Transcript Insurance Marketing Concepts

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
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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.
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Life Insurance Tax Basics
• Premiums are not tax deductible
• Death benefits are income tax exempt
• Cash values are tax-deferred
Life Insurance
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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.
• John’s 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
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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.”
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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
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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
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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
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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
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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
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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)
• Policy’s 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
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Taxation of Life Insurance
Modified Endowment Contracts (MECs)
“Material Changes”
• Term rider attachments
• Conversion of Dividend Accumulations to Paidup Additions
• Death Benefit Increases
• Certain Universal Life corridor increases
Life Insurance
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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
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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 owner’s beneficiary
Life Insurance
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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
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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
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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 owner’s beneficiary
Annuities
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Taxation of Annuities
Death 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
holder’s death
Annuities
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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
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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
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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?, can’t 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
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Life Insurance Death Proceeds
Transfer 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
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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
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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 A’s
estate
 B buys A’s interest in policy on C’s life
 C buys A’s interest in policy on B’s life
• Transfer for Value?
Life Insurance
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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
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Transfer for Value
Examples:
• Mom gifts life insurance policy to daughter.
Policy has outstanding loan.
 Premiums paid
 Outstanding loan
 Net Cash Surrender Value
$ 8,000
$ 5,000
$10,000
• Transfer for Value?
Life Insurance
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Transfer for Value
Examples:
• Mom gifts life insurance policy to daughter.
Policy has outstanding loan.
 Premiums paid
 Outstanding loan
 Net Cash Surrender Value
$20,000
$25,000
$12,000
• Transfer for Value?
Life Insurance
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Transfer for Value
Examples:
• Policy on A owned by A’s Irrevocable Trust
• A, concerned about one of trust beneficiary’s
ability to handle money, wants to change trust
Can A create new trust to buy the life insurance
policy from old trust?
Life Insurance
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Transfer for Value
Examples:
• Can A’s 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 200518061
Life Insurance
PLR 200247006
PLR 200514001
PLR 200606027
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. 28
PLRs cannot be relied on as can published rulings (Revenue Rulings).
Transfer for Value
Examples:
• Getting A’s Policy from A’s Old Trust to A’s
New Trust
• Any Other Options?
Life Insurance
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Transfer for Value
Getting A’s 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
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Transfer Value of a Life Insurance Policy
Rev. 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
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Transfer Value of a Life Insurance Policy
Rev. 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
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Transfer Value of a Life Insurance Policy
Rev. Proc. 2005-25; TD 9223 Regulations
PERC Definition: Aggregate of :
1) Cumulative premiums paid
2) Plus earnings credited on contract
3) Minus mortality charges and other reasonable
charges actually charges
4) Minus any distributions, withdrawals or
surrenders taken prior to valuation date
Life Insurance
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Transfer Value of a Life Insurance Policy
Rev. 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
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Transfer Value of a Life Insurance Policy
Rev. 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
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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
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Estate Tax Inclusion of Life Insurance
Section 2042
Death Proceeds includable in Decedent’s
Taxable Estate if:
• Payable to Decedent’s Estate
• Payable to Others, and decedent possessed at
his death any of the policy’s incidents of
ownership, exercisable alone or in conjunction
with any other person.
Life Insurance
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.
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Estate Tax Inclusion of Life Insurance
Section 2035
Death Proceeds includable in Decedent’s
Taxable Estate if:
• Decedent transferred or relinquished an
interest in property (including any incidents
of ownership in a life insurance policy on
Decedent’s life) during the 3 year period
ending on the date of decedent’s death.
Life Insurance
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.
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Life Insurance Tax Traps
Goodman Triangle Problem
• Dad doesn’t 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
Life Insurance
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.
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Life Insurance Tax Traps
Life Insurance Owned by Multiple Individuals:
Present Interest Exclusion Issue
• Dad doesn’t 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
Life Insurance
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.
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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
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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
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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
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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. Let’s keep things in
perspective as abusive uses of the tax benefits can lead to
loss of those benefits.
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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
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Common Uses of Life Insurance
Proceeds
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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
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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
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MassMutual Financial Group is a marketing designation (or fleet name) for
Massachusetts Mutual Life Insurance Company (MassMutual) and its affiliates.
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Massachusetts Mutual Life Insurance Company and affiliates, Springfield, MA 01111-0001 • www.massmutual.com