Chapter 30 - § 30.5 • INCOME TAX ISSUES — GENERALLY

• Jurisdiction: Colorado

§ 30.5 • INCOME TAX ISSUES — GENERALLY

Holding a life insurance policy by a trust that has not been funded with other types of assets and the collection of death benefits by a trust generally do not result in adverse or complex income tax issues for the trust, its beneficiaries, or an insured.

Adverse income tax consequences and complex income tax issues for an ILIT can occur when there is a transfer for value of a policy or by operation of the grantor trust rules. Transfer for value issues often arise in the context of curation of a poorly designed trust instrument or a change of circumstances that requires modification of the terms of the trust. When a trust recognizes income as a result of the trust holding property in addition to life insurance policies or as a consequence of an event that has occurred with respect to a policy that results in income recognition, the grantor trust rules may create uncertainty as to who owns the items of income, loss, deduction, or credit.

§ 30.5.1—General Rule of Income Tax Exclusion

I.R.C. § 101(a) provides that "gross income does not include amounts received (whether in a single sum or otherwise) under a life insurance contract, if such amounts are paid by reason of the death of the insured."

The exclusion from gross income applies whether the payment is made to the estate of the insured or any beneficiary. It further applies regardless of whether payment is made directly or in trust. Treas. Reg. § 1.101-1(a)(1). The proceeds are excluded from gross income of the beneficiary regardless of whether payments by reason of death are paid in a single sum or in installment form; however, the exclusion does not apply to the portion of any payment that constitutes interest. I.R.C. § 101(c).⁴⁵

To qualify for the income tax exclusion, the policy must meet the tax law definition of a "life insurance contract."⁴⁶ Insurers typically exercise particular diligence to ensure a policy meets the definition and even if a policy fails to satisfy the test, the IRS may disregard the failure if it was due to reasonable error and the insurer is attempting to remedy the error. I.R.C. § 7702(f)(8). The determination of whether a life insurance contract meets the definition requires sophisticated actuarial computations; such an analysis is generally inappropriate and unnecessary for the purpose of the purchase of a policy.

§ 30.5.2—The Transfer for Value Rule

If an existing life insurance policy is transferred for a valuable consideration, the exclusion from gross income is not available to the beneficiary of the death benefits. I.R.C. § 101(a)(2). The beneficiary includes in his or her gross income the policy proceeds, less the total of the actual value of the consideration paid, premiums paid, and other amounts subsequently paid by the transferee. Id. Actual assignment of the policy need not occur to trigger the rule, and a contractual right to receive policy proceeds will cause the application of the rule. Lambeth v. Comm'r, 38 B.T.A. 351 (1938).

§ 30.5.3—Exceptions to the Transfer for Value Rule

Basis Determined by Reference to Transferor's Basis

Where the transferee's basis is determined, in whole or in part, by reference to the transferor's basis, the transfer avoids the transfer for value rule and the general rule of exclusion from gross income applies. I.R.C. § 101(a)(2)(A). A gift of a policy to an ILIT therefore falls within this exception to the transfer for value rule.⁴⁷

Example: The insured transferred a life insurance policy into an irrevocable trust. The beneficiaries of the trust are the children of the insured. The insured's basis in the policy was $75,000. The policy is subject to indebtedness in the amount of $65,000. The trust's acquisition of the policy was therefore acquired in part for valuable consideration and in part by gift. The basis of the policy was determinable, in part, by reference to the basis of the policy in the hands of the insured. Four years after the assignment of the policy, the insured died.

Result: Since the transferee's basis is determined by reference to the transferor's basis, the transfer for value rule does not apply and amounts received by the beneficiary of the policy (the trustee) are excluded from gross income.

See Treas. Reg. § 1.1015-4; Rev. Rul. 69-187, 1969-1 C.B. 45; PLR 8951056.

Transfers to the Insured

I.R.C. § 101(a)(2)(B) specifically lists transfers "to the insured" as an exception to the transfer for value rule. Transfers to or from grantor trusts of which the insured is considered the owner pursuant to the grantor trust rules are considered to be a transfer to or from the insured. Rev. Rul. 2007-13, 2007-11 I.R.B. 684. See also Swanson v. Comm'r, 518 F.2d 59 (8th Cir. 1975); Rev. Rul. 85-13, 1985-1 C.B. 184.

