer, the basis may not carry over, and there may be a violation of the transfer-for-value rule. See below. 4. Transfers That Are Part Gift and Part Sale a. The most typical part gift / part sale transaction occurs when a transferor gives a policy that has an outstanding loan. Because the policy loan is nonrecourse and the transferee takes on the loan along with ownership of the policy, the transferor benefits from discharge of the indebtedness, which is treated as an amount paid by the transferee to the transferor. (1) The part gift is equal to the net surrender value of the policy. The part sale is equal to the loan, which the transferee is deemed to pay for the policy. 64 I.R.C. 102(a). 65 I.R.C. 1015(d). 66 I.R.C. 101(a)(2)(A). 67 Treas. Reg (h)(8). 68 I.R.C. 170(e)(1)(A). 25

26 (2) If the part gift / part sale is made to a charitable organization, the transferor s basis is allocated partly to the gift portion and partly to the sale portion of the transaction. 69 If the transferee is not a charity, this allocation does not happen. (3) In a part gift / part sale, the transferee s basis in the contract is the greater of the following: (a) (b) transferor s basis, or the amount of the outstanding loan that the transferee is deemed to have paid. 70 (4) If the policy loan is greater than the transferor s basis in the policy: (a) (b) the transferor currently recognizes gain to the extent the amount of the loan exceeds the basis. because the transferee s basis is determined by the loan and not by the transferor s basis, the carryover basis exception to the transfer-for-value rule is unavailable, and the death proceeds will be income-taxed unless the transferee is an exempt transferee. See II.C.3., above. (5) If the policy loan is lower than the transferor s basis: (a) (b) the transferor does not recognize gain. because transferee s basis is determined in part by the transferor s basis, the transferfor-value rule does not apply, and the death proceeds remain income tax-free. 69 I.R.C. 1011(b). 70 Treas. Reg (a)(1). 26

27 III. COMMON TRANSACTIONS, TRAPS, AND SOLUTIONS: OR, LIFE INSURANCE IN THE WILD The foregoing rules are often viewed in a petting zoo context: they re nice lambs and goats and ponies that we can pet or ride. The strange anomalies, like the MEC and transfer-for-value rules, are often fancied in glass encasements: not dangerous from tapping distance. But this is not how we see these beasts, if we spot them at all, and some are not pettable or rideable. Some are slithery venomous varmints that lurk along the most pedestrian of planning paths. This section takes a walk through the advanced planning jungle to encounter these tax rules in their natural habitat: common, every day planning situations. When reading the following case studies, carefully consider the possibility that basis is lower than investment in the contract (cumulative premiums) due to the application of Revenue Ruling , discussed above. A. WITHDRAWALS 1. CASE 1: Modified Endowment Contract. Parent purchases a permanent life insurance policy that becomes a MEC in the fifth year. In year 6, the policy has cash value of $50,000 and a basis of $20,000. In that year, Parent withdraws $20,000 from the policy to pay his child s tuition expense. a. Tax Trap: The gain in the contract will be taxed before the basis is recovered. Of the $30,000 gain, $20,000 of it (the amount of the distribution) will be taxed. Parent will either have to withdraw more funds than actually needed to pay the tax or pay it with funds outside the contract. b. Tax Trap: To make matters worse, if Parent is under age 59½, Parent will have to pay an additional 10% tax on the $20,000 of gain recognized. 2. CASE 2: Partial Surrenders Because Less Insurance Needed. Taxpayer purchased a non-mec (but cash rich) policy a few years ago to pay off the mortgage in the event of a premature death. Policyowner has paid down the mortgage much faster than originally planned. Taxpayer now wants to reduce the policy s death benefit to match the mortgage amount, and withdraw the excess cash value from the policy to use for other purposes. a. Tax Trap: Forced-Out-Gain. If the policy s cash value before the reduction exceeds the maximum allowable cash value after the reduction, some or all the gain in the contract is taxed under 7702(f)(7). The amount of tax due reduces the amount of cash available for other purposes. 27

28 b. Tax Trap: Reduction in Death Benefit Can Create a MEC. To make matters worse, the drop in the death benefit in the first seven years of the contract triggers a recalculation of the 7-pay test, which can cause the policy to become a MEC. If the policy becomes a MEC, withdrawals (including loans) are taxed to the extent of policy gain, plus a potential 10% penalty. This greatly reduces Taxpayer s future flexibility with the contract. c. Solution: The forced-out-gain rule is avoided if Taxpayer waits until the 16 th year to make the reduction. Also, waiting longer to withdraw money makes triggering of MEC status less likely. If cash is needed now, take a policy loan and pay the loan interest (instead of tax) until the contract can be reduced without forcing out gain or causing MEC status. 3. CASE 3: Terminating a Split Dollar Plan. Employer sets up a split dollar plan with Employee, where Employee owns policy and collaterally assigns policy to Employer to the extent of Employer s interest. Under the plan, Employer s interest is equal to the premiums it pays, with the Employee controlling any cash value exceeding premiums (this excess amount controlled by Employee is often called equity ). If this arrangement is entered into after September 17, 2003, it is taxed as a loan under the final split dollar regulations (account for yearly interest rates); if entered into before that date, it is taxed as traditional split dollar (account for yearly term rates). The intent is to terminate the plan in the 14 th year by surrendering additions (cash values accumulated from applying policy dividends to buy additional insurance) to repay the employer. a. Tax Trap: Forced-Out-Gain. If the policy s cash value before the surrender exceeds the maximum allowable cash value after the surrender, some of the gain in the contract is taxed to the Employee-policyowner under the forced-outgain rule of 7702(f)(7). The amount of tax due reduces the amount of cash available to the Employee to repay Employer. b. Solution: Use resources outside the policy to pay back Employer. Or, if such resources aren t available, and it is important to terminate the plan in the 14 th year, Employee can borrow from the policy to repay Employer and then surrender additions in the 16 th year to eliminate the loan on 28