Chapter 15

Question 1

Accelerated Death Benefits Paid to Terminally or Chronically Ill Insureds

Answer 1

Amounts received under a life insurance contract covering the life of an insured who is terminally or chronically ill are now excludible from gross income

Question 2

terminally ill insured

Answer 2

A terminally ill insured is one who has been certified by a physician as having an illness or condition that can be expected to result in death within 24 months of the date the certification is given.

Question 3

Life Insurance Withdrawals

Answer 3

Withdrawals of cash value from a life policy are generally taxed on a first-in first-out (FIFO) basis; that is, withdrawals are treated as a nontaxable return of capital to the extent of premiums paid. Withdrawals in excess of premiums paid are taxable.
However, it is critically important to understand that withdrawals will be taxed as income first (a last-in first-out [LIFO] treatment) if the policy is classified as a modified endowment contract (MEC).
In addition, withdrawals from a life insurance policy that are made during the first 15 policy years and are associated with a reduction in the policy’s death benefit will also be subject to LIFO tax treatment, even if the policy is not a MEC.

Question 4

Gain realized upon surrender or maturity of United States Government Life Insurance (WWI) or National Service Life Insurance (WWII) is exempt from tax.12

Answer 4

True

Question 5

Where the owner of a life insurance contract receives the lifetime maturity proceeds or cash surrender value of the policy in one lump-sum payment from the insurance company, the amount received in excess of the owner’s cost basis is taxed as ordinary income.

Answer 5

True

Question 6

Deductions for life insurance premiums are allowed if owned by a business

Answer 6

Generally, premiums paid on business life insurance are not deductible. The Internal Revenue Code is explicit: “No deduction shall be allowed for . . . premiums on any life insurance policy, or endowment or annuity contract, if the taxpayer is directly or indirectly a beneficiary under the policy or contract.”

Question 7

Deductibility of disability premiums

Answer 7

The Internal Revenue Code provides that premiums paid for personal disability income insurance are not deductible.33 Included in the definition of disability income insurance are policies that pay a weekly income payment to the insured while hospitalized.

Question 8

Deductibility of health care premiums for individuals

Answer 8

Premiums paid for medical reimbursement insurance are considered a medical care expense under the Code35 and are deductible to the extent that they, along with other itemized medical expenses, exceed 10 percent of adjusted gross income. Different rules apply to self-employed taxpayers.

Question 9

Life Insurance transfer-for-value rule

Answer 9

A transfer-for-value rule stipulates that, if a life insurance policy (or any interest in that policy) is transferred for something of value (money, property, etc.), a portion of the death benefit is subject to be taxed as ordinary income.

Question 10

Exceptions to the transfer-for-value rule?

Answer 10

(1) transfers to the insured
(2) transfers to a partner of the insured
(3) transfers to a partnership in which the insured is a partner (4) transfers to a corporation in which the insured is a shareholder or an officer
(5) transfers in which the transferee’s basis in the transferred policy is determined in whole or in part by reference to the transferor’s basis. (occasionally referred to as the carryover-basis exception)

Question 11

insurable interest

Answer 11

As a general rule, the requirement of insurable interest applies only at the time of policy inception.

Question 12

What are the three types of losses deductible to an individual?

Answer 12

It is key to remember that three types of losses are deductible to an individual:

(1) losses incurred in a trade or business
(2) losses incurred in a transaction entered into for profit
(3) casualty or theft losses.

Section 165 of the Code generally allows deductions for such losses provided they are “not compensated by insurance or otherwise.”

Question 13

Charitable Life Policies and premium deductions

Answer 13

Premiums paid on life insurance owned by a qualified charitable organization are deductible to the donor as a charitable contribution, subject to the charitable contributions limitations. It is important that the charity be the owner of the policy and have the exclusive right to cash in the policy, borrow on it, or change the beneficiary.

Question 14

Premium payments as income for separated spouses

Answer 14

For divorce and separation agreements executed before January 1, 2019, premium payments by one spouse or former spouse for life insurance owned by and benefiting the other spouse are deductible as alimony.

For divorce and separation agreements executed after December 31, 2018, alimony payments are not income to the payee-spouse and not deductible by the payer-spouse.

Question 15

Split Dollar Life Insurance

Answer 15

A well-known fringe benefit for selected employees is the split-dollar life insurance plan. Under such an arrangement, an employee and employer share or split the premium payments. In the most basic form of split-dollar, cash-value-type policies are used and the employer’s share of the annual premium is measured by each year’s increase in cash value. Correspondingly, the employee’s share of each premium payment is the difference between each year’s cash value increase and the amount of net premium due. The employer can be named beneficiary to the extent of the cash value. The employee can have the right to name his or her own beneficiary for the difference between the total death proceeds payable and the cash value.

Question 16

No deduction is available to the employer for contributions to a split-dollar plan because the employer is also a beneficiary under such a policy within the meaning of Section 264(a) (1) of the Code.

Answer 16

True - the employee names the beneficiary for the death benefit but the employer retains interest in the cash value.

