Life insurance is a complex financial planning tool, accompanied by a number of intricate tax provisions. Most clients know that premiums paid on a personal policy are not tax-deductible, but that may be where their wisdom ends. As an advisor, this means you likely face a lot of questions around the tax implications of individual policies — especially at this time of year.

In the spirit of answering some of these questions before they’re asked, we’ve compiled 15 little-known tax facts that you and your clients may need to know. Curious whether the “seven pay test” applies to a policy, or when death proceeds are includable in an insured’s gross estate? Now you’ll know.

If you have questions about the taxation of life insurance that are not answered here, please let us know in the comments section below.

Related: 10 life insurance tax facts you need to know 

1. Can a taxpayer deduct interest paid on a loan to purchase or carry a life insurance, endowment, or annuity contract?

Interest paid or accrued on indebtedness incurred to purchase or continue in effect a single-premium life insurance, endowment, or annuity contract purchased after March 1, 1954, is not deductible. For this purpose, a single-premium contract is defined as one on which substantially all the premiums are paid within four years from the date of purchase, or on which an amount is deposited with the insurer for payment of a substantial number of future premiums. One court has held that payment in the first four years of 73 percent of total annual premiums for a limited-pay policy did not constitute payment of “substantially all” of the premiums. Another court has ruled that payment of eight annual premiums in the first four years on a whole life policy was neither “substantially all” nor a “substantial number” of the premiums.

When a single-premium annuity is used as collateral to either obtain or continue a mortgage, the IRS has found that Internal Revenue Code (IRC) Section 264(a)(2) disallows the allocable amount of mortgage interest to the extent that the mortgage is collateralized by the annuity. However, this result does not hold when a taxpayer’s use of available cash to purchase an annuity results in a larger home mortgage or when a taxpayer does not surrender an annuity even though cash obtained from the surrender would make it possible to reduce the amount of the mortgage. A general counsel memorandum has concluded that borrowing against the cash value of a single-premium life insurance policy is equivalent to using the policy as collateral.

In restating the rule concerning single-premium contracts, the conference committee report accompanying the Tax Reform Act of 1986 (TRA ’86) states that “no inference is intended that universal life insurance policies are always treated as single-premium contracts.” It is still unclear whether the four exceptions applicable to contracts other than single-premium contracts can be used in the case of universal life contracts.

Other than single-premium contract

A deduction is denied under IRC Section 264(a)(3) for interest on indebtedness incurred or continued to purchase or carry a life insurance, endowment, or annuity contract, that is not a single-premium contract, if it is purchased pursuant to a plan of purchase that contemplates the systematic direct or indirect borrowing of part or all of the increases in the cash value of such contract (either from the insurer or otherwise).

 

2. Are there any exceptions to the rule that disallows a deduction for interest paid on a loan to purchase or carry a life insurance, endowment or annuity contract?

There are four exceptions to this disallowance rule. However, with respect to interest paid or accrued on policies or contracts covering an individual who is a “key person,” the deduction may be limited as explained here, even if one of the four exceptions to this disallowance rule is met, or even denied.

The four exceptions are:

1. The seven-year exception. The deduction will not be disallowed under this rule when no part of four of the annual premiums due during the seven-year period, beginning with the date of payment for the first premium on the contract, is paid by means of indebtedness. If there is a substantial increase in the premiums, a new seven-year period for the contract commences on the date the first increased premium is paid. However, a new seven-year period does not begin upon transfer of the policy, whether for value or by gift. A new seven-year period does not commence if modification of a life insurance policy after December 31, 1990, becomes necessary because of the insurer’s financial insolvency. The addition to a policy of a provision that interest on policy loans is payable in arrears rather than in advance will not cause a new seven-year period to begin. A systematic plan of purchase will be presumed when there is borrowing in connection with more than three of the annual premiums due during the seven-year period, but will not be presumed earlier. 

Once a taxpayer has used borrowed funds to pay the first four premiums, the taxpayer cannot undo the effect of this action by repaying the policy loan. If in any year during the seven-year period, the taxpayer, in connection with any premium, borrows more than an amount necessary to pay one annual premium, the excess will be treated as though he or she borrowed to pay premiums that were paid in prior years with non-borrowed funds (beginning with the first prior year and working backwards).

