L54) Life Insurance vs. Modified Endowment Contracts

1.3 – Life Insurance vs. Modified Endowment Contracts

Current tax law specifies that a life insurance policy is one that passes the 7-pay test. This test requires that the premiums paid during the policy’s first seven years cannot exceed the sum of the net level premiums necessary to fund a fully paid-up policy at the end of seven years. If cumulative premiums do not exceed the specified amount during the first seven years, the policy is deemed a life insurance contract, subject to tax treatment normally applicable to life insurance. If cumulative premiums exceed the specified amount during any one of the first seven years, the policy will be deemed a modified endowment contract, or MEC, subject to different, less favorable tax treatment.

Example: Life Insurance vs. MECs

For example, assume that a policy provides for a death benefit that would require the payment of $14,000 in premiums by the end of Year 7 to be a fully paid-up policy. As long as cumulative premiums paid do not exceed the cumulative maximum amount in any year, the policy will pass the 7-pay test and will be considered life insurance.

As the following chart shows, in Year 4, the policyowner pays an amount into the policy that causes the total premium paid to exceed the total amount allowed as of that point. In that year, the policy fails the 7-pay test and will be deemed a MEC. And although the total premiums paid through Year 7 do not exceed the total cumulative limit, the amount deposited in Year 4 caused the policy to become a MEC.

mec

MEC Status

Once classified as a MEC, a policy remains a MEC for its lifetime, even if it is later changed or reconfigured. It can never revert to non-MEC status. A policy exchanged for a MEC is also considered a MEC. Any time a policy undergoes a “material change,” such as a reduction in the death benefit, the 7-pay test is applied again. If, at that point, the policy fails the test, it becomes a MEC. Thus, a policy may become a MEC at any time.

The tax code allows policy owners up to one year after a policy becomes a MEC to withdraw the excess premium paid so that MEC status can be avoided. Life insurance companies are responsible for providing their policy owners with information regarding MECs and the 7-pay test. (Policies purchased before June 1, 1988, were grandfathered and are not subject to the MEC rules unless they undergo a material change.)

 

2.3 – Tax Treatment of MEC Death Proceeds

It’s important to understand that the tax treatment of death benefits paid from a policy that is classified as a MEC is no different from the treatment given to death benefits paid from a life insurance policy. Death proceeds paid in a lump sum from a MEC are received tax free by the beneficiary. If the MEC proceeds are paid under a settlement option, the interest element of the payments is subject to ordinary income tax; the balance (representing the policy’s proceeds) is received tax free.

For this reason, MECs can still serve the needs of many life insurance buyers. If the sole purpose of the policy is to provide a death benefit to one or more beneficiaries—and the policy owner does not intend to utilize the policy’s values during the insured’s lifetime—a MEC may be an appropriate option. For instance, it may be the best choice of action for a client to purchase a life insurance policy with a single premium (which would cause the policy to be deemed a MEC) if his or her intent is to benefit a named beneficiary or to create a sizable estate (and all other factors support this option).

At the insured’s death, the policy’s status as a MEC becomes irrelevant; benefits paid to the beneficiary receive the same income tax treatment as benefits paid from a policy classified as life insurance. Thus, MECs can be used to generate and transfer wealth on an income tax-favored basis.

3.1 – Transfer-for-Value Rule and the Taxation of Premiums

As we just learned, one of the most significant advantages of life insurance is that the policy’s principal proceeds are generally tax free to the beneficiary. However, there is one notable exception: the transfer-for-value rule.

Set forth in Section 101(a)(2) of the Internal Revenue Code, this rule holds that in the event a life insurance policy (or an interest in the policy) is transferred or assigned to another party for valuable consideration of any form, the income tax exclusion for the beneficiary does not fully apply. In a transfer-for-value case, the beneficiary is taxed on the amount of the death benefit that exceeds the amount paid to purchase the policy plus the amount of premium paid by the transferee.