Question 17

Nondeductibility of Interest Payments

Answer 17

The general rule is that no interest deduction is allowable with respect to indebtedness incurred in connection with a life insurance, endowment, or annuity contract issued after June 8, 1997. Exceptions to this general rule provide for limited interest deductions for loans in connection with certain business-owned contracts, as discussed in the following sections. There are complex and overlapping sets of rules regarding interest deductions for policy loans with respect to policies issued on or before June 8, 1997

Question 18

Nondeductibility of Interest Payments - Key Person Exception

Answer 18

The “Key Person” Rule. This provision is the most significant exception to the general rule that interest deductions on policy loans are disallowed. The key person rule provides that interest on loan amounts not in excess of $50,000 per insured person is deductible if the insured or other covered person under the contract is a key person. The definition of a key person is an officer or 20 percent owner of the taxpayer.

There are further restrictions on the definition of a key person. The total number of key persons per business taxpayer may not exceed the GREATER of:
• five individuals, or
• the LESSER of:
– 5 percent of the total number of officers and employees of the business taxpayer, or
– 20 individuals.

Question 19

Interest on Policy Loans

Answer 19

Interest on Policy Loans
• Interest is deductible only if the business-owned policy insures a “key person”.
• A key person is either an officer or 20 percent owner of taxpayer/business.
• No business can have more than 20 “key persons”.
• Interest is deductible only to extent of $50,000 of loan principal.
• Moody’s rates must be used.

Question 20

If the transfer of a life insurance policy falls within one of the enumerated exceptions to the transfer-for-value rule, the entire death proceeds will be received income tax free by the beneficiary.

Answer 20

True

Question 21

Interest deductions for loans from business-owned single-premium life insurance policies are limited to $1,000 annually.

Answer 21

False

Interest on loans from single-premium life insurance policies cannot be deducted.

Question 22

An individual who transfers a policy on his or her life to a qualified charity and continues to pay the premiums may deduct the amount of the premium payments each year as a charitable contribution only if the charity is the owner of the policy and has exclusive rights as owner.

Answer 22

True

Question 23

A surviving spouse may exclude all interest income payable under any settlement option for a matured life insurance policy.

Answer 23

False
If the amount is received with respect to a death occurring on or before October 22, 1986, the interest will be included in the gross income.

Question 24

TA corporation may take a deduction for premium payments made for insurance on the life of an officer of the corporation if the beneficiary is the corporation.

Answer 24

False
IRC Sec. 264 prohibits a deduction by any taxpayer for premiums paid on life insurance contracts if the taxpayer is directly or indirectly a beneficiary.

Question 25

When a life insurance policy is surrendered during the period that the contract is in force, the owner will be subject to income taxation on the amount received in excess of his or her cost basis.

Answer 25

True

Question 26

When the primary beneficiary dies before receiving all installments under a fixed-period or fixed-amount option, the contingent beneficiary will be taxed on installment payments based on his or her life expectancy.

Answer 26

False
The contingent beneficiary will be taxed in the same manner as the primary beneficiary. The contingent beneficiary may exclude the same portion of each installment from his or her gross income as the primary beneficiary was entitled to exclude.

Question 27

Allowable interest deductions for loans from business-owned policies are now subject to limitations based upon the “Moody’s” rate. [4]

Answer 27

True

Question 28

Life insurance death benefits are generally excluded from the gross income of an individual beneficiary but are taxable income to a trust.

Answer 28

False
Lump-sum proceeds payable by reason of the insured’s death are generally excluded from the gross income of individuals, trusts, and estates.

Question 29

Interest on a life insurance policy loan of $50,000 may be deductible if the insured is a “key person” with respect to the taxpayer.

Answer 29

True

Question 30

Under a split-dollar life insurance plan, the covered employee receives the full value of the insurance coverage income tax free.

Answer 30

False
The covered employee must generally include in gross income each year the value of the “economic benefit” received as determined by IRS guidance on this subject.

Question 31

Death benefits received under an annuity contract are tax free in the same manner as life insurance proceeds.

Answer 31

False

Death benefits payable under an annuity contract do not qualify for the exclusion applicable to life insurance proceeds.

Question 32

Accelerated death benefits paid under a life insurance contract to a terminally ill insured are generally excludible from gross income as amounts paid by reason of death.

Answer 32

True

Question 33

One exception to the transfer-for-value rule is a transfer from the insured to another shareholder of a corporation in which the insured is a shareholder or officer.

Answer 33

False

A transfer to another shareholder is not an exception to the transfer-for-value rule.

Question 34

An employer who pays the premiums on an individual policy owned by an employee and insuring the employee’s life may deduct these payments as additional compensation to the employee.

Answer 34

True

Question 35

Premium payments for life insurance generally constitute personal nondeductible expenses.

Answer 35

True

Question 36

A policyowner who surrenders a level-premium whole life insurance policy and elects one of the installment options will be taxed under the annuity rules.

Answer 36

True

Question 37

Local law generally requires an insurable interest only at the time a life insurance policy is originally purchased.

Answer 37

True

Question 38

Certain withdrawals from universal life policies that result in a reduction in the death benefit may be taxed on a last-in, first-out (LIFO) basis.

Answer 38

True

Question 39

The transfer-for-value rule provides that if an insured transfers a policy on his or her life to another for valuable consideration, the transferee will receive the death proceeds free of income tax.

Answer 39

False
The transfer-for-value rule applies to the transfer of a life insurance policy for valuable consideration. When the insured dies, the transferee will have taxable income on that portion of death proceeds in excess of the amount of consideration paid on the transfer, plus the total net premiums subsequently paid by the transferee.

Question 40

The portion of each installment of life insurance living benefits received income tax free under an installment option is found by dividing the investment in the contract by the expected total return.

Answer 40

True