The Life Insurance Fiscal Cliff: No Tax Preference Is Safe

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The potential elimination of many tax preferences currently afforded life insurance is one facet of today’s fiscal cliff discussions that is often overlooked.

Current proposals include provisions that could result in the imposition of taxes and elimination of deductions for both individual and corporate-owned life insurance policies, the proceeds of which are received tax-free under existing law. Clients today assume that the tax-free status of life insurance is a given and may have even engaged in fiscal cliff planning that involves the purchase of life insurance to provide a source of tax-free investment income. Given today’s political climate, it is important that clients realize that no tax preference is safe and that the tax benefits they have come to expect from life insurance are no exception.

The Life Insurance Fiscal Cliff

With the fiscal cliff looming, no tax preferences are immune from Congressional scrutiny. Various proposals to impose taxes on life insurance proceeds and policies are circulating and, while it is unlikely that all of the proposals will become law, it is entirely possible that life insurance will not escape the fiscal cliff discussions unscathed.

For example, while taxing the interest that accrues within a policy would not completely eliminate its tax-preferred status, it would provide substantial revenue to the Treasury. Today, when a life insurance policy earns interest, that interest typically increases the cash value of the policy tax-free, accumulating to provide a fund from which the policyholder can borrow tax-free.

Many business owners and high-net worth clients purchase life insurance specifically because it provides a tax-free investment that accumulates during many years that can be withdrawn without worrying about capital gains or the new investment income taxes at some point in the future.

In the case of corporate-owned life insurance, corporations often borrow to purchase or pay the premiums on a life insurance policy. An exception to the general rule allows a corporation to deduct the interest paid on any related debts if the policy covers the life of an officer, director or employee of the corporation—essentially providing a double tax motivation for corporations to purchase life insurance. However, eliminating this exception could generate an estimated $7.3 billion in tax revenue over 10 years.

Another proposal would impose reporting requirements on any transfer of a life insurance policy that provides a death benefit of at least $500,000. Usually, when a policyholder sells his life insurance policy, he must pay taxes on the difference between the value of the insurance proceeds collected and the amount that the investor paid for the policy. The goal of the reporting requirements is to aid in the elimination of transactions structured to avoid the tax that must be paid on any gain realized when a policy is transferred.

Conclusion: Prepare Your Clients

Essentially, clients should be prepared for the reality that in today’s world, no tax preferences are certain. Even though it is likely that the primary tax preferences afforded life insurance policies will not be eliminated any time soon, certain benefits could fall victim to the year-end compromise discussions. It is therefore important to remind clients that substantial non-tax reasons exist for purchasing life insurance—of course, the primary purpose is to provide liquidity to the policy beneficiaries upon the insured’s death—but the steady returns typical of a life insurance contract can also provide a conservative investment option for clients who are wary of today’s fluctuating stock market.

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