1. Cash and Cash Equivalents Chapter 1 Tools & Techniques of Investment Planning Taxation of Benefits Chapter 21 Tools & Techniques of Life Insurance Planning 21 - 1  Taxation during the insured’s lifetime  Life insurance defined  Contracts must contain elements of risk shifting and risk distribution  Contracts must meet IRC Section 7702 requirements  Cash Value Accumulation Test (CVAT) or  Meet certain guideline premium requirements  If contract meets the definition of life insurance  Cash value grows tax deferred  Death benefits are income tax free  Withdrawals up to the policy basis and policy loans are income tax deferred

2. Cash and Cash Equivalents Chapter 1 Tools & Techniques of Investment Planning Taxation of Benefits Chapter 21 Tools & Techniques of Life Insurance Planning 21 - 2  Taxation during the insured’s lifetime  Cash value increases  Grow income tax deferred  Dividends  Until total dividends received in cash exceed the policyowner's basis, these distributions are income tax free  Election to make policy paid-up  Applying cash value as a single premium to purchase a paid-up policy at a reduced face amount does not create a taxable event  Cash values were never constructively received by the policy owner  However if an outstanding loan is reduced during this transaction, the policyowner may incur some taxation

3. Cash and Cash Equivalents Chapter 1 Tools & Techniques of Investment Planning Taxation of Benefits Chapter 21 Tools & Techniques of Life Insurance Planning 21 - 3  Taxation during the insured’s lifetime (cont'd)  National service life insurance  No gain is subject to income tax  Policy withdrawals  Withdrawal is a partial surrender of a policy  No taxable income until withdrawals exceed policyowner's basis  Exception – income tax liability is accelerated if a cash distribution occurs within the first 15 years of the policy’s issue and  That distribution is coupled with a reduction in the policy’s death benefit  Does not apply to policies issued after 1985

4. Cash and Cash Equivalents Chapter 1 Tools & Techniques of Investment Planning Taxation of Benefits Chapter 21 Tools & Techniques of Life Insurance Planning 21 - 4  Taxation during the insured’s lifetime (cont'd)  Surrender, redemption of maturity of policy  Lump sum cash-in  Excess over investment in the contract is ordinary income  Interest only option  Interest is taxable as received  Definition of investment in the contract  Total premiums paid less total amount of nontaxable distributions (dividends, unrepaid loans, tax free withdrawals)  Annuity taxation  Annuity – systematic liquidation of principal and interest over a fixed or contingent period of time  Annuitant can exclude from tax a fixed (return of cost) portion of each payment from gross income and pay income tax at ordinary rates on the balance of each payment

5. Cash and Cash Equivalents Chapter 1 Tools & Techniques of Investment Planning Taxation of Benefits Chapter 21 Tools & Techniques of Life Insurance Planning 21 - 5  Taxation during the insured’s lifetime (cont'd)  Deductibility of premium payments  No deduction allowed for premiums paid on personally owned policy  No deduction for business policyowners if they are directly or indirectly a beneficiary under the policy  Policy loan interest  Trade or business situations  Contracts purchased before June 21, 1986 are not subject to any limit on deductibility of interest  1996 Legislation – interest deductible for corporate owned polices insuring a key employee up to $50,000 of indebtedness  Number of persons who may be treated as key employees is limited to the greater of (1 ) five employee or (2) the lessor of 5% of total officers and employees or twenty individuals

6. Cash and Cash Equivalents Chapter 1 Tools & Techniques of Investment Planning Taxation of Benefits Chapter 21 Tools & Techniques of Life Insurance Planning 21 - 6  Taxation during the insured’s lifetime (cont'd)  Policy loan interest (cont'd)  Investment or passive activity situations  Where policyowner can document that proceeds of a policy loan were used to purchase an investment or expended on a passive activity  Interest should be considered investment interest  Deductible subject to investment interest limitations  Personal situations  Interest not deductible  Single premium contracts  No deduction allowed for interest paid or accrued on indebtedness incurred to purchase or continued in effect a single premium life insurance contract  Single premium – substantially all the premiums are paid within four years after the policy was purchased

