Insurance Marketing Concepts - University of Nebraska College of

advertisement

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

1

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.

2

Life Insurance Tax Basics

Premiums are not tax deductible

Death benefits are income tax exempt

Cash values are tax-deferred

Life Insurance

3

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).

4 Life Insurance

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.”

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

5

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

6

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

7

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

1 st 15 Years

 Pre-7702 (pre-January 1, 1985)

 reduce “investment in the contract”

7702 Contracts

D istribution may be treated as income on contract

Separate formulas for years 1-5, 6-10 and 11-15

Life Insurance

8

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

9

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

10

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

11

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

12

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

13

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

14

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

15

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

16

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

17

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

18

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

19

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

20

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

21

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

22

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

23

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

24

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

25

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

26

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

27

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

PLR 200247006

PLR 200514001

PLR 200606027

Life Insurance

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

29

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

30

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

31

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

32

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

33

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

34

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

35

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

36

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.

37

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.

38

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.

39

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.

40

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

41

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

42

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

43

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.

44

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

45

Common Uses of Life Insurance

Proceeds

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

46

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

47

MassMutual Financial Group is a marketing designation (or fleet name) for

Massachusetts Mutual Life Insurance Company (MassMutual) and its affiliates.

48

Massachusetts Mutual Life Insurance Company and affiliates, Springfield, MA 01111-0001 • www.massmutual.com

Download