Lesson 4 - Life Ins. Advanced Concepts

Question 1

Taxation of Life Ins. Policies

Answer 1

• Depends if income generated during or after life
• Depends if income received during life if a dividend or a withdrawal
• -Dividends = not taxable, considered return of basis but taxable if they exceed premiums
• -Withdrawals - those who wish for lifetime benefits from whole life policy can:
• —-withdraw their basis, typically taxed FIFO
• —-take loans against CV, as long as policy in force at time of death, outstanding loans against CV will be free of fed in. tax…loans will reduce the DB by amount outstanding
• **If a MEC, those loan rules do not apply

Question 2

Taxation of Life ins. policies surrenders

Answer 2

Lump Sum: amount above premiums paid is taxed as OI

Interest Only: Int. taxable as OI

Installment Payments: portion return on principle and portion is interest…int. is taxed as OI

Question 3

Taxation of Life ins. After Death

Answer 3

• DB generally excluded from taxable income and CV not taxable if withdrawn at death
• if you own life ins on your own life or if proceeds available to executor of estate….the DB will be included in owner’s gross estate and could be subject to estate tax

Question 4

MEC (modified endowment contract)

Answer 4

• loss of favorable tax treatment
• Taxed as LIFO (gains first and taxed as OI)
• 10% penalty for withdraws under age 59 1/2
• MEC if 7 pay test - pay premiums faster than 7 yr CORRIDOR
• fails to meet the 7-pay test if the cumulative premiums paid at any time during the first 7 policy years exceeds the cumulative 7-pay premiums on or before such time being considered
• Once MEC always a MEC
• MEC only bad if going to borrow, otherwise no consequence…benefits would still be tax free to bene

Question 5

Taxation of Transfer of Life Policies

Answer 5

• DB becomes taxable to transferree for whatever exceeds basis
• Exceptions to Transfer of Value Rule - when policy transferred to insured, business partner of insured, partnership of insured, corportation for which the insured is shareholder
• Exception for a transfer that results in carryover basis from transferor to transferee

Question 6

Viatical Settlements

Answer 6

• Allow insured to sell their policy to a third party if the owner-insured of a policy is terminally ill at the time the policy is sold, the gain in policy wont be subject to income tax (terminal illness = life exp. of less than 24 months)
• Chronically ill - proceeds income tax free to extent proceeds cover LTC of the insured

Question 7

Accelerated Death Benefits

Answer 7

• entitles a qualified insured to receive a nontaxable lifetime benefit
• similar to viatical except only parties are insurer and insured

Question 8

Group Life Ins.

Answer 8

• A very common employee benefit is $50,000 of annually renewable term life insurance
• Benefit is received tax free by employee and deductible by employer
• Group whole life: premiums paid by employer are taxable income to employee….not widely offered by employers
• Taxation of Group Life: premiums paid not tax deductible by individuals, deductible by employer, not taxable to employee for first 50k
• Calculation for taxation: function of age and benefits per 1,000 in excess (given by chart that age 40 of ind. in example is 0.10), salary 75k, ins. twice salary

75,000 x 2 = 150k DB
150k - 50k (exclusion) = 100k in excess
100,000/1,0000.1012 = 120 imputed income

Question 9

Buy Sell Agreements (uses of Life ins. in business)

Answer 9

• use life insurance policies to orderly transfer business interests in the event of an early and unexpected death of one partner
• the family will be required to sell and the surviving partner will be required to purchase

This will:

• Create a market for otherwise unmarketable business interests
• Provide liquidity in the estate of a deceased business owner

Question 10

Forms of Buy Sell Agreements

Answer 10

Cross Purchase Agreement: each partner buys bus. interest of deceased partner, Each purchases a life insurance policy on the life of all the other parties to agreement …. N x (N-1)

Entity Purchase Agreement (simplest): Obligates the business entity to purchase an owner’s interest upon a triggering event

Wait and See Agreements: Hybrid between the two^^

• Business has first option to purchase the interest
• if they don’t, each partner can purchase deceased owner interest in proportion to their ownership interest
• if owners do not….any remaining interest is bought by business

Other triggering events for buy sell agreement: disability, divorce, retirement, withdrawal from business (this would cause seller to realize taxable gain on their sale of interest)