Income Taxation of Life Insurance

Question 1

Taxation of Whole Life Insurance

Answer 1

Ordinary Income
CV - cost basis

Cost basis: premiums paid - dividends received
Surrender value: CV + cash value of paid up additions - loans
withdrawals/ loans: only when amount owed exceeds what was paid in

Tax-free income
DB: face amount + paid up additions - loans
Dividends: exception, MEC

Question 2

Uniform Simultaneous Death Act (USDA)

Answer 2

any person who dies within 120 hours of each other is deemed to predecease one another
- prevents assets from going to others estate before survivors

Question 3

Modified Endowment Contracts (MECs) - Tests

Answer 3

1. Fails cash value accumulation test (CVAT)
   or
2. Fails guideline premium & corridor test (GPT)
   - Entered into on or after June 21, 1988 (1984 Act)
   - Fails to meet 7-pay test

Question 4

MEC - 1984 Act and 7-pay test

Answer 4

1984 Act
- single premium policy issued after 1988
7-pay test
- excess premiums paid within first 7 years
- max non-MEC premium in year 1 must be less than annual net level premium
- after 1st year, annual and aggregate rules apply

Question 5

MEC - Characteristics

Answer 5

• must pass tests
• once a MEC always a MEC
• material change will affect policy type

Question 6

MEC - Taxation

Answer 6

• LIFO
• taxable distribution before 59 1/2 and subject to 10% penalty (if not disabled)
• DB excluded from income
• dividends taxed: if received as cash, used to reduce premium, or retained by insurer in repayment of loan

Question 7

MEC - Material Change - Grandfathered Rules

Answer 7

• rules apply to policies before and after 1988
  -DB increases by more than $150k, can lose grandfathered status
• if insurability is needed to be proved, any amount, can lose grandfathered status

Question 8

Transfer for Value

Answer 8

• causes DB to become taxable if policy is transferred for value from one person to another for consideration
• taxable: consideration paid - premiums paid

Question 9

Transfer for Value - Exceptions

Answer 9

I C Dead People
- sale or transfer to insured
- sale or transfer to partner on insured (partnership)
- transfer to corporation with insured as shareholder or director
- due to divorce

Question 10

Section 1035 Exchange

Answer 10

Tax free exchanges
- LI to LI
- LI to Annuity
- Annuity to Annuity
- LI or Annuity to qualified LTC

NOT allowed
-Annuity to LI