Death Proceeds

<div class="Section1">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 ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="579">579</a>). For possible gift tax consequences when a policy is owned by one individual but insures another, <em>see</em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="214">214</a>.</div><br />

<div class="Section1">No. The death benefit is generally tax-exempt as proceeds payable by reason of an insured&rsquo;s death.<a href="#_ftn1" name="_ftnref1">¹</a> If the proceeds are held under a settlement option, the regular rules apply ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="70">70</a>, Q <a href="javascript:void(0)" class="accordion-cross-reference" id="71">71</a>).<div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp;&nbsp;&nbsp;&nbsp; IRC &sect;&nbsp;101(a); Treas. Reg. &sect;&nbsp;1.101-1(a)(1).<br /> <br /> </div></div><br />

<div class="Section1"><br /> <br /> Yes. All amounts paid or credited to a beneficiary as interest (excess and guaranteed) must be included in the beneficiary&rsquo;s gross income regardless of whether the insured or the beneficiary elected the option.<a href="#_ftn1" name="_ftnref1">¹</a> The interest is taxable in the first year that it can be withdrawn. If the beneficiary elects an option under which there is no right to withdraw either principal or interest for a specified number of years, the entire amount of accumulated interest is taxable in the year during which it first becomes withdrawable.<a href="#_ftn2" name="_ftnref2">²</a> But if the beneficiary has a right to withdraw principal, the interest is taxable when credited even though the agreement stipulates that the interest cannot be withdrawn.<a href="#_ftn3" name="_ftnref3">³</a><br /> <br /> The principal amount held by the insurer, representing the value of the proceeds at the insured&rsquo;s death, is income tax-free to the recipient when withdrawn ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="63">63</a>).<br /> <br /> For a discussion of the tax treatment when proceeds are held for a period under the interest option and subsequently paid under a life income or installment settlement, <em>see</em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="71">71</a>.<br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp;&nbsp;&nbsp;&nbsp; IRC &sect;&nbsp;101(c); Treas. Reg. &sect;&nbsp;1.101-3(a).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp;&nbsp;&nbsp;&nbsp; Treas. Reg. &sect;&nbsp;1.101-4 (g), Ex. 1.<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp;&nbsp;&nbsp;&nbsp; <em>Strauss v. Commissioner</em>, 21 TC 104 (1953); <em>see also</em> Rev. Rul. 68-586, 1968-2 CB 195.<br /> <br /> </div></div><br />

<div class="Section1"><br /> <br /> Under IRC Section&nbsp;7702, for death proceeds of a life insurance contract (including an endowment contract) issued after December&nbsp;31, 1984, to be fully excludable from the beneficiary&rsquo;s gross income, the contract generally must be a life insurance contract under applicable state (or applicable local foreign) law <em>and</em> must meet one of two alternative tests: the cash value accumulation test ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="66">66</a>) or the guideline premium and corridor test ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="67">67</a>).<a href="#_ftn1" name="_ftnref1">¹</a> Any plan or arrangement provided by a church or a convention or association of churches to its employees or their beneficiaries that provides for the payment of a death benefit is not required to meet the requirement that the arrangement constitute a life insurance contract under applicable law.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> The IRS may waive an insurer&rsquo;s failure to satisfy the requirements of IRC Section&nbsp;7702(a) if the errors were reasonable and reasonable steps to remedy the errors have been taken.<a href="#_ftn3" name="_ftnref3">³</a> For example, when six life insurance policies were temporarily out of compliance with the guideline premium test requirements due to the inadvertence of the insurer&rsquo;s employees during a change in computer systems, the IRS granted such a waiver after the insurer increased the policy death benefits.