Chapter 31 - § 31.4 • TAXATION OF LIFE INSURANCE

• Jurisdiction: Colorado

§ 31.4 • TAXATION OF LIFE INSURANCE

§ 31.4.1—Income Taxation of Life Insurance

Tax Definition of Life Insurance Contract

A life insurance policy must meet the state and federal law definitions of life insurance to be able to reap the special tax benefits provided life insurance policies.³ The issue date and type of life insurance policy will determine which federal tax definition applies. All single premium and fixed premium policies issued before 1985 are subject only to judicial definition, which generally requires risk shifting and risk distribution. See Helvering v. LeGierse, 312 U.S. 531 (1941). Flexible premium policies issued before 1985 must meet the requirements of I.R.C. § 101(f). These requirements are similar to those later required under I.R.C. § 7702 and are designed to ensure a reasonable relationship between pure insurance coverage and policy cash values.

All policies issued after December 31, 1984, must meet the definition of life insurance contained in I.R.C. § 7702. All variable policies issued after 1983 must, in addition, meet the safe-harbor diversification requirements under I.R.C. § 817(h) and Treas. Reg. § 1.817-5T.

Under I.R.C. § 7702(a), a contract will be considered life insurance only if it meets the traditional requirements for life insurance by distributing mortality risk among many insureds. I.R.C. § 7702 also requires that an insurance policy must meet either the cash value accumulation test or the combined test of guideline premium and cash value corridor. The cash value accumulation test is usually used to qualify traditional whole life products, and basically requires that the cash surrender value never exceed the net single premium that would be necessary to fund all future benefits to a maturity date of age 95 to 100. I.R.C. § 7702(b)(1).

The guideline premium and cash value corridor test is usually used to qualify most flexible premium products. The guideline premium component is a limitation that prevents excessive premium payments compared to traditional fixed premium products. The cash value corridor limitation prevents excessive build-up of premium plus income (cash value) as compared to the death benefit. I.R.C. § 7702(c)(1), (c)(2), and (d). For the purpose of computing these tests, death benefits are those amounts payable by reason of the insured's death, other than "qualified additional benefits." Qualified additional benefits include policy features such as family term coverage, disability waiver of premium, accidental death or disability benefits, and other benefits prescribed by regulations. I.R.C. § 7702(f)(5)(A). If a policy fails to meet the I.R.C. § 7702 test in a particular year, the insurance company may return excess premium to the owner within 60 days of the close of the year. I.R.C. § 7702(f)(1)(B).

Lifetime Benefits

General Rules

Generally, the annual increases in the cash surrender value of a life insurance policy are not currently taxable to the policy owner under I.R.C. § 7702(g) and pre-1985 case law. However, if a life insurance policy does not meet the tax definition of a life insurance contract, this general rule will not apply. The amount of inside build-up that will be currently income taxable will depend on which definition disqualifies the policy.

For income tax purposes, a life insurance policy is generally valued the same as for gift tax. See Rev. Rul. 59-195, 1959-1 C.B. 18. See the discussion of "Gift of a Policy" in § 31.4.2. However, there are exceptions to this rule when a policy is transferred in connection with a qualified plan, a plan governed by I.R.C. § 79, or in connection with the performance of services. In those cases, the value of the policy will be determined by Revenue Procedure 2005-25, which applies to life insurance policies that are sold or distributed from qualified plans (including 412(i), 401(k), and profit-sharing plans), transfers of life insurance under I.R.C. § 79, and transfers of life insurance made in connection with the performance of services governed by I.R.C. § 83.

These valuation guidelines were aimed at curbing abusive practices involving transfers of life insurance. Upon the sale or distribution of a life insurance policy governed by these guidelines, the fair market value of such a contract (i.e., the value of all rights under the contract, including any supplemental agreements thereto and whether or not guaranteed) is generally included in the distributee's income and not merely the entire cash value of the contracts. Rev. Proc. 2005-25 (26 C.F.R. § 601.201). In other words, neither cash value nor cash surrender value can be relied upon as providing the value of a life insurance policy under these circumstances. The guidelines provide two alternative safe harbor formulas for non-variable policies and two safe harbor formulas for variable policies. Although meant to provide guidance for taxpayers, these new formulas are complex and difficult to apply. They also indicate that the IRS will carefully scrutinize attempts to minimize taxes by distributing policies for less than full fair market value.