7. Cash and Cash Equivalents Chapter 1 Tools & Techniques of Investment Planning Taxation of Benefits Chapter 21 Tools & Techniques of Life Insurance Planning 21 - 7  Taxation during the insured’s lifetime (cont'd)  Policy loan interest (cont'd)  Financing the policy through policy loans  No deductions is allowed for interest payments  Exceptions  Four out of seven premiums paid without borrowing  $100 exception - for interest less than $100  Unforeseen events – (1) There was an unforeseen substantial increase in the policyowner’s financial liability, or (2) the policyowner suffered an unforeseen substantial loss in income  Interest paid on conversion of term policy  For original age conversions – back premiums plus interest payments made to insurance company

8. Cash and Cash Equivalents Chapter 1 Tools & Techniques of Investment Planning Taxation of Benefits Chapter 21 Tools & Techniques of Life Insurance Planning 21 - 8  Taxation during the insured’s lifetime (cont'd)  Timing of interest deduction  Accrual basis policyowners take deduction in year interest accrues  Cash basis policyowners take deduction in the year interest is paid  Only policyowner can take deduction, and only if they made the interest payment  Assignee cannot deduct interest that accrued before policy was transferred to him/her  Taxation of policyowner or insured in business situations  If the employer is directly or indirectly the beneficiary of the insurance contract, the insured-employee is not taxed on corporation payment of policy premiums  Exceptions – (1) Proceeds payable to employees beneficiary or estate (2) Proceeds paid to a personal beneficiary or estate of an employee

9. Cash and Cash Equivalents Chapter 1 Tools & Techniques of Investment Planning Taxation of Benefits Chapter 21 Tools & Techniques of Life Insurance Planning 21 - 9  Taxation during the insured’s lifetime (cont'd)  Taxation of policyowner or insured in business situations (cont'd)  Stock redemption – premiums not taxed to any shareholder  Buy-sell – where policy used to fund a buy-sell agreement is personally owned by a shareholder and shareholder has named a personal beneficiary or designated his or her estate as beneficiary, corporate premium payments may be considered a distribution of dividend  Taxation of policyholder in creditor situation  Creditor receives proceeds in satisfaction of a debt – proceeds are tax free  Taxation of policyholder in alimony situation  Premium payments are taxable as alimony to non-insured spouse owner

10. Cash and Cash Equivalents Chapter 1 Tools & Techniques of Investment Planning Taxation of Benefits Chapter 21 Tools & Techniques of Life Insurance Planning 21 - 10  Taxation during the insured’s lifetime (cont'd)  Taxation of advance premium deposits  Discount allowed to a policyowner who pays premiums more than one year before they come due  IRS taxes the interest increment earned on those pre-paid premiums  Taxation of accelerated death benefits  Amounts received under a life insurance policy on the life of a (1) terminally ill person, or (2) chronically ill insured  Treated as an amount paid by reason of death of the insured  Amounts paid to chronically ill persons subject to same limitation that apply to long term care  In 2008 - $270 per day

11. Cash and Cash Equivalents Chapter 1 Tools & Techniques of Investment Planning Taxation of Benefits Chapter 21 Tools & Techniques of Life Insurance Planning 21 - 11  Taxation during the insured’s lifetime (cont'd)  Sale of a life insurance policy  Gain on sale taxable as ordinary income  No loss deduction is allowed  If policy sold for less than fair market value  Difference may be taxable to buyer  Corporate distribution of policy  Corporation buys back its own stock or purchases land and, in return, pays for the purchase by distributing a life insurance policy on the life of the selling shareholder or landowner  Seller of stock would realize gain equal excess of stock over (1) value of policy over (2) seller’s basis in the stock or land

12. Cash and Cash Equivalents Chapter 1 Tools & Techniques of Investment Planning Taxation of Benefits Chapter 21 Tools & Techniques of Life Insurance Planning 21 - 12  Taxation at and after the insured’s death  Implication of meeting definition  If contract meets definition of life insurance under IRC Section 7702, then proceeds are generally income tax exempt  Proceeds payable at insured’s death  Generally income tax free  Even if proceeds are payable to  Corporation  Trust  LLC  Partnership  Paid in lump sum or installments  From riders on the policy (accidental death benefits)