3.2 – Example: Transfer-for-Value Rule

Assume that Mary transfers a $500,000 permanent life insurance policy on her life to her sister, Chris, for $50,000. Chris names herself as beneficiary and assumes responsibility for paying the policy’s $3,000 annual premium. At Mary’s death four years later, Chris receives the $500,000 death benefit. Of that amount, $62,000 will be tax free (the amount paid for the policy—$50,000—plus the $12,000 in premiums Chris paid). The $438,000 balance is considered ordinary taxable income to Chris

3.3 – Applicability of the Rule

The transfer-for-value rules apply to all types of policies, including term, universal, variable, whole life, and so on. The rules also apply to both group and individual coverage.

The rules extend to more than outright sales of life insurance policies. For example, naming a beneficiary in exchange for any kind of valuable consideration would be considered a transfer for value, as would creating an enforceable contractual right to receive all or part of the insurance proceeds. However, merely assigning or pledging a policy as collateral for a loan is not considered a transfer for valuable consideration.1 Thus, if a policy owner makes a collateral assignment of his or her life insurance policy to secure a bank loan, the bank can recover the proceeds income tax free in the event the insured dies before the loan is repaid.

3.4 – Exceptions to the Transfer-for-Value Rule

A number of exceptions to the transfer-for-value rule allow a policy to be transferred for valuable consideration without subjecting the death benefit to income taxation. If the transfer is made to any of the following, the rule does not apply and the death benefit is received income tax free:

  • the insured individual (or the insured’s ex-spouse, if transferred incident to a divorce)
  • a partnership in which the insured is a partner
  • a partner of the insured
  • a corporation in which the insured is a shareholder or officer
  • any person where the transferee’s basis is determined in whole or in part by referring to the transferor’s basis

Let’s take a look at each of these exceptions in more detail.

Transfers to the Insured

The same life insurance policy may sometimes be transferred more than once. For example, a father may transfer a policy to his daughter, who agrees to pay premiums. If the daughter later transfers the policy back to her father because she can no longer afford the premiums, the transfer-for-value rule will not apply. The proceeds will consequently regain their income tax free status.

Transfers to a Partnership

A policy can also be transferred to a partnership in which the insured is a partner without running afoul of the transfer-for-value rule.

For example, assume that two partners in a financial planning partnership each own a policy covering their own lives. Each partner could sell the policy on his life to the partnership to provide funds for the business if either partner dies. Although there is a transfer for value, this exception ensures that the proceeds will not be subject to income taxation.

Note that for this exception to apply, the partnership should be a viable, legitimate entity with an independent business or investment purpose. A partnership created solely to avoid the transfer-for-value rule would likely not be recognized for purposes of this exception.

Limited liability companies (LLCs) that elect to be treated as partnerships for tax purposes are also considered to fall within the partnership exception.

Transfers to a Partner

Under this exception, an insured can transfer a life insurance policy to a person who is the insured’s partner in a partnership. Using the example just noted, the two partners could sell the policy covering each one’s life to the other partner without causing the proceeds to be subject to income tax.

Transfers to a Corporation

Under the transfer to a corporation exception, the transfer-for-value rule will not apply if the insured transfers a policy to a corporation and he or she is an officer or shareholder of the company. For example, a small business owner may transfer an individually owned policy to his or her company to provide key person coverage if he or she dies prematurely. As long as the insured is an officer or shareholder of the company, the transfer will fall within this exception to the transfer-for-value rule.

3.5 – Transferor’s Basis

Finally, the transfer-for-value rule will not apply if the transferee’s basis in the policy is determined in whole or in part by the transferor’s basis. This means that if the basis in the contract will be carried over from the transferor to the recipient, the death proceeds will not be taxable.

One of the most common scenarios where this exception comes into play is when a policy is gifted to another person in exchange for “love and affection.” In this case, no consideration changes hands, and the transferor merely gives the policy to the transferee. The transferee’s basis in the gifted policy would be determined by carrying over the donor’s basis (with an adjustment for any gift taxes paid). Similarly, transferring a policy to an insured’s spouse falls under this exception because a transfer among spouses will always be treated as a gift. With transfers to spouses, the previous owner’s basis will carry over to the spouse.