Example. Taxpayer, in Year 1, purchased a $100,000 policy and the annual premium was $2,200. The taxpayer paid the first four premiums without borrowing. In Year 5, the taxpayer borrowed $10,000 with respect to the policy. The borrowing will be attributed first to paying the premium for Year 5 and then attributable to paying the premium for Years 4, 3, 2, and 1 (in part).

If borrowing in connection with any premium in any year exceeds the premium for that year plus premiums paid in prior years without borrowing, the excess will be attributed to premiums (if any) paid in advance for future years. However, once the seven-year exception has been satisfied, and the seven-year period has expired, there would appear to be no limit under this exception to the amount that might be borrowed (from the policy or otherwise) to pay premiums on the policy. (But if a substantial number of premiums are prepaid, the policy might be considered a single-premium policy – see previous question.)

Thus, three of the first seven annual premiums may be borrowed, and the interest deduction would not be disallowed by reason of this rule, provided the balance of premiums during the seven-year period is paid with non-borrowed funds. But if the seven-year exception is not met, and the taxpayer cannot rebut the presumption of a systematic plan of borrowing, the interest deduction will be disallowed under this rule for all future years and for all prior years not closed by the statute of limitations. This assumes, of course, that none of the other exceptions to this rule applies.

2. $100-a-year exception. Regardless of whether there is a systematic plan of borrowing, the interest deduction will not be disallowed under this rule for any taxable year in which the interest (in connection with such plans) does not exceed $100. But when such interest exceeds $100, the entire amount of interest (not just the amount in excess of $100) is nondeductible under IRC Section 264(a)(3).

3. Unforeseen event exception. If indebtedness is incurred because of an unforeseen substantial loss of income or unforeseen substantial increase in the taxpayer’s financial obligations, the deduction will not be disallowed under this rule even though the loan is used to pay premiums on the contract. An event is not “unforeseen,” however, if at the time the contract was purchased it could have been foreseen.

4. Trade or business exception. If indebtedness is incurred in connection with the taxpayer’s trade or business, the interest deduction will not be denied under IRC Section 264(a)(3). Thus, if an insurance policy is pledged as part of the collateral for a loan, the interest deductions will come within this exception if the taxpayer can show that the amounts borrowed actually were used to finance the expansion of inventory or other similar business needs. The IRS has ruled privately that a company that borrowed against key-person life insurance policies to take advantage of the policies’ lower interest rate and generally to improve its financial position by reducing its overall debt was considered to have incurred the policy loan interest in connection with its trade or business. But borrowing to finance business life insurance (such as key person, split dollar, or stock purchase plans) is not considered to be incurred in connection with the borrower’s trade or business. Systematic borrowing to finance a life insurance policy is not debt incurred in connection with an employer’s trade or business even when the net death proceeds and the amounts borrowed in excess of premiums are used to fund employee retirement benefits.

The interest deduction will not be disallowed under IRC Section 264(a)(3) if any one of these exceptions applies. For example, even though the purchase of business life insurance does not come within the trade or business exception, the interest deduction may be allowed if the borrowing comes within the four-out-of-seven exception, provided no other IRC section operates to disallow or limit the interest deduction.

 

3. How are cash distributions received as a result of changes in the benefits of a life insurance contract taxed?

Cash distributions received as a result of certain changes in the benefits of a contract may not be taxed under the cost recovery rule, but are taxed under the “interest-first” rule. Any change in the benefits under a life insurance contract or in other terms of the contract (other than automatic increases such as change due to the growth of the cash surrender value, payment of guideline premiums, or changes initiated by the company) that was not reflected in any earlier determination or adjustment will require a redetermination as to whether the definitional guidelines of IRC Section 7702 are still satisfied. (A modification made to a life insurance contract after December 31, 1990, that is necessitated by the insurer’s financial insolvency, however, will not cause retesting under IRC Sections 7702(f)(7)(B)-(E).) If such a change occurs during the fifteen-year period beginning on the issue date of the policy and reduces the benefits under the contract, then any cash distribution made to the policyholder as a result of such change will be taxed as ordinary income to the extent there is income on the contract; however, the amount to be included will be limited to the applicable recapture ceiling.

