Tax treatment of living benefits under life insurance policies.

• Author: Swayze, Jim
• Position: Proposed regulations would make tax treatment more uniform

Life insurance companies have recently developed and marketed insurance contracts that, under certain circumstances, dispense all or a part of a life insurance policy's face value before the death of the insured. These products provide both traditional death benefits as well as sundry forms of "living benefits," ostensibly designed to help policyholders cope with continually increasing medical care and long-term care costs. Historically, these "living benefits" have been known variously as accelerated death benefits (ADBs), living benefits, living needs and long-term care arrangements. Such payments can be divided into two categories: those associated with premature death (mortality) and those associated with various forms of disability (morbidity). Payments under the first category, accelerated death benefits, are triggered by the needs of terminally ill individuals who may incur substantial medical or living expenses before death. The second category of living benefits provides accident and health benefits on the occurrence of certain morbidity risks, such as conditions requiring long-term care in nursing homes or specified dread diseases.

Although policies of this type have been in existence for approximately 30 years, only in the past five years have they evolved and gained relatively wide acceptance.(1) At this time, the products offered vary widely in nature and, as a consequence, their tax treatment is uncertain. In December 1992, the Treasury promulgated proposed regulations on living benefits to provide guidance on their tax treatment to those selling policies, the policy owners and their tax advisers.

The payment of benefits under an insurance policy is triggered by a specific event or events. For example, the following categories of events have served as functional triggers of accelerated benefits, resulting in payment under the terms of the policy.(2)

1. Diagnosis of a terminal illness with the prognosis of death within a specified period. This requires that the life expectancy be severely limited. Policies marketed in recent years vary in the term of life expectancy necessary to trigger payment from six months to two years, but one year has been the most common.

2. Diagnosis of a dread disease or catastrophic illness. This trigger requires a diagnosis of a specified (listed) disease or illness, which is typically catastrophic in nature from a cost viewpoint.

3. A need for long-term care in a nursing home, for home health care, or the loss of the ability to perform certain necessary activities of daily living.

4. A need for confinement to a long-term custodial care facility with the prognosis that the insured's stay be of a lifetime duration.

   The, proposed regulations allocate benefits related to these triggers into two categories: "qualified accelerated death benefits" and "additional benefits." The proposed regulations allow treatment of "qualified" ADBs as amounts paid by reason of death for purposes of Secs. 101 (a) and 7702, resulting in exclusion from income for the recipient. This "qualified accelerated death benefit" is specifically defined under the proposed regulations.(3)

   The proposed regulations also address the treatment under Sec. 7702 of "additional benefits" that provide payments on the occurrence of a morbidity(4) risk of an amount determined by reference to all or a portion of the death benefit otherwise payable under an insurance contract. This is important because, as the IRS explained in the preamble to the proposed regulations, For purposes of section 7702, the benefit could be viewed as an amount paid upon surrender of a contract and accordingly would be included in the cash surrender value of the contract. The impact of this characterization would be to disqualify as life insurance under section 7702 many contracts providing these benefits.(5)

   This article will compare the tax treatment of those living benefits deemed "qualified accelerated death benefits" as well as those deemed "additional benefits" under current law with their treatment if the proposed regulations are adopted. The article will also analyze the strengths and deficiencies of the proposed regulations and focus on a potential unexpected result of the receipt of ADBs.

   Tax Treatment of ADBs

   As noted above, under current law, the tax treatment of living benefits is uncertain. For example, living benefits might be treated as proceeds from a life insurance contract (and receive tax treatment under Secs. 101, 7702 and 7702A), as compensation for injuries or sickness (in which case the tax treatment would be governed by Secs. 104 and 213), or as amounts received from accident and health plans (which fall within the scope of Secs. 105 and 213). Obviously, the tax effect on the recipient taxpayer will vary depending on the assumed tax treatment. At one extreme, if living benefits are deemed to be disability payments from an employee-sponsored accident and health plan, they will be fully taxable to the recipient as ordinary income.(6) At the other end of the spectrum, if they are treated as amounts received under a life insurance contract that are paid by reason of the insured's death, they can be excluded from the taxpayer's gross income.(7)

   The proposed regulations seem to indicate that the Treasury's position is that all living benefits are proceeds from life insurance contracts. Therefore, this article will concentrate on the tax consequences when mortality and morbidity payments are treated as proceeds from a life insurance contract.

   * ADBs treated as life insurance proceeds under current law

   Generally, Sec. 101(a) allows taxpayers to exclude from gross...