Chapters 16 and 17 - Income Taxation Income Chapters 16 and...

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Unformatted text preview: Income Taxation Income Chapters 16 and 17: Income Taxation of Life Income Insurance and Modified Endowment Contracts Endowment Life Insurance Proceeds Life Generally, life insurance Generally, death benefits payable by reason of the death of the insured are excludible from the gross income of the beneficiary. beneficiary Accelerated Death Benefits Accelerated Must be paid by insurer or licensed Must viatical settlement provider viatical “Terminally ill” means death is Terminally expected within 24 months of physician’s certification physician’s Payments to “Chronically ill” insured Payments must be made pursuant to qualified LTC rider LTC Taxation of Policy Benefit Options Taxation Policy in Force: Dividends treated as return Policy of capital; withdrawals generally taxed on FIFO basis FIFO Lump-Sum Payments: Gain taxed as Lump-Sum ordinary income ordinary Interest-Only Option: Interest taxable Installment Options: Interest portion of Installment payment taxable Contingent beneficiary taxed in generally Contingent the same way as primary beneficiary the Consider “60-Day Rule” for surrendered Consider policies policies Surrender of Policy Surrender Face Amount of Policy: $50,000 Cash Surrender Value: $8,000 Premiums Paid: $9,000 Dividends Paid on Policy: $2,000 Amount Taxable: $1,000 --$8,000 – ($9,000 - $2,000) = $1,000 “5-15” Withdrawals Taxed on LIFO basis if associated Taxed with a reduction in policy benefits during first 15 policy years during Greater taxable amount during first Greater 5 policy years policy “Ceiling” applies to taxable amount Typically associated with universal Typically life policies life Transfer-for-Value Rule Transfer-for-Value A tax law providing that where a policy tax transferred by assignment or otherwise for a valuable consideration matures by reason of death, the transferee will be liable for income tax on the amount of death proceeds in excess of the actual value of the consideration paid for the contract plus the total of net premiums and other amounts subsequently paid by the transferee. by Example Example Face amount of policy: $100,000 Amount paid for policy by transferee: Amount $20,000 $20,000 Premiums subsequently paid by Premiums transferee: $10,000 transferee: Amount taxable to transferee upon Amount death of insured: $70,000 death --$100,000 – ($20,000 + $10,000) = $70,000 Transfer For Value EXCEPTIONS Transfer Transfers to the insured Transfers to a partner of the insured Transfers to a partnership in which the Transfers insured is a partner insured Transfers to a corporation in which the Transfers insured is a shareholder or officer insured Transfers to which carryover basis Transfers rules apply (i.e., tax-free exchange) rules Transfer For Value Transfer NON-EXCEPTION Transfers Transfers from one shareholder in a corporation to a fellow shareholder! to Insurable Interest Insurable The legal principle that requires the The policy owner under a life insurance policy to have a sufficient business or personal relationship with the insured at the time of policy inception. inception Premium Payments Premium Premium payments by one spouse or former Premium spouse for life insurance owned by and benefiting the other spouse are deductible as alimony, if the following occurs: alimony, Payments are made in cash and terminate at the death of the Payments payee-spouse. Payments are made under a divorce decree or separation Payments agreement. The parties are not members of the same household and do The not file joint tax returns. Payments are not for child support. Payments Payments must be made for at least 3 years unless either Payments spouse dies or the payee-spouse remarries. Nondeductibility of Premiums Nondeductibility NEVER deductible if taxpayer paying NEVER premiums is directly or indirectly a policy beneficiary policy If payor is NOT a policy beneficiary, If premiums are deductible only if they qualify under a specific rule of tax law (e.g., Alimony, Compensation, or Charitable Contribution) Charitable Key Person Rule Key For purposes of determining the For deductibility of interest payments on a loan from an insurance contract, an individual insured who is an officer or 20 percent owner of the taxpayer. 20 Rule provides that interest on loan Rule 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 Key Person Rule Key There are further restrictions on the There definition of a key person. The total number of key persons per The business taxpayer may not exceed the GREATER of: five individuals or five the LESSER of the o o 5 percent of the total number of officers and percent employees of the business taxpayer, or 20 individuals Result: Interest on Policy Loans Result: Interest is deductible only if businessowned policy insures “Key Person” Key person must be either an officer or Key 20 percent owner of taxpayer/business 20 No business can have more than 20 No “Key Persons” “Key Interest deductible only to extent of Interest $50,000 of loan principal per insured $50,000 “Moody’s” rates must be used MECs MECs MEC is a life insurance policy that has MEC failed the “7-Pay Test” (post June 20,1988) (post Partial withdrawals, loans and Partial collateralizations subject to LIFO (“Last –in, First-out) taxation –in, 10 Percent penalty, if applicable, 10 applies only to taxable portion of transaction with policy transaction 7-Pay Test applies again if policy 7-Pay experiences a “Material Change” experiences MECs MECs The “7-Pay Test” -- A test to determine if a particular life -insurance contract is or is not a modified endowment contract. If the total premium paid into the policy in the first 7 years or in the 7 years following a material change in it exceeds the sum of the “net level premiums” that would be needed to pay up a policy in 7 years, the policy is as MEC. MECs MECs Net Level Premiums -- An artificially constructed amount -based on reasonable mortality charges, an assumed interest rate, and (in some an in cases) reasonable insurance company cases reasonable expense charges, used in determining whether a life insurance contract is a MEC. MEC. See example on 17.4 (note that taxable amounts See increase basis in policy) increase MECs: Material Changes MECs: Substantial increases in death Substantial benefits due to large deposits of premium premium Reduction in benefits during first 7 Reduction policy years policy Reduction in benefits anytime for Reduction survivorship policies survivorship Term conversions (to cash value) 1035 exchanges ...
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This note was uploaded on 06/06/2011 for the course ACE 346 taught by Professor Peter during the Spring '11 term at University of Illinois, Urbana Champaign.

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