If the change occurs during the five-year period beginning on the issue date of a traditional life policy (that is, a policy that originally qualified under IRC Section 7702 by satisfying the cash value accumulation test), the recapture ceiling is the excess of the cash surrender value of the contract immediately before the reduction over the net single premium immediately after the reduction. If the change occurs during the five-year period beginning on the issue date of a universal life policy (that is, a policy that originally qualified under IRC Section 7702 by satisfying the guideline premium/cash value corridor tests), the recapture ceiling is the greater of (1) the excess of the aggregate premiums paid under the contract immediately before the reduction over the guideline premium limitation for the contract, taking into account the proper adjustment for the change in benefits, or (2) the excess of the cash surrender value of the contract immediately before the reduction over the cash value corridor immediately after the reduction.

If the change occurs after the five-year period and during the fifteen-year period beginning on the date of issue of the policy, the recapture ceiling is the excess of the cash surrender value of the contract immediately before the reduction over the cash value corridor immediately after the reduction.

Distributions made in anticipation of a reduction in benefits under the contract will be treated as resulting from a change in the contract. Any distribution that reduces the cash surrender value of a contract and that is made within two years before a reduction in benefits under such contract will be treated as made in anticipation of a reduction.

The IRS has provided examples of how these rules work.

 

4. What is the “seven pay test” and how does it apply to a modified endowment contract (MEC)?

A life insurance contract will fail the seven pay test if the accumulated amount paid under the contract at any time during the first seven contract years exceeds the sum of the net level premiums that would have been paid on or before such time if the contract provided for paid-up future benefits after the payment of the seven level annual payments. Generally, the “amount paid” under the contract is defined as the premiums paid less distributions, not including amounts includable in gross income. An amount received as a loan or the repayment of a loan does not affect the amount paid under the contract. Additionally, amounts paid as premiums during the contract year but returned to the policyholder with interest within sixty days after the end of the contract year will reduce the sum of the premiums paid during the contract year. The interest paid on the premiums returned must be included in gross income.

When a whole life insurance policy is coupled with an increasing whole life rider plus a term insurance rider, and the amount of coverage provided under the term rider increases or decreases solely in relation to the amount of coverage provided by the base policy and whole life rider, the IRS has ruled privately that the policy’s “future benefits” for purposes of IRC Section 7702A(b) are equal to the aggregate amount of insurance coverage provided under the base policy, the whole life rider, and the term insurance rider at the time the policy is issued. When a variable whole life policy is coupled with a twenty-year decreasing term rider, the future benefits for purposes of IRC Section 7702A(b) are equal to the coverage under the base policy plus the lowest amount of coverage under the term rider at any time during the first seven contract years.

The seven level premiums are determined when the contact is issued, and the first contract year death benefit is deemed to be provided to the contract’s maturity, disregarding any scheduled death benefit decrease after the first seven years. In one private letter ruling, the death benefit for purposes of applying IRC Section 7702A(c)(1)(B) was the policy’s “target death benefit,” defined as the sum of the base policy death benefit and a rider death benefit.

If there is a reduction in benefits under the contract within the first seven contract years, the seven pay test is applied as if the contract had originally been issued at the reduced benefit level. Any reduction in benefits due to the nonpayment of premiums is not taken into account, however, if the benefits are reinstated within ninety days after the reduction.

In the case of a contract that pays a death benefit only on the death of one insured that follows or occurs at the same time as the death of another insured, if the death benefit is reduced below the lowest level of death benefit provided during the contract’s first seven years, the MEC rules must be applied as if the contract had originally been issued at that lower benefit level. This rule is effective for contracts entered into on or after September 14, 1989.

 

5. Which life insurance contracts are subject to the seven pay test?

Subject to the following exceptions, life insurance contracts entered into after June 20, 1988, are subject to the seven pay test. Contracts entered into prior to this date are “grandfathered” for purposes of the seven pay test. 

If the death benefit under a grandfathered contract increases by more than $150,000 over the death benefit in effect as of October 20, 1988, the contract becomes subject to the material change rules and may lose its grandfathered status. This rule does not apply if the contract required at least seven annual premiums as of June 21, 1988, and the policyholder continued to make at least seven annual premium payments. In determining whether a material change has occurred, the death benefit payable as of June 20, 1988, rather than the lowest death benefit payable during the first seven years, is applicable.