13. Cash and Cash Equivalents Chapter 1 Tools & Techniques of Investment Planning Taxation of Benefits Chapter 21 Tools & Techniques of Life Insurance Planning 21 - 13  Taxation at and after the insured’s death (cont'd)  Proceeds payable at a date later than death  If delay results in payment of interest in addition to proceeds  Interest is taxable as ordinary income to the recipient  Payments taken in installments  Amount of proceeds systematically liquidated over time  Part of each payment considered tax free and part will be taxable, in much the same way annuities are taxed  Tax free portion called – amount held by insurer  Step 1 - Compute amount held by insurer  Step 2 - Determine number of years in the payment period  Step 3 – Dividend Step 1 answer by Step 2 answer

14. Cash and Cash Equivalents Chapter 1 Tools & Techniques of Investment Planning Taxation of Benefits Chapter 21 Tools & Techniques of Life Insurance Planning 21 - 14  Taxation at and after the insured’s death (cont'd)  Life Income option elected  Tax free amount continues regardless of how long the beneficiary lives  Even if beneficiary outlives the life expectancy (from Step 2), these amounts remain income tax free  Fixed period option elected  Beneficiary can chose to take insurance proceeds over a number of years  The same three-step process is used to determine the taxable and non-taxable portion of each payment

15. Cash and Cash Equivalents Chapter 1 Tools & Techniques of Investment Planning Taxation of Benefits Chapter 21 Tools & Techniques of Life Insurance Planning 21 - 15  Taxation at and after the insured’s death (cont'd)  Fixed amount option elected  Beneficiary selects an amount to be paid to them  Length of time over which lump sum will be paid depends on size of the proceeds and amount of payments selected  Three-step procedure applies  If the primary beneficiary dies before end of the guaranteed period, the secondary beneficiary can also exclude from gross income the same amount of pro-rated principal  Interest only option  Beneficiary leaves proceeds with insurer and takes only interest payments  Interest is fully taxable to the beneficiary

16. Cash and Cash Equivalents Chapter 1 Tools & Techniques of Investment Planning Taxation of Benefits Chapter 21 Tools & Techniques of Life Insurance Planning 21 - 16  Taxation at and after the insured’s death (cont'd)  Exception for government life insurance  None of the interest element payable is subject to income tax if proceeds are payable under government life insurance  Exception to the general rule for transfer for value  Where a policy, or an interest in a policy transferred in return for any type of valuable consideration in money or money’s worth  Proceeds, except to the extent of the dollar value of that consideration and any premiums paid after the transfer by the new policy owner lose their income tax free status  Exception where proceeds are considered compensation or dividends  Insured never reports income from corporation payment of premiums on policy owned by employee or third party  Tax on premiums plus interest and penalties payable by the estate  Proceeds would still be income tax free

17. Cash and Cash Equivalents Chapter 1 Tools & Techniques of Investment Planning Taxation of Benefits Chapter 21 Tools & Techniques of Life Insurance Planning 21 - 17  Taxation at and after the insured’s death (cont'd)  Exception where proceeds are considered compensation or dividends (cont'd)  If corporation owns and is the beneficiary of the policy and pays all premiums  Proceeds received income tax free  May be subject to the AMT tax  If those proceeds are subsequently paid out to the beneficiary of the employee  Payments taxable to the beneficiary  Corporation can take deduction for those payments as compensation  Corporation owns policy and pays all premiums, but proceeds are payable to an employee or employee shareholder’s beneficiary  Payments are compensation in the case of an employee  Payments are dividends in the case of a shareholder employee

18. Cash and Cash Equivalents Chapter 1 Tools & Techniques of Investment Planning Taxation of Benefits Chapter 21 Tools & Techniques of Life Insurance Planning 21 - 18  Taxation at and after the insured’s death (cont'd)  Exception where policy owned but a qualified retirement plan  Portion of proceeds equal to the cash surrender value will be taxable as ordinary income when death benefits are paid from the qualified plan  The “net amount at risk” portion of the proceeds are income tax free