The other common scenario in which this exception will apply is when a policy is transferred from one business entity to another as part of a tax-free corporation reorganization.

3.6 – Income Taxation of Premiums

As a general rule, premiums paid for personal life insurance policies are considered personal expenses and are not deductible for income tax purposes. There are only a few limited situations in which a tax deduction can be taken for personally owned life insurance policies. For example, if the premiums are paid on a policy owned by an ex-spouse as part of an alimony settlement, they may be deductible as alimony payments (and taxable as income to the receiving spouse). Or, a policy owner may assign all rights in a policy to a charity, making the charity the owner and beneficiary of the policy. Alternatively, a person may purchase a new policy with the charity as owner and beneficiary. In both cases, any future premium payments for the policy may be deductible as a charitable contribution for income tax purposes.

Taxation of Premiums in Business Situations

Premiums may also be deductible in certain business situations. For example, premiums paid by an employer for a group life insurance plan are typically deductible by the employer as a business expense. The value of those premiums, up to certain limits, is not included for tax purposes in the employee’s income.

As a general rule, the premiums for the first $50,000 of group life insurance paid by an employer on behalf of an employee are not taxable to the employee. Premiums that pay for coverage of more than $50,000 are considered “imputed income” to the employee, and that cost of coverage—the premium for amounts greater than $50,000—is subject to ordinary tax to the employee.

Premiums that are waived under a policy provision—in the event of the insured’s disability, for example—are not considered imputed income to the owner and are not subject to income taxation.

4. – Income Taxation of Dividends and Policy Cash Values

While the valuable role that life insurance plays in providing a death benefit is well known, the many “living benefits” of life insurance are often overlooked. Permanent life insurance, for example, can be a valuable tool for providing supplemental retirement income because it combines insurance protection with a savings or accumulation element, which builds over the life of the policy. Depending on the type of policy, the cash value growth may be guaranteed (traditional whole life) or may vary, depending on the underlying investment fund (variable life or variable universal life).

The cash values belong to the policyowner, who can use the funds however he or she likes. The ever-increasing cash value is an asset that a policyowner can rely on at any point in the policy’s life—it can be borrowed at very reasonable rates; it can be surrendered and taken as cash (in which case the policy terminates); it can be withdrawn at any time to supplement retirement income; or it can be left intact to grow and support the death benefit. Life insurance cash values can even be used as collateral for a loan. Many life insurance policies pay dividends to their owners. The law also permits long-term care insurance premiums and benefits to be paid in a tax-advantaged way by using hybrid life insurance or annuity products.

When dividends are paid or a policy’s cash values are withdrawn, there may be tax consequences to the life insurance policyowner, as we’ll learn next.

mec money

Tax Treatment of Policy Dividends

Owners of participating life insurance policies are entitled to the payment of dividends that the company declares on the policy. Dividends are payable when a company’s actual mortality experience, operating costs, and investment results are better than what was expected. Premiums charged for life insurance are based on these factors, and companies typically make conservative assumptions about these factors to ensure that they will be able to meet the long-term guarantees their policies provide.

When the actual results of a company’s operations turn out to be more favorable than what the company assumed, a surplus is created: amounts that are more than needed to provide coverage and benefits, cover expenses, and maintain the company’s financial standing. At the company’s option, it may pay a portion of this surplus to its participating policyowners in the form of dividends.

Dividend Payments

Dividends are a function of a company’s investment and operating experience and are declared only when such experience produces a certain level of surplus. They are never guaranteed. Policyowners should not be encouraged to rely on dividends, especially if they are used to pay the policy’s premiums. Also, keep in mind that owners of nonparticipating policies have no rights to policy dividends because they do not share in the insurer’s experience.