<a href="#_ftn4" name="_ftnref4">⁴</a> When a combination of clerical errors (including lost records, missed testing dates, and the failure to make scheduled premium adjustments) and the conversion of the insurance company&rsquo;s policy administration system from a manual procedure to a fully computerized one caused policies to be out of compliance, the IRS granted a waiver, but required that the policies be brought into compliance within 90 days.<a href="#_ftn5" name="_ftnref5">⁵</a> When a clerk failed to realize that a certificate holder had paid in additional premiums that put a group universal life certificate out of compliance, the IRS granted a waiver provided that the company refund the excess premiums, with interest, or increase the policy death benefit from the time of noncompliance.<a href="#_ftn6" name="_ftnref6">⁶</a> The IRS refused to waive an insurer&rsquo;s failure to satisfy these requirements, however, when several policies were discovered to be out of compliance due to the company&rsquo;s use of a software program that contained an &ldquo;inherent structural flaw.&rdquo;<a href="#_ftn7" name="_ftnref7">⁷</a><br /> <br /> Modification of a life insurance contract after December&nbsp;31, 1990 that is necessitated by the insurer&rsquo;s insolvency will not affect the date on which the contract was issued, entered into, or purchased for purposes of IRC Section&nbsp;7702.<a href="#_ftn8" name="_ftnref8">⁸</a><br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp;&nbsp;&nbsp;&nbsp; IRC &sect;&nbsp;7702(a).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp;&nbsp;&nbsp;&nbsp; IRC &sect;&nbsp;7702(j).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp;&nbsp;&nbsp;&nbsp; IRC &sect;&nbsp;7702(f)(8).<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.&nbsp;&nbsp;&nbsp;&nbsp; Let. Rul. 9042039. <em>See also</em> Let. Ruls. 9801042, 9727025, 9621016.<br /> <br /> <a href="#_ftnref5" name="_ftn5">5</a>.&nbsp;&nbsp;&nbsp;&nbsp; Let. Rul. 9416017. <em>See also</em> Let. Ruls. 200006030, 199924028, 9834020, 9838014.<br /> <br /> <a href="#_ftnref6" name="_ftn6">6</a>.&nbsp;&nbsp;&nbsp;&nbsp; Let. Rul. 9623068. <em>See also</em> Let. Ruls. 200027030, 9805010, 9601039, 9517042, 9322023, 9146016, 9146011.<br /> <br /> <a href="#_ftnref7" name="_ftn7">7</a>.&nbsp;&nbsp;&nbsp;&nbsp; Let. Rul. 9202008.<br /> <br /> <a href="#_ftnref8" name="_ftn8">8</a>.&nbsp;&nbsp;&nbsp;&nbsp; Rev. Proc. 92-57, 1992-2 CB 410; Let. Rul. 9239026. <em>See also</em> Let. Rul. 9305013.<br /> <br /> </div></div><br />

<div class="Section1"><br /> <br /> To satisfy the cash value accumulation test, the cash surrender value of a contract, according to its terms, must not at any time exceed the net single premium that would be necessary at such time to fund future benefits (death benefits, endowment benefits, and charges for certain additional benefits, such as a disability waiver) under the contract.<a href="#_ftn1" name="_ftnref1">¹</a> The <em>cash surrender value</em> of a contract is its cash value, disregarding any surrender charges, policy loans, or reasonable termination benefits. The <em>net single premium</em> is determined by using (1) an annual effective interest rate of 4 percent or the interest rate(s) guaranteed in the contract, whichever is greater, (2) the mortality charges specified in the contract or if none are specified, the charges used in figuring the statutory reserves for the contract, and (3) any other charges specified in the contract.<br /> <br /> For contracts issued on or after October 21, 1988, the mortality charges used must be reasonable charges that meet the requirements, if any, identified in the applicable regulations and that do not exceed the mortality charges specified in the “prevailing commissioners’ standard tables” at the time the contract is issued.