Income Taxation of Life Insurance and Annuity Contracts, considers the federal income tax rules applicable to life insurance and annuity contracts, addressing, for example, the exclusion from gross income of death benefit proceeds and the taxation of annuity payments; deductions related to the purchase of life insurance policies and annuity contracts; the federal income tax rules applicable to dispositions of life insurance policies and annuity contracts; international aspects; and valuation. This Portfolio does not address the definition of a life insurance or annuity contract for federal tax purposes. That topic is discussed in Tax Management Portfolio 546 T.M., Annuities, Life Insurance, and Long-Term Care Insurance Products.

As life insurance and annuity products are used in a variety of contexts, the tax treatment of these products is an issue that arises under a broad array of Code sections. For example, these products may be used in the qualified retirement plan context and thus raise tax issues under Subchapter D of the Code, and may be used generally in the compensation context. These products are also commonly used in the context of estate and gift tax planning, thus raising tax issues under Subtitle B of the Code.

This Portfolio focuses on the federal income tax treatment of nonqualified life insurance and annuity products. Life insurance and annuity tax issues relating to qualified retirement plans, employee compensation, and to estate and gift tax rules are covered in other Tax Management portfolios. See, e.g., 386 T.M., Insurance-Related Compensation, and 826 T.M., Life Insurance. Similarly, this Portfolio focuses on life insurance and annuity contracts issued by commercial insurance companies. A discussion of “private” annuities can be found in 805 T.M., Private Annuities and Self-Canceling Installment Notes.

A separate but important topic relating to life insurance and annuity products is the definition of these products for federal tax purposes. These definitions are beyond the scope of this Portfolio. Another aspect of life insurance and annuity products that is beyond the scope of this Portfolio relates to the taxation of the issuer of the contract, generally a life insurance company. Life insurance companies are subject to special tax rules in Subchapter L of the Code. 

Portfolio 529-1st: Income Taxation of Life Insurance and Annuity Contracts

Portfolio Description

Authors

Technical Advisors

Description

Detailed Analysis

I. Death Benefit Proceeds

A. Exclusion from Gross Income — Historical Background

1. Overview

2. Statutory Evolution of §101

B. Amounts Fully Excludible from Gross Income

1. “Under a Life Insurance Contract”

a. Pre-1982 Meaning of “Life Insurance Contract”

b. Post-1982 Meaning of “Life Insurance Contract”

2. “Paid by Reason of Death”

3. Employer-Employee, Corporation-Shareholder Situations

a. Shared Ownership of Life Insurance: “Split-Dollar Arrangements”

b. Non-Split-Dollar Situations

(1) Corporation or Employer Pays Premiums, Owns Policy, and Is Beneficiary

(2) Corporation or Employer Pays Premiums, Owns Policy; Shareholder/Employee Is Beneficiary

(3) Corporation or Employer Pays Premiums; Third Party Owns Policy or Controls Beneficiary Designation

4. Conduit Situations

5. Amount of Death Benefit Proceeds Excludible Under §101(a)(1)

6. Relevance of State Law

7. Relevance of Intent

C. Special Situations Involving the § 101(a)(1) Exclusion

1. Creditor-Owned Life Insurance

a. In General

b. Historical Overview

c. Current State of the Law

2. Accelerated Death Benefits and Viatical Settlements

a. Background of §101(g)

b. Excludibility of Certain Accelerated Death Benefits

c. Excludibility of Certain Viatical Settlement Proceeds

3. Certain Amounts Paid to Public Safety Officers/Terrorism Victims

a. Public Safety Officers

b. Certain Terrorist Victims

4. “Employer-Owned Life Insurance” §101(j))

a. Background

b. Section 101(j): In General

c. Section 101(j): Exceptions

d. Notice and Consent Requirements

e. Reporting and Recordkeeping

f. Effective Date of §101(j); Effect of § 1035 Exchanges

5. Corporate-Owned Life Insurance — The “AMT”

6. Investor-Owned Life Insurance

D. Limitations on § 101(a)(1) Exclusion

1. Transfer-for-Value Rules

a. Historical Overview

b. What Is a Transfer?

c. Valuable Consideration

d. Exceptions to Transfer-for-Value Rule

(1) Carryover Basis Transactions

(2) Transfer of Policy to Insured Party

(3) Transfer of Policy to Partner of Insured Party

(4) Transfer of Policy to Partnership of Which Insured Party Is a Partner

(5) Transfer of a Policy to a Corporation in Which Insured Is a Shareholder or Officer