Dividend Options

The following are common options owners have when they receive dividends:

  • purchase paid-up insurance amounts—Dividends can be used to purchase amounts of fully paid-up additional insurance amounts to supplement the base policy. These “paid-up adds,” as they’re called, are fully paid insurance amounts that generate cash value and are eligible for dividends. The cash value of additional insurance purchased with dividends is available to the policyowner for withdrawals, loans, and surrenders.
  • reduce premium payments—Dividends can be applied toward the payment of the policy’s premium, reducing the owner’s out-of-pocket expenses.
  • take the dividends in cash—Dividends can be paid directly to the policyowner in cash. Because these amounts are considered a return of premium paid, they are not taxable to the policyowner.
  • accumulate at interest—Dividends can be left on deposit with the insurance company and will be credited with interest earnings. These accumulations may be withdrawn at any time or at times specified by the insurer (such as policy anniversary dates). The interest paid on accumulating dividends is considered taxable income to the owner.
  • repay policy loans—Dividends can be used to repay any outstanding policy loan.
  • purchase one-year term insurance amounts—Dividends can be used to purchase one-year term insurance amounts to supplement the base policy.

Selecting a Dividend Option

As a general rule, an owner has to actively select a dividend option; otherwise, the company will simply apply the dividends according to its own standard. For most insurers, this standard is the purchase of paid-up insurance amounts. A dividend payment option can be changed by the owner at any time.

Income Taxation of Policy Dividends

Dividends paid in cash to owners of participating life insurance policies are considered a return of premium for tax purposes. For this reason, they are generally not subject to income tax—the policyowner is simply recouping a portion of what he or she put into the policy. Further, dividends applied to pay the policy’s premium or to purchase one-year term or paid-up additions are not taxable.

There are two situations in which policy dividends may be taxable:

  • when they are left to accumulate at interest; and
  • when they exceed the amount of premium paid for the policy.
When Dividends Are Left to Accumulate at Interest

If a policyowner elects not to receive dividends and chooses instead to let them accumulate at interest, the interest earnings on those dividends are considered taxable income to the owner. Dividend interest is taxable to the owner for the year it is credited to the owner’s account, whether or not the interest is actually withdrawn. The insurance company is required to report the accumulated interest earnings to the IRS every year. The dividends themselves, when paid to the policyowner, are not taxable.

When Dividends Exceed Premiums Paid

The second situation in which policy dividends are taxable is when they exceed the amount of premium paid for the policy. At that point, they are considered a gain in the policy and are taxable, if withdrawn or paid to the policyowner. This gain is taxable at ordinary income tax rates, not capital gains rates.

Keep in mind the distinction between life insurance policy dividends and dividends paid to life insurance stockholders. Life insurance stock dividends are treated, for income tax purposes, the same as other corporate dividends: they are taxable to the stockholder.

Factors Impacting Taxation of Living Benefits

For tax purposes, the receipt of living benefits is treated differently, depending on:

  • whether the policy is life insurance or a MEC
  • whether the policy is surrendered or sold
Life Insurance vs. MECs

The first factor that differentiates the tax treatment of living benefits is whether the policy is life insurance or a modified endowment contract. Living benefits taken from a life insurance policy receive far more favorable tax treatment than benefits taken from a MEC. This is explained in detail later in the course.

Surrenders vs. Third-Party Sales

The second factor that affects the tax treatment of living benefits applies when a policy is surrendered or is sold to a third-party investor.

Surrender implies a relinquishing of the policy to the issuing insurance company for its cash surrender value. A third-party policy sale involves the outright sale of the policy to a third-party investor, such as a viatical or life settlement company, for an amount more than its surrender value.

For tax purposes, the IRS makes a distinction between surrenders and sales, applying a calculation of the policyowner’s “investment in the contract” for surrenders and a calculation of the policyowner’s “adjusted cost basis” to sales.

Definition of “Investment in the Contract”

The term “investment in the contract” (or “basis”) generally refers to the amount of premium a contract holder paid into his or her policy. To be precise, however, investment in the contract is the total amount of premium and other consideration paid for a policy, minus the total amount received under the policy, to the extent these amounts were not taxed.