<a href="#_ftn2" name="_ftnref2">²</a> The 2017 tax reform legislation modified the definition of the prevailing commissioners’ standard tables. The exercise of an option to change a policy’s death benefit after October 21, 1988, added to the policy by endorsement prior to this date, did not cause the policy to become subject to the reasonable mortality requirements of IRC Section 7702(c)(3)(B)(i), as amended by Technical and Miscellaneous Revenue Act (TAMRA).<a href="#_ftn3" name="_ftnref3">³</a><br /> <br /> Proposed regulations provide three safe harbors for meeting the reasonable mortality charge requirement in contracts that insure only one life and that are entered into on or after October 21, 1988.<a href="#_ftn4" name="_ftnref4">⁴</a> A contract issued before October 21, 1988 will meet the reasonable mortality charge requirements if it has mortality charges that do not differ materially from the charges actually expected to be made.<a href="#_ftn5" name="_ftnref5">⁵</a> Any other reasonable charges taken into account for purposes of determining the net single premium must be reasonably expected to actually be paid and must be actually specified in the contract.<a href="#_ftn6" name="_ftnref6">⁶</a><br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.     IRC § 7702(b).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.     IRC § 7702(c)(3)(B)(i). The prevailing commissioners’ standard tables are defined in IRC Section 807(d)(5). <em>See also</em> 2001 CSO Table. The 2017 tax reform legislation (Pub. Law No. 115-97) modified the definition of “prevailing commissioners’ standard tables” to include the most recent NAIC tables used for computing reserves under the laws of at least 26 states’ insurance laws when the contract was issued. If there is any change in these tables from one year to the next, the issuer may use the prevailing commissioners’ standard tables as of the beginning of the preceding calendar year with respect to any contract issued after the change and before the close of the 3-year period beginning on the first day of the year of change.<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.     Let. Rul. 9853033.<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.     Prop. Treas. Reg. § 1.7702-1.<br /> <br /> <a href="#_ftnref5" name="_ftn5">5</a>.     TAMRA ’88 § 5011(c).<br /> <br /> <a href="#_ftnref6" name="_ftn6">6</a>.     IRC § 7702(c)(3)(B)(ii).<br /> <br /> </div>

<div class="Section1"><br /> <br /> A policy issued before January&nbsp;1, 1985 that is exchanged for one issued after December&nbsp;31, 1984 will be treated as a contract issued after 1984 and subject to the definitional requirements of IRC Section&nbsp;7702 discussed in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="65">65</a>, according to the General Explanation of the Deficit Reduction Act of 1984 (the General Explanation). The General Explanation states that a change in policy terms after December&nbsp;31, 1984, could be considered an exchange that would bring the policy under the IRC Section&nbsp;7702 definitional requirements. Examples of &ldquo;changes in terms&rdquo; are changes in &ldquo;amount or pattern of death benefit, the premium pattern, the rate or rates guaranteed on issuance of the contract, or mortality and expense charges.&rdquo;<a href="#_ftn1" name="_ftnref1">¹</a> A change in minor administrative provisions or a loan rate change generally would not be considered to result in an exchange, the General Explanation adds. Modification of a life insurance contract after December&nbsp;31, 1990 that is made necessary by the insurer&rsquo;s insolvency will not affect the date on which the contract was issued, entered into, or purchased for purposes of IRC Section&nbsp;101(f).<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> Otherwise, universal life insurance and any other flexible premium contract, issued before January&nbsp;1, 1985, qualify for the death proceeds exclusion only if (1) the sum of the premiums does not exceed at any time a guideline premium <em>and</em> the death benefit is not less than a certain percentage of the cash value (140 percent until the start of the policy year the insured attains age 40, thereafter reducing 1 percent for each year over 40, but not below 105&nbsp;percent) <em>or</em> (2) the contract provides that the cash value may not at any time exceed the net single premium for the death benefit at that time.