Transfers Pursuant to I.R.C. § 1041

There is no gain or loss recognized on transfers of property between former spouses where the transfer is incident to divorce or between spouses not within the context of a divorce. I.R.C. § 1041(a). See also PLR 200120007. Where such transfers occur, the transfer is treated as a gift and the transferee takes the transferor's basis. I.R.C. § 1041(b). Accordingly, the general rule of exclusion from gross income applies.

Other Exceptions

There are other exceptions to the transfer for value rule. Transfers to a partner of the insured (or a partnership of which the insured is a partner) and transfers to a corporation in which the insured is a shareholder or officer are among the other exceptions that allow the general rule of exclusion to apply. I.R.C. § 101(a)(2)(B).

§ 30.5.4—Increase in Cash Value

A policy owner recognizes no income on the annual increases in cash surrender value of a life insurance policy. I.R.C. § 7702(g) (for policies issued after 1984). For policies issued before 1985, the same rule applies. See Cohen v. Comm'r, 39 T.C. 1055 (1963), acq. 1964-1 C.B. 4.

§ 30.5.5—Dividends Received in a Life Insurance Policy

Policy dividends on a participating life insurance policy are considered to be a return of premiums and are not included in the policy owner's gross income until the dividends, combined with previous non-taxable distributions from the policy, exceed all of the premiums or other consideration paid.⁴⁸ If, however, the dividends remain with the insurance carrier, the dividend is not taxable.⁴⁹

§ 30.5.6—Amounts Received in Surrender of a Policy

A single sum amount received by a policy holder upon surrender is included in the policy holder's gross income to the extent the amount received exceeds the "investment in the contract." I.R.C. § 72(e)(5)(A) and (E).⁵⁰ The term "investment in the contract" is defined in I.R.C. § 72(c)(1) to mean the aggregate amount of premiums or other consideration paid for the contract less the aggregate amount received under the contract before such date, to the extent that such amount was excludable from gross income. For further discussion, see H. Zaritsky & S. Leimberg, Tax Planning with Life Insurance, § 3.03[3].

§ 30.5.7—Single Premium and Modified Endowment Rules

A modified endowment contract is defined in I.R.C. § 7702A to mean any life insurance contract (that meets the definitional requirements of I.R.C. § 7702) that (1) is entered into on or after June 21, 1988; and (2) fails to meet the "seven-pay test."

The seven-pay test is not met when the cumulative premium payments in any one of the first seven years exceeds the sum of the net level premiums that would have been paid to provide a paid-up policy after the payment of seven level annual premiums. I.R.C. § 7702A(b).⁵¹ The computation involves actuarial calculations.

Result of Modified Endowment Contract Classification

Death Benefits and Cash Value Buildup

Death benefits are treated the same as other contracts (i.e., they are received by the beneficiary income tax free). Cash value buildup is also treated in the same manner as other insurance contracts (i.e., it grows on a tax-free basis).

Policy Withdrawals, Loans, and Pledges

If a policy withdrawal or distribution occurs, cash value earnings are recognized as gross income before any investment or basis is recovered. I.R.C. § 72(e)(10) and (2)(B). Loans against cash value or a pledge of the contract are treated as distributions. I.R.C. § 72(e)(4)(A). Dividends used by the insurer to pay premiums and paid-up additions are a different matter. Such amounts are not considered distributions (according to the legislative history). Conference Committee Report, H.R. 4333. All other dividends are taxed as distributions if the policy is determined to be a modified endowment contract.

Ten Percent Penalty Tax

In addition to inclusion in the policy holder's gross income, a 10 percent additional tax is imposed on the distribution. I.R.C. § 72(v)(1). Exceptions to the penalty tax occur when distributions are made after the recipient attains age 59½, or if the recipient is disabled, or receives the distribution as part of a series of qualifying periodic payments. I.R.C. § 72(v)(2)(A), (B), and (C).

Grandfathered Contracts

If a policy was issued prior to June 21, 1988, the modified endowment rules do not apply. It is possible for a contract to lose its grandfathered status as a result of changes made to the contract, policy exchanges, and term conversions. I.R.C. § 7702A(c)(3).

Conclusion — Modified Endowment Contracts

It is possible for a trustee of an ILIT to purchase a policy by making a single premium or a small number of premium payments, thereby causing the policy to be categorized as a Modified Endowment Contract. Funding of the trust must, of course, be in sufficient amounts to allow such a...