[Total amount of premium  +  other consideration paid]  –  [Total nontaxable amount received]  =  Investment in the contract

The total premium paid includes only premiums paid for the basic contract; it does not include premiums paid for additional benefits such as disability income or waiver of premium. Any premiums waived under the waiver of premium due to the insured’s disability are also excluded from total premiums paid.

From total premium paid, any nontaxable distributions are subtracted to arrive at investment in the contract. Thus, nontaxable distributions reduce the total premium paid. The most common sources of nontaxable distributions are dividends, policy withdrawals, and policy loans.

  • dividends received in cash—In general, dividends received in cash reduce the investment in the contract.
  • dividends used to purchase paid-up adds—Dividends used to purchase paid-up adds are essentially adding insurance coverage and cash value. They do not reduce investment in the contract.

piggy bank

  • dividends used to reduce premium payments—Though dividends used to reduce premium payments lower the owner’s out-of-pocket expense, they do not reduce the investment in the contract since they are considered to be retained within the policy as part of the premium payment.
  • dividends left to accumulate at interest—When a dividend is paid on a policy and left on deposit earning interest, it reduces the investment in the contract. The interest earnings on accumulating dividends, which are taxable to the owner, do not reduce the investment in the contract.
  • dividends used to pay off a policy loan—Generally, dividends applied to pay the principal or interest on a policy loan reduce the investment in the contract.
  • withdrawals—A nontaxable withdrawal or partial surrender from a policy that provides for these options will reduce the investment in the contract. However, to the extent the withdrawal or partial surrender is taxed, such amount increases the investment in the contract.
  • policy loans—A policy loan does not reduce investment in the contract if it is not taxable to the policyowner. (If the loan is taxable, the owner’s investment in the contract is increased.) However, if a loan is outstanding at the insured’s death or surrender, the investment in the contract will be reduced by the amount outstanding.

Investment in the contract—total premium paid less total nontaxable amounts received under the contract—is the starting point for determining the taxation of a withdrawal or surrender. In the event that a policy is sold to a third-party investor (discussed in lessons 7 and 8), the IRS takes a different approach. For life insurance sales, the IRS uses adjusted cost basis, which it has defined to mean the amount of premiums paid less the cost of insurance earned and used over the policy’s term. Thus, for policy sales and the calculation of income received by the seller, the starting point is adjusted cost basis.

5.3 – Example #2—Surrender

At the age of 64, Wilson, a widower, decides to surrender his $100,000 participating whole life insurance policy and use the cash value for other investment purposes. Over the years, he had paid a total of $24,000 in premiums and had allowed the policy’s dividends to accumulate at interest. Upon surrender of the policy, the total dividend accumulations came to $9,000, and the interest earned on those dividends amounted to $1,000. To determine his investment in the contract, the total dividend amount is subtracted from premiums paid ($24,000 – $9,000 = $15,000). The $1,000 in dividend interest is not included in the calculation since it was taxable to Wilson as it was earned. Assuming the policy’s accumulated surrender value is $65,000, Wilson’s gain upon contract surrender is $50,000 ($65,000 – $15,000 = $50,000). That $50,000 will be treated as ordinary income, taxable at ordinary rates.

6.4 – Taxation of Proceeds Paid as a Matured Contract

Most permanent life insurance policies contain a provision that specifies payment of the policy’s face amount in the event the insured lives to the policy’s maturity date. This date is typically the insured’s age 95 or 100. In the event the insured lives to this age, the policy matures and will pay out its full value as a living benefit to the policyowner, thus terminating the policy.

In these cases, the proceeds will be considered a distribution of a living benefit, and the tax treatment will be the same as with other forms of life insurance living benefits: the owner amount that was paid into the policy is received tax free; the amount that represents interest earnings is taxable as ordinary income.

6.5 – Maturity Extension

With increasing life expectancies, it is not uncommon today for insureds to live beyond a policy’s stipulated maturity date of 95 or 100. Ordinarily, policies that pay their face amount as a living benefit create a taxable event for the policyowner: the amount of the maturity proceeds that exceeds premium paid is taxable as ordinary income. To address this contingency, many insurance companies now include a maturity extension provision in their contracts (or simply do not specify a maturity date in their newer life insurance contracts). These maturity extensions serve to avoid coverage cancelation and the payout of the face value by extending the death benefit payout date to a very advanced age, such as 121.