(6) Policies Transferred More than Once

e. Premiums and Other Amounts Subsequently Paid

f. Life Settlements

g. Legislative Proposals

2. Death Benefits Paid Other than in a Lump Sum at Death §101(c) and (d))

a. Historical Overview

b. Section 101(c)

c. Section 101(d)

d. Delays on Account of Illiquidity/Valuation

E. Special $5,000 Exclusion for Employee Death Benefits

1. Background and Statutory Evolution

2. Key Aspects of Former §101(b)

a. Operation of the General Exclusion

b. $5,000 Limitation

c. Forfeitability Requirement

d. Qualified Plans

e. Annuities

3. Brouhaha over Voluntary Death Benefit Payments

4. Relationship Between §101(a) and Former §101(b)

II. Amounts Payable Under Life Insurance Policies and Annuity Contracts (Other Than Death Benefit Proceeds Under Life Insurance Policies)

A. Introduction

1. Deferral of Tax on the “Inside Buildup”

a. General Rule

b. Corporate-Owned Deferred Annuities

c. “Failed” Contracts

d. The Corporate Alternative Minimum Tax

2. Statutory Evolution of §72

B. Overview of §72

C. Annuity Starting Date

1. In General

2. Transfer for Value

3. Contract Exchange

4. Wage Continuation Plan

5. Maximum Annuity Starting Date

D. Annuity Contracts: Amounts Received as an Annuity

1. Overview

2. What Is an Amount Received as an Annuity?

a. In General

b. Variable Periodic Payments

c. Dividends and Refund Amounts

d. A Fund Plus Interest

e. Increasing Periodic Payments

3. Determining the Exclusion Ratio

a. In General

b. Exclusion Limited to Investment

c. Variable Periodic Payments

d. Multiple Annuity Elements

4. Expected Return

a. In General

b. Fixed Periodic Payments

(1) In General

(2) Single Life Annuity

(3) Temporary Life Annuity

(4) Scheduled Increase or Decrease in Payments

(5) Joint and Survivor Annuity and Joint Annuity

(6) Term Certain

(7) Amount Certain

c. Variable Periodic Payments

d. Multiple Annuity Elements

5. Investment in the Contract

a. In General

b. Multiple Annuity Elements

c. Payments in the Nature of a Refund of the Consideration Paid

(1) In General

(2) Refund Features

(3) Adjusting the Investment in the Contract: Generally

6. Recalculation of the Exclusion Ratio and Amount Received as an Annuity

7. Deduction for Unrecovered Investment in the Contract

E. Annuity Contracts: Amounts Not Received as an Annuity

1. In General

2. Investment in the Contract

3. Taxation of Amounts Received Before Annuity Starting Date

a. Income-First Treatment Generally

b. Loans, Assignments, and Pledges Treated as Distributions

c. Transfer Without Full and Adequate Consideration

d. Dividends

e. Constructive Distributions

4. Taxation of Amounts Received on or After the Annuity Starting Date

a. In General

b. Dividends

c. Payment of a Fund Plus Interest

d. Annuity Payments Differing in Amount and/or Duration

(1) In General

(2) Surrender or Commuted Value After the Annuity Starting Date

e. Amounts Received in the Nature of a Refund

f. Amounts Received upon Surrender, Redemption, or Maturity

F. Amounts Received Under Life Insurance Contracts

1. Overview

2. Historical Background

3. Pre-Death Distributions from a Non-MEC

a. In General

b. Investment in the Contract and Constructive Distributions

c. Section 7702(f)(7) Adjustment Events

d. Loans, Assignments, and Pledges

e. Dividends

f. Surrender, Redemption, or Maturity

g. No Penalty Tax

4. Pre-Death Distributions from an MEC

a. In General

b. Income-First Treatment

c. Loans, Assignments, and Pledges Treated as Distributions