A policy entered into before June 21, 1988, may lose its grandfathered status and, therefore, may be treated as if it were entered into after this date, if (1) the policy death benefit is increased or an additional qualified benefit is purchased after June 20, 1988, and (2) prior to June 21, 1988, the contract owner did not have the right to obtain such an increase or addition without providing additional evidence of insurability. If a term life insurance contract is converted after June 20, 1988, to a policy that is not term insurance, without regard to the right of the owner to such a conversion, the policy will lose its grandfathered status. A policy entered into before June 21, 1988, did not lose its grandfathered status when the insurer changed the policy loan provision to make interest payable in arrears rather than in advance.The IRS has stated that modification of a life insurance contract after December 31, 1990, that is made necessary by the insurer’s insolvency will not affect the date on which the contract was issued, entered into, or purchased for purposes of IRC Section 7702.

 

6. What are the tax consequences of leaving life insurance cash surrender values or endowment maturity proceeds with the insurer under the interest-only option?

The interest is fully taxable to the payee as it is received or credited.

Under some circumstances, election of the interest option will postpone tax on the proceeds. If the option is elected before maturity or surrender without reservation of the right to withdraw the proceeds, the proceeds are not constructively received in the year of maturity or surrender. But if the right of withdrawal is retained, the IRS apparently considers the proceeds as constructively received when they first become withdrawable. (It can be argued, however, that the proceeds are not constructively received when the policyholder has a contractual right to change to another option.) If the option is elected on or after the maturity or surrender date, the proceeds are constructively received in the year of maturity or surrender. The sixty-day extension rule, applicable to the election of a life income or installment option, does not apply to an election of the interest option.

If the proceeds are constructively received, the entire gain on the contract (if any) is taxable in the year of constructive receipt as if the proceeds had been actually received in a one sum settlement. If the proceeds are not constructively received, the gain will be taxable to the person who ultimately receives the proceeds. 

7. What are the tax results when life insurance or endowment dividends are used to purchase paid-up insurance additions?

Normally, no tax liability will arise at any time when life insurance or endowment dividends are used to purchase paid-up insurance additions. Dividends not in excess of investment in the contract are not taxable income (see here, however, with regard to modified endowment contracts), the annual increase in the cash values of the paid-up additions is not taxed to the policyholder, and death proceeds are tax-free. In effect, dividends reduce the cost basis of the original amount of insurance and constitute the cost of the paid-up additions. Consequently, upon maturity, sale, or surrender during an insured’s lifetime, gross premiums, including the cost of paid-up additions, are used as the cost of the insurance in computing gain upon the entire amount of proceeds, including proceeds from the additions. 

The treatment of cash value increases and the death benefit of a contract subject to the definitional requirements of IRC Section 7702 will be different if the contract fails to meet certain requirements.

8. What are the income tax consequences when the owner of a life insurance or endowment contract takes the lifetime maturity proceeds or cash surrender value in a one sum cash payment?

Amounts received on complete surrender, redemption, or maturity of a life insurance or endowment contract are taxed under the cost recovery rule. If the maturity proceeds or cash surrender value exceeds the cost of the contract, the excess is taxable income in the year of maturity or surrender, even if the proceeds are not received until a later tax year. The gain is ordinary income, not capital gain. 

The IRC provides that aggregate premiums are the investment in the contract, which is used for computing gain upon the lifetime maturity or surrender of a life insurance or endowment contract. Consequently, although the portion of the premiums paid for current life insurance protection is generally a nondeductible personal expense, that portion nevertheless may be included in the investment in the contract for the purpose of computing gain upon the surrender or lifetime maturity of the policy. 

Example. Mr. Green purchases a whole life policy in the face amount of $100,000. He uses dividends to purchase paid-up additions. Over a twenty-year period, gross premiums amount to $47,180. Of this amount, $13,018 represents the net protection portion of the premiums, and $34,162 the investment portion. At the end of the twenty-year period, Mr. Green surrenders his policy for its cash surrender value of $48,258 (cash value of the original $100,000 policy plus cash value of insurance additions). His investment in the contract is $47,180 (not $47,180 less $13,018). Thus, his taxable gain is $1,078 ($48,258 – $47,180), not $14,096 ($48,258 – $34,162).

In a 2009 Revenue Ruling, the IRS reiterated the above conclusion, ruling that a policy owner who surrenders a policy in a life settlement transaction is not required to subtract the cost of insurance charge from the policy owner’s investment in the contract. In the revenue ruling, the cash surrender value of the subject policy was $78,000 (the IRS assumed that the cash surrender value already reflected the subtraction of the cost of insurance protection ($10,000)). The amount of premiums paid was $64,000. According to the IRS, the taxpayer’s recognized gain was only $14,000 ($78,000 surrender proceeds – $64,000 investment in the contract), all of which was declared ordinary income by the IRS.