Maturity Extension Provisions

Under such provisions, the following are typical:

  • The charge for insurance coverage ceases, and premiums are no longer accepted.
  • Administrative charges and expenses cease.
  • Outstanding policy loans are allowed to remain in place; however, interest charges continue.
  • Under variable policies, the mortality and expense (M&E) charge and investment management fees continue unless the owner transfers the policy’s values to a guaranteed general account.
  • Any additional coverage provided by term riders ceases.

Death Benefit Payable under Policies with a Maturity Extension

The amount of death benefit payable under policies that include a maturity extension depends on the type of policy: traditional whole life, universal life, or variable life. Traditional whole life policies will typically pay an amount equal to the cash value. Level benefit universal life policies will typically pay the greater of the basic insurance amount or the cash value. Variable life policies will typically pay the basic insurance benefit plus the cash value. Regardless of the amount, if the proceeds are paid as a lump-sum death benefit, they are not subject to income tax.

Accelerated Benefits Taxation

When accelerated benefits are paid to terminally ill individuals, the funds are exempt from income taxation just as if they were paid at the insured’s death. They are deemed paid “by reason of the death of the insured.”

When paid to chronically ill individuals, a limited tax exemption is available. The exclusion is limited to the actual amount of expenses incurred in receiving long-term medical or nursing care, or a maximum of a specified daily amount ($330 per day as of 2015), as indexed for inflation.

Example

Assume that Jim Smith, who is chronically ill, received qualified long-term care for 140 days in 2015, which cost a total of $35,000 ($250 per day). He received a benefit of $335 per day ($46.900 total) as an accelerated benefit from his life insurance policy. Because Jim is chronically ill and received accelerated benefits on a per diem basis (without regard to the actual cost of care), the amount excludable is limited to $330 per day, or $46,200 total. Jim must therefore include $700 in income for that year.

Tax-Free Distributions to Pay Premiums

One of the provisions of the PPA allows owners of hybrid policies to pay the premiums for LTC coverage without any adverse income tax consequences. This is set forth in the tax code as follows.

[I]n the case of any charge against the cash value of an annuity contract or the cash surrender value of a life insurance contract as payment for coverage under a qualified long-term care insurance contract which is part of or a rider on such annuity or life insurance contract—

  • the investment in the contract shall be reduced (but not below zero) by such charge and
  • such charge shall not be includible in gross income3

Thus, distributions can be made from a contract’s cash values and applied to cover the charges for LTC coverage provided by the contract without causing tax to the owner. However, while charges against an annuity’s or life insurance policy’s values to pay LTC premiums are not taxable, such distributions will reduce the owner’s investment in the contract or policy (but not below zero)

Impact on Death Benefit

What impact does a long-term care rider or benefit have on the life insurance policy’s death benefit? There are two approaches that insurers use. Under the first approach, the rider is independent from the life insurance policy, which means that if any long-term care benefits are paid to the insured, the life insurance policy’s face amount will not be affected.

For example, let’s say that Jerome has a $300,000 life insurance policy with an independent long-term care rider. When he enters a nursing home, he receives $40,000 in long-term care benefits. At Jerome’s death, the $300,000 face amount of the life insurance policy as well as the policy’s cash value will not be reduced by the amount of long-term care benefits paid.

Under the second approach, long-term care benefits paid are linked to the life insurance policy’s face amount and cash value. When the insured dies, the beneficiary is paid the life insurance amount less any amounts the insured collected under the long-term care rider.

Using the previous example, let’s assume Jerome collects $40,000 in long-term care benefits and then dies. The face amount of Jerome’s policy is reduced by the amount of long-term care benefits paid, which means that his beneficiary will receive $260,000 rather than the full $300,000 as a death benefit.