d. Aggregation of Contracts

e. Penalty Tax on Premature Distributions

G. The Special Case of Partial Annuitizations

1. In General

2. Direct Partial Annuitization

3. Exchange Partial Annuitization

H. Death Benefits Under an Annuity Contract

I. Penalty Tax on Premature Distributions

1. Statutory Evolution

2. Premature Distributions from Nonqualified Annuity Contracts

3. The “SEPP” Exception to the Penalty Tax

a. Overview

b. Cost-of-Living Increases

c. Election Requirement

d. Entire Interest Requirement

e. Scheduled Stream of Payments

f. Acceptable Methods of Computing SEPP Amounts

(1) Overview

(2) Required Minimum Distribution Method

(3) Fixed Amortization Method

(4) Fixed Annuitization Method

g. Life Expectancy Tables

h. Interest Rates

i. Account Balances

j. One-Time Switch to Required Minimum Distribution Method

k. The “Annuity Unit” Method for Variable Contracts

l. Periodic Payments that Increase Annually by a Constant Percentage

m. Modifications to SEPP Amounts

4. Immediate Annuity Contract Exception to the Penalty Tax

J. Insurance/Long-Term Care Combination Products

K. Definitional Aspects of the § 72 Rules

1. Overview

2. Annuity vs. Amount Held Under Agreement to Pay Interest

3. Multiple Annuity Elements

4. Section 72(s)

a. In General

b. Identity of the “Holder”

c. Applying the At-Least-As-Rapidly Rule Before the First Annuity Payment

5. Section 72(u)

a. In General

b. Exceptions to § 72(u)(1)

c. Income on the Contract

6. Aggregation of Contracts

a. Overview

b. Aggregation Under § 72(e)(12)

(1) In General

(2) “Split-Funded” Annuity Arrangements

(3) Aggregation of Exchanged Contracts

III. Deductions Related to the Purchase of Life Insurance Policies and Annuity Contracts

Introductory Material

A. Personal Expenditures

B. Capital Expenditures

C. Ordinary and Necessary Business Expenses

D. Insurance Premiums

1. In General: The Prohibition of § 264(a)(1)

2. Deductibility of Premiums as Additional Compensation

3. Premiums Paid by Creditors

4. Premiums as Charitable Contributions

5. Payment of Premiums in the Divorce Context

6. Premiums and § 265(a)(1)

E. Interest Deductions on Related Borrowing (§ 264(a)(2)-(4))

1. Introduction

a. Overview

b. “Life Insurance, Endowment or Annuity Contract”

c. The Existence of Valid Indebtedness

2. Section 264(a)(2) - Single-Premium Life Insurance, Endowment and Annuity Contracts

a. Statutory Evolution

b. In General

c. What Is a Single-Premium Contract?

d. The Meaning of “to Purchase or Carry”

3. Section 264(a)(3)

a. Overview

b. A Plan of Systematic Borrowing

c. The 4-out-of-7 Test

d. Measuring Premiums and Correlating Premiums to Borrowings

e. The De Minimis Rule

f. The Unforeseen Events Exception

g. The Business Borrowing Exception

4. Section 264(a)(4)

a. Overview

b. General Disallowance Rule/Relationship to § 264(a)(2) and (3)

c. Meaning of “Key Person”/“20% Owner”

d. The $50,000 Cap

e. “Applicable Rate of Interest”

f. Effective Date and Transition Rules

F. Interest Deductions on Unrelated Borrowing (§ 264(f))

1. In General

2. “Unborrowed Policy Cash Values”

3. Allocation of Interest Expense

4. Exception for Employees et al.

5. Special Rule for Insurance Companies

6. Policies Held by Individuals

7. Policies Held by Partnerships: S Corporations

8. Aggregation Rules

9. Effective Date

IV. Dispositions of Life Insurance Policies and Annuity Contracts

Introductory Material

A. Taxable Sales/Exchanges

1. Basis and Adjusted Basis

a. Basis vs. “Investment in the Contract”