Corporate Alternative Minimum Tax

The passage of the Tax Cuts and Jobs Act of 2017 (TCJA) lowered the maximum corporate income tax rate to 21 percent and eliminated the corporate alternative minimum tax (AMT). Prior to the TCJA, there was one exception to the general rule that the annual increases in cash surrender value were not currently taxable to the policy owner. The inside build-up on a corporate-owned life insurance policy would be taken into account for purposes of the corporate alternative minimum tax (AMT). A corporation was required to pay the AMT if the AMT exceeded the corporation's regular taxable income liability. I.R.C. § 55(a). For taxable years beginning after 1989, a C corporation adjusted its reported income to reflect its adjusted current earnings (ACE). The inside build-up of corporate life insurance was included in ACE for each year, except the year in which the insured dies or the policy is surrendered. Also, the death benefit paid to the corporation in excess of basis was an ACE adjustment. However, corporate ownership of life insurance did not necessarily result in the corporation being subject to AMT, as life insurance is only one of the many factors that determine the AMT.

Also, under The Taxpayer Relief Act of 1997, for tax years beginning after December 31, 1996, the AMT was eliminated for certain small C corporations with gross receipts of $5 million or less in the first year, or $7.5 million thereafter, as defined in I.R.C. § 448(c).

Policy Dividends

Dividends paid on a participating or "par" policy are considered to be a return of premiums and as a general rule are income-tax free until the dividends, plus any other amounts received income-tax free, exceed the premiums paid. I.R.C. § 72(e)(5); Treas. Reg. § 1.72-11(b)(1). This general rule applies to dividends regardless of whether the dividends are received in cash, used to purchase paid-up additions, used to buy one-year term insurance, or left with the insurance company to accumulate at interest (although the interest would be included in income if there are no restrictions on the owner's right to withdraw it). Cohen v. Comm'r, 39 T.C. 1055 (1963), acq. 1964-2 C.B. 4. When the dividends, together with other non-taxable distributions, exceed the premiums paid by the owner, any excess amounts are taxed as ordinary income. I.R.C. § 72(e)(5)(A).

Withdrawals

As a general rule, withdrawals from a life insurance policy will only result in inclusion in the gross income of the owner when the total previous withdrawals and tax-free distributions from the policy exceed the total premiums paid. Id. Policy loans from a policy that is not classified as a modified endowment contract are not treated as distributions (i.e., income) under I.R.C. § 72. There is an exception to the withdrawal rule for flexible premium policies when there is a cash distribution within the first 15 years after the issuance of the policy, accompanied by a reduction in the death benefits under the policy. I.R.C. § 7702(f)(7)(B) treats a cash distribution made on a reduction in the death benefit as includable in gross income to the extent of the excess of the cash value before the distribution over the policyholder's investment in the contract. The amount taxable depends on the "applicable recapture ceiling," which depends on when the reduction in benefits occurs, and which test is used to qualify the policy as life insurance under I.R.C. § 7702.

Surrender

Upon the complete surrender of a life insurance policy, any amount received in a single sum greater than the investment in the contract will be included as ordinary income in the gross income of the owner, as an amount not received as an annuity. See the discussion of "Distributions — Amounts Not Received as an Annuity" in § 31.7.1. If the policy has a loan in excess of the owner's basis at the time of surrender or lapse, the difference will result in a taxable gain.

Modified Endowment Contracts (MEC)

Even with the enactment of the tax definition of life insurance contract under I.R.C. § 7702 for policies issued after December 31, 1984, Congress was still concerned that certain single premium life insurance policies and other cash-rich policies were being marketed as tax-shelter investments. As a result, I.R.C. § 7702A was enacted, providing for a modified endowment contract. If a contract is a MEC, loans and lifetime distributions from the contract will be income to the owner to the extent of income in the contract. However, death benefits of a MEC are treated as any other life insurance policy and are income tax-free. In addition, there is a 10 percent penalty if the distribution is received before the policy owner reaches age 59½.

Generally, the definition of a MEC is any policy entered into after June 20, 1988, that fails to meet the "7-pay" test, either initially or after a material change, or a contract...