<br /> <br /> The guideline premium is the greater of (1) the single premium necessary to fund future benefits under the contract based on the maximum mortality rates and other charges fixed in the contract and the minimum interest rate guaranteed in the contract at issue, but at least 6&nbsp;percent, or (2) the aggregate level annual amounts payable over the life of the contract (at least 20 years but not extending beyond age 95, if earlier) computed in the same manner as the single premium guideline (using an annual effective rate of 4 percent instead of 6&nbsp;percent). The IRS can allow excessive premiums paid in error to be returned (with interest) within 60&nbsp;days after the end of the policy year; in such case, the policy will still qualify as life insurance.<a href="#_ftn3" name="_ftnref3">³</a><br /> <br /> The death benefit of a flexible premium contract entered into before January&nbsp;1, 1983, will be excludable if the contract met the requirements on September&nbsp;3, 1983. In determining if the level annual premium guideline is met by such a contract, an annual effective interest rate of 3 percent may be substituted for 4 percent.<a href="#_ftn4" name="_ftnref4">⁴</a><br /> <br /> For life insurance contracts (other than flexible premium contracts) issued before January&nbsp;1, 1985, there is no clear definition of &ldquo;life insurance&rdquo; for purposes of the tax-free death benefit. Despite this, the death proceeds are not considered proceeds of life insurance unless the contract under which they are paid provided protection against the risk of early death. The IRS has taken the position that, for income tax purposes, a contract is a life insurance contract if it contained an element of life insurance risk at any time.<a href="#_ftn5" name="_ftnref5">⁵</a> Thus, the IRS apparently has not attempted to tax the proceeds of a retirement income contract, even when the insured&rsquo;s death has occurred after the cash value has exceeded the face amount but before the maturity of the contract. This ruling involved a contract purchased by a qualified retirement plan and the IRS could attempt to limit its position to such contracts.<a href="#_ftn6" name="_ftnref6">⁶</a> On the other hand, the Tax Court has held that a retirement income contract is an annuity contract once the element of risk has disappeared.<a href="#_ftn7" name="_ftnref7">⁷</a> The IRS also has ruled that the exclusion applies to variable life insurance death benefits that may increase or decrease, but not below a guaranteed minimum amount, on each policy anniversary depending on the investment experience of the separate account of the prior year&rsquo;s net premium.<a href="#_ftn8" name="_ftnref8">⁸</a> Regulations provide that death benefits having the characteristics of life insurance proceeds payable by death under contracts such as workers compensation and accident and health contracts are excludable under IRC Section&nbsp;101(a).<a href="#_ftn9" name="_ftnref9">⁹</a><br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp;&nbsp;&nbsp;&nbsp; General Explanation of the Deficit Reduction Act of 1984 at p.&nbsp;656.<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp;&nbsp;&nbsp;&nbsp; Rev. Proc. 92-57, 1992-2 CB 410; Let. Rul. 9239026.<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp;&nbsp;&nbsp;&nbsp; IRC &sect;&nbsp;101(f).<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.&nbsp;&nbsp;&nbsp;&nbsp; TEFRA &sect;&nbsp;266(c).<br /> <br /> <a href="#_ftnref5" name="_ftn5">5</a>.&nbsp;&nbsp;&nbsp;&nbsp; Rev. Rul. 66-322, 1966-2 CB 123.<br /> <br /> <a href="#_ftnref6" name="_ftn6">6</a>.&nbsp;&nbsp;&nbsp;&nbsp; GCM 38934 (12-8-82); GCM 39022 (8-12-83).<br /> <br /> <a href="#_ftnref7" name="_ftn7">7</a>.&nbsp;&nbsp;&nbsp;&nbsp; <em>Evans v. Commissioner</em>, 56 TC 1142 (1971).<br /> <br /> <a href="#_ftnref8" name="_ftn8">8</a>.&nbsp;&nbsp;&nbsp;&nbsp; Rev. Rul. 79-87, 1979-1 CB 73.<br /> <br /> <a href="#_ftnref9" name="_ftn9">9</a>.&nbsp;&nbsp;&nbsp;&nbsp; Treas. Reg. &sect;&nbsp;1.101-1(a)(1).<br /> <br /> </div></div><br />