With respect to a viatical settlement, however, the IRS has ruled privately that at the time of the assignment to a viatical settlement company, the basis of a whole life policy was equal to premiums paid less the sum of the cost of insurance protection provided up to the assignment date and any amounts, such as dividends, that were received under the contract but were not included in gross income. The cost of insurance protection in the private letter ruling was found to equal the aggregate premiums paid less the cash value of the policy. This ruling implies that, at least according to the IRS, the terms “basis” and “investment in the contract” do not mean the same thing. 

(For a discussion of the exception to the general rule that gain on endowment maturities and cash surrenders is taxable income, see here.)

 

9.  How are proceeds taxed if a life insurance policy is owned by someone other than the insured?

The proceeds are taxed in the same manner as if the insured owned the policy. When a person retains all the incidents of ownership in an endowment or annuity contract but designates another to receive the maturity proceeds, the proceeds will be taxed to the owner rather than to the payee. For possible gift tax consequences when a policy is owned by one individual but insures another, see here.

10. What benefits payable at death are included in the term “life insurance” for estate tax purposes?

IRC Section 2042 deals with the estate taxation of proceeds from insurance on the life of a decedent. According to regulations, the term “insurance,” as used in IRC Section 2042, means life insurance of every description, including death benefits paid by fraternal societies operating under the lodge system. In the case of a retirement income endowment, the death proceeds are treated as insurance proceeds under IRC Section 2042 if the insured dies before the terminal reserve value equals or exceeds the face value. If the insured dies after that time, the proceeds are treated as death proceeds of an annuity contract. 

With respect to the proceeds of “no-fault” automobile liability insurance, the IRS has ruled on three categories of benefits:

(1) Survivors’ loss benefits. These are benefits payable only to certain named dependent survivors of the insured. If the insured dies leaving no such eligible dependents, no benefits are paid. The value of any such benefit is not includable in the insured’s gross estate under IRC Section 2033 or under IRC Section 2042(2) because if the proceeds are life insurance (an issue the ruling did not decide) the insured would not have owned any incidents of ownership at his or her death. 

(2) Basic economic loss benefit. This benefit covers the insured’s medical expenses and loss of income arising from the insured’s injury while operating an automobile. The value of this benefit is includable in the insured’s gross estate under IRC Section 2033, but not under IRC Section 2042(1) (life insurance proceeds payable to or for the insured’s estate).

(3) Death benefit. This is a benefit payable unconditionally to the estate of the insured and to the estate of any passenger in the insured’s car killed in a covered accident. The value of this benefit is includable under IRC Section 2042(1) in the estate of each insured receiving the benefit.

 

11. When are death proceeds of life insurance includable in an insured’s gross estate?

They are includable in the following four situations:

(1) The proceeds are payable to the insured’s estate, or are receivable for the benefit of the insured’s estate;

(2) The proceeds are payable to a beneficiary other than the insured’s estate but the insured possessed one or more incidents of ownership in the policy at the time of the insured’s death, whether exercisable by the insured alone or only in conjunction with another person; 

(3) The insured has made a gift of the policy on the insured’s life within three years before his or her death; or 

(4) The insured has transferred the policy for less than an adequate consideration (i.e., the transaction was not a bona fide sale) and the transfer falls within one of the rules for includability contained in IRC Sections 2035, 2036, 2037, 2038, or 2041. Under these circumstances, the value of the proceeds in excess of the value of the consideration received is includable in an insured’s estate. A grantor may retain the power to substitute property of an equivalent value. Such a power, in and of itself, generally does not cause the trust corpus to be includable under IRC Section 2036 or 2038.

12. How are life insurance policies and endowment contracts valued for gift tax purposes?

Generally, the value of a gift of life insurance is established through the sale by the company of comparable contracts.

If a new policy is purchased for another, or is transferred as a gift immediately after purchase, its gift value is the gross premium paid by the donor to the insurance company.