This second approach is not recommended when life insurance is needed to provide funds for survivors. The life insurance policy’s death benefit can be significantly lowered or even reduced to zero if the need for long-term care benefits lasts long enough.

The following cites the types of exchanges that are permitted under Section 1035.

Product

Can Be Exchanged Tax Free For:

Life insurance policy

  • life insurance policy
  • an annuity
  • an endowment
  • a qualified LTCI policy

Annuity

  • an annuity
  • a qualified LTCI policy

Endowment

  • an endowment
  • an annuity
  • a qualified LTCI policy

Qualified long-term care insurance (LTCI) policy

  • a qualified LTCI policy

Exchanges Involving Outstanding Policy Loans

A policy loan on a life insurance contract being replaced can affect the tax treatment of the transaction. No adverse tax consequences result if the owner repays the loan in cash before the exchange. However, if the policy loan is reduced or simply eliminated from the new contract in the exchange, then the discharged loan amount is treated as a non-like kind distribution (boot) by the contract owner on the exchange. Any boot received in a Section 1035 exchange is taxable to the extent of gain in the contract. This gain is reported by the original contract’s insurer on IRS Form 1099-R.

Accelerated Benefits Taxation

When accelerated benefits are paid to terminally ill individuals, the funds are exempt from income taxation just as if they were paid at the insured’s death. They are deemed paid “by reason of the death of the insured.”

When paid to chronically ill individuals, a limited tax exemption is available. The exclusion is limited to the actual amount of expenses incurred in receiving long-term medical or nursing care, or a maximum of a specified daily amount ($330 per day as of 2015), as indexed for inflation.

Example

Assume that Jim Smith, who is chronically ill, received qualified long-term care for 140 days in 2015, which cost a total of $35,000 ($250 per day). He received a benefit of $335 per day ($46.900 total) as an accelerated benefit from his life insurance policy. Because Jim is chronically ill and received accelerated benefits on a per diem basis (without regard to the actual cost of care), the amount excludable is limited to $330 per day, or $46,200 total. Jim must therefore include $700 in income for that year.

Assume that a life insurance owner had paid $75,000 in premiums, and the policy now has a cash value of $100,000 (a $25,000 gain). If the cash value is used to cover the cost of the LTC coverage included in the policy, the amount used to pay for the coverage would be subtracted from the owner’s $75,000 cost basis. Assuming the cost of the LTC coverage this year is $2,000, the policyowner’s cost basis would now be $73,000 ($75,000 – $2,000 = $73,000).

Exchanges Involving Outstanding Policy Loans

A policy loan on a life insurance contract being replaced can affect the tax treatment of the transaction. No adverse tax consequences result if the owner repays the loan in cash before the exchange. However, if the policy loan is reduced or simply eliminated from the new contract in the exchange, then the discharged loan amount is treated as a non-like kind distribution (boot) by the contract owner on the exchange. Any boot received in a Section 1035 exchange is taxable to the extent of gain in the contract. This gain is reported by the original contract’s insurer on IRS Form 1099-R.

Example

For example, assume Ernest owns a life insurance policy that has a current cash value of $50,000 and a basis of $30,000, giving it a $20,000 gain. The policy is also subject to a $5,000 policy loan. Ernest replaces that contract with another life insurance contract through a 1035 exchange. The loan is discharged at the time of exchange by reducing to $45,000 the cash value that is transferred to the new contract. The new policy would have a starting cash value of $45,000, which is less than the cash value of the original contract when the exchange process was initiated. The $5,000 boot is treated as cash received by Ernest and is reported by the original policy’s carrier on Form 1099-R.

The IRS has issued private letter rulings that indicate it will not treat a policy loan as boot in a 1035 exchange if the insurer that issues the new policy is willing to carry over the same loan amount to the new policy.4 In these cases, the policyowner has not recognized any gain; therefore, no tax would apply. Whether a company will issue a new policy under a 1035 exchange transaction with an outstanding loan is a matter of company policy.

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January 15, 2016 · Jennifer · No Comments
Posted in: L54) MEC Modified Endowment Cont

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