b. Adjusted Basis: Life Insurance Policies

(1) The London Shoe Doctrine

(2) IRS Position

(3) Determining Cost of Insurance Charges

(4) Adjusted Basis of a Life Insurance Policy in Other Contexts

(5) Disallowed Interest Expense

c. Adjusted Basis — Annuity Contracts

2. Character of Gains

a. Surrenders

b. Sales or Exchanges

c. Death Benefit Proceeds

d. Section 1234A

3. Recognition of Losses

a. Establishment of a Loss

b. A Transaction Entered into for Profit

c. Character of the Loss

d. Adjustment to Gross Income vs. Miscellaneous Itemized Deduction

B. Nontaxable Exchanges Under § 1035

1. Tax-Free Exchange Treatment Generally

a. Nonrecognition of Gain or Loss

b. Carryover Basis

2. The Occurrence of an Exchange

a. Exchange Under § 1001

b. Contracts Issued by Troubled Insurers

c. Administrative Delays

3. “Endowment Contract” Defined

4. “Contract of Life Insurance” Defined

5. “Annuity Contract” Defined

6. “Qualified Long-Term Care Insurance Contract” Defined

7. The Same “Obligee” Requirement

8. The Same “Insured” Requirement

9. Exchanges into an Existing Contract

10. Treatment of “Boot” Received in an Exchange

11. Exchanges of or for Multiple Contracts

12. Partial Exchanges

a. The Conway Case

b. Rev. Rul. 2003-76 and Notice 2003-51

c. Rev. Proc. 2008-24

d. Rev. Proc. 2011-38

e. Other Types of Partial Exchanges

13. Exchanges Involving Contracts Issued by Foreign Insurers

14. Characteristics that Carry Over in an Exchange

a. Basis

b. “Grandfather” Status

c. Purchase Date

d. Aggregation Treatment

15. Treatment of Failed § 1035 Exchanges

V. International Aspects of Life Insurance and Annuities

Introductory Material

A. Contracts Issued to or Held by Foreign Persons

1. Withholding and Source Rules

a. “FDAP” Income

b. Source

2. U.S. Trade or Business

3. Treaty Issues

B. Foreign-Issued Contracts

1. In General

2. “FBAR” Reporting

3. Reporting Under § 6038D

C. Foreign Account Tax Compliance Act: Insurance Aspects

1. In General

2. Definitions of “Financial Account” and FFI

3. Withholding on Payments to FFIs

4. Participating FFIs

D. The Insurance Excise Tax

VI. Issuance of Life Insurance Policies and Annuity Contracts in Special Situations

Introductory Material

A. Business-Owned Life Insurance

B. Compensating with Life Insurance

C. Qualified Plans and Arrangements; “412(i) Plans”

D. Estate Planning

E. Life Settlements and Premium Finance Transactions

F. Life Insurance Involving Charities

1. Charitable Split-Dollar Arrangement

2. CHOLI

G. Private Annuities

H. Structured Settlements and Other Periodic Payment Funding Situations

I. “Stranger-Owned” Life Insurance and Annuity Contracts

J. Life Insurance and Welfare Benefit Plans

VII. Valuation of Life Insurance and Annuities

A. Overview

B. Valuation for Estate and Gift Tax Purposes

C. Life Insurance and § § 79, 83 and 402

D. Valuation of Annuity Contracts in Roth IRA Conversions

Working Papers

Table of Worksheets

Worksheet 1 Section 72 - Legislative History of the 1954 Code

Worksheet 2 Section 101 - Legislative History of the 1954 Code

Worksheet 3 Section 7702A - Legislative History of the TAMRA

Worksheet 4 Section 264(f) - Legislative History of the Taxpayer Relief Act of 1997

Worksheet 5 Rev. Rul. 2009-13, 2009-21 I.R.B. 1029

Worksheet 6 Rev. Rul. 2009-14, 2009-21 I.R.B. 1031

Bibliography

Books

Reports

Newspapers

Periodicals

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Kirk Van Brunt, Locke Lord LLP, Washington, DC. Kirk Van Brunt, B.A., magna cum laude, Northwest Nazarene University; J.D., cum laude, Harvard Law School. Editor, Harvard Law Review (1984–85). Member: Massachusetts State Bar, District of Columbia Bar; American Bar Association (Tax Section) (former Chair of the Insurance Companies Committee); Federal Bar Association; Association of Life Insurance Counsel. Mr. Van Brunt is widely published in the area of insurance taxation and a frequent speaker at tax and insurance events.

Mark E. Griffin, Davis & Harman LLP, Washington, DC, Mark E. Griffin, B.A., Hamilton College, magna cum laude (1981), J.D., Syracuse University College of Law, cum laude (1984), LLM in Taxation, Georgetown University Law Center (1988); Tax Law Specialist, Office of the Assistant Commissioner, Exempt Organizations Technical Division, Internal Revenue Service, Washington, D.C. (1985–1986); Attorney-Advisor, U.S. Tax Court, Washington, D.C. (1986–1988); member, New York State Bar, District of Columbia Bar; American Bar Association (Taxation Section); Federal Bar Association (Taxation Section); Association of Life Insurance Counsel; National Structured Settlement Trade Association; National Tax Sheltered Account Association.