If a person makes a gift of a previously purchased policy, and the policy is single-premium or paid-up, its gift value is the single premium that the company would charge currently for a comparable contract of equal face value on the life of a person who is the insured’s age at the time of the gift. A 1978 ruling concerned a single premium life policy in force for 20 years where the replacement cost of a single premium life policy of the same face value on the same insured was substantially less than the cash surrender value of the existing policy. The IRS ruled that the replacement contract would not be “comparable” and that in the absence of information pertaining to a “comparable contract” the value of the policy would be determined by reference to the interpolated terminal reserve value (see below).

If the gift is of a policy on which further premiums are payable, the value is established by adding the “interpolated terminal reserve” (the reserve adjusted to the date of the gift) and the value of the unearned portion of the last premium. 

Example. A gift is made four months after the last premium due date of an ordinary life insurance policy issued nine years and four months before the gift was made by the insured, who was thirty-five years of age at date of issue. The gross annual premium is $2,811. The computation is as follows:

Terminal reserve at end of tenth year

$14,601.00

Terminal reserve at end of ninth year

$12,965.00

      Increase

$1,636.00

One-third of such increase (the gift having been made four  months following the last preceding premium due date) is

$545.33

Terminal reserve at end of ninth year

$12,965.00

Interpolated terminal reserve at date of gift

$13,510.33

Two-thirds of gross premium ($2,811)

$1,874.00

      Value of gift

$15,384.33

   

The amount of a policy loan outstanding at the time of the gift would be subtracted.

The effect of the circumstance that the insured is uninsurable at the time of the gift is uncertain; there is no case directly on point.

See here regarding gifts with respect to split-dollar arrangements.

If the gift of the policy or contract is conditioned upon payment of the gift tax by the donee, the value of the gift is reduced by the amount of the gift tax paid by the donee.

A group term life policy assigned by an employee to an irrevocable trust on the day before a monthly premium was due was held to have no ascertainable value for gift tax purposes, but it was also held that after the assignment the employee would be deemed to have made a gift to the assignee whenever the employer paid a premium.A 1984 revenue ruling valued the gift as follows: If the plan of group term insurance is nondiscriminatory or the employee is not a key employee, the Table I rates may be used. If the employee chooses not to use Table I, or if the plan is discriminatory and the employee is a key employee, the employee should use the actual cost allocable to the employee’s insurance by obtaining the necessary information from the employer. The rates apply to the full face amount of the insurance.Projecting the holding of the 1984 ruling to the nondiscrimination rules applicable to taxable years ending after October 22, 1986, it would seem that if the plan of group term insurance is discriminatory with respect to the employee, the employee must use the higher of Table I rates or actual cost.

13. May a charitable contribution deduction be taken for the gift of a life insurance policy or premium? May a charitable contribution deduction be taken for the gift of a maturing annuity or endowment contract? 

Yes, subject to the limits on deductions for gifts to charities.

The amount of any charitable contribution must be reduced by the amount of gain that would have represented ordinary income to the donor had the donor sold the property at its fair market value. Gain realized from the sale of a life insurance contract is taxed to the seller as ordinary income. Therefore, the deduction for a gift of a life insurance policy to a charity is restricted to the donor’s cost basis in the contract when the value of the contract exceeds the premium payments. Thus, if a policy owner assigns the policy itself to a qualified charity, or to a trustee with a charity as irrevocable beneficiary, the amount deductible as a charitable contribution is either the value of the policy or the policy owner’s cost basis, whichever is less.It is not necessary, however, to reduce the amount of the contribution when, by reason of the transfer, ordinary income is recognized by the donor in the same taxable year in which the contribution is made. Letter Ruling 9110016, in which the IRS denied a charitable deduction when a policy was assigned to a charity that had no insurable interest under state law, was revoked after the taxpayer decided not to proceed with the transaction.

Premium payments also are deductible charitable contributions if a charitable organization or a trustee of an irrevocable charitable trust owns the policy. It is not settled whether premium payments made by the donor to the insurer to maintain a policy given to the charity, instead of making cash payments directly to the charity in the amount of the premiums, are gifts to the charity or merely gifts for the use of the charity. The difference is important when the donor wishes to take a charitable deduction of more than 30 percent of the donor’s adjusted gross income. When the policy is merely assigned to a charitable organization as security for a note, the premiums are not deductible even though the note is equal to the face value of the policy and is payable from the proceeds at either the insured’s death or the maturity of the policy. The reason is that the note could be paid off and the policy recovered after the insured has obtained charitable deductions for the premium payments. A corporation, as well as an individual, can take a charitable contribution deduction for payment of premiums on a policy that has been assigned to a charitable organization. 

Planning Point: For a number of reasons, including concerns over the rules limiting a tax deduction to the lesser of fair market value or basis and because of the uncertainty regarding tax consequences of premium payments made by the donor directly to the insurance company on a policy owned by a charity, it is generally preferable for a donor to make cash gifts to a charity and allow the charity to pay premiums on policies owned by the charity. It is important, however, not to require that the cash gifts be used for premium payments.

14. When can a beneficiary of life insurance proceeds be held liable for payment of federal estate tax falling on the insured’s estate? 

The executor has primary liability for paying federal estate tax and is expected to pay it from the probate estate before distribution. Under IRC Section 2206, unless the decedent has directed otherwise, the executor ordinarily may recover from a named beneficiary such portion of the total tax paid as the proceeds included in the gross estate and received by the beneficiary bear to the taxable estate. In the case of insurance proceeds receivable by the surviving spouse and qualifying for the marital deduction, IRC Section 2206 applies, if at all, only to proceeds in excess of the aggregate amount of the marital deduction allowed the estate. Most states also have apportionment laws under which life insurance beneficiaries share the estate tax burden with estate beneficiaries. It is not entirely clear whether IRC Section 2206 imposes a duty on the executor to seek apportionment, or only gives the executor the power to do so. When the executor is unable to recover a pro-rata share of the estate tax from the beneficiary of the life insurance proceeds, the estate cannot claim a deduction under IRC Section 2054; it is a bad debt and as such is not deductible under IRC Section 2054. A legatee whose share of the estate bears the burden of tax attributable to the proceeds, however, is entitled to a bad debt deduction.

If the government is unable to collect the estate tax from the insured’s estate, the tax can be collected from the beneficiary of the life insurance proceeds up to the full amount of the proceeds if the value of the proceeds was includable in the gross estate. Any person who receives property includable in a decedent’s gross estate under IRC Sections 2034 to 2042 is liable for the tax. It is immaterial that the insured’s will directed payment from the insured’s general estate. An insurance company holding the proceeds under a settlement option is not liable for the tax. There is a split of authority as to whether transferee liability for interest on any unpaid tax is limited to the amount of proceeds received from the decedent’s estate. 

15. Are the proceeds of group term life insurance available through an employer includable in an insured’s estate?

The general rules for including life insurance proceeds in the gross estate apply. Accordingly, the proceeds are includable if they are payable to or for the benefit of the insured’s estate, or if the insured possesses any incident of ownership in the policy at the time of his or her death. There is no question, for example, that if at the employee’s death the employee possessed the right to designate or change the beneficiary of his or her group life insurance, the employee possessed an incident of ownership within the meaning of IRC Section 2042(2). In addition to the general rules concerning incidents of ownership, in group life insurance, the insured’s right to convert to an individual policy on termination of employment is not an incident of ownership. Moreover, the power of an employee to effect cancellation of his or her coverage by terminating his or her employment is not an incident of ownership. 

Estate tax regulations that attribute corporate-held incidents of ownership to an insured who is a stockholder-employee under certain circumstances provide (as amended in 1979) that in the case of group term life insurance, as defined in the regulations under Section 79, the power to surrender or cancel a policy held by a corporation “shall not be attributed to any decedent” through his or her stock ownership.

Drawing somewhat of a parallel to the controlling stockholder regulations, the IRS has held that a partnership’s power to surrender or cancel its group term life insurance policy is not attributable to any of the partners. According to the IRS, it does not matter that partners do not qualify for the income exclusion provided in IRC Section 79 because they are not employees. Under the facts of the ruling, the insured partner was one of thirty-five partners. The IRS has ruled privately in a case involving optional contributory plans of group life insurance that provide that if an employee opts not to participate on his or her own, certain specified relatives of the employee could, with the employee’s consent, apply and pay for the insurance on the employee’s life and own all incidents of ownership. The plan also provided that should the third-party applicant-owner cease to qualify as such, the insurance would terminate, in which event the employee would be eligible again to apply for coverage on his or her own. The IRS held that the employee did not possess an incident of ownership within the meaning of IRC Section 2042.

The Tax Court has held that the death proceeds of a combination group term life and disability income policy are taxable for estate tax purposes under IRC Section 2042 as proceeds of life insurance.

 

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