B1—Taxation Of Proceeds Payable At Death

As a general principle, the proceeds of a life insurance policy paid by reason of the insured`s death are exempt from federal income tax.

The Transfer For Value Rule is an exception to this general principle and is discussed separately in Section 19.1, Subdivision B2.

Accelerated Death Benefits and Viatical Settlements are discussed in Section 19.1 Subdivision C.

Insurance Proceeds Exempt from Income Tax

Death Benefits

The proceeds of a life insurance or endowment policy paid because of an insured`s death generally are not includable in gross income. This exclusion applies regardless of whether the proceeds are paid to an individual, a partnership, corporation, or trust as long as the policyholder has an insurable interest in the insured`s life. In addition, death benefit payments which have the characteristics of life insurance proceeds payable by reason of death, such as workmen`s compensation or accident and health contracts, are also exempt from income taxation [I.R.C. §101(a)(1); Reg. §1.101-1(a)].

Dividends

Accumulated dividends are not properly considered life insurance proceeds payable at death, but as property owned by the insured which passes to the beneficiary under the terms of the policy. They are excluded from gross income, however, as property received by inheritance [I.R.C. §102].

A postmortem dividend for the last, uncompleted policy year should assume the same exempt status as a dividend accumulation. A mortuary dividend, a special dividend payable at the insured`s death, should also qualify for tax-free treatment under Code §102.

Life Insurance Settlement Options

The proceeds of a life insurance policy can be paid out in a variety of ways. The choice is up to the policy owner, as a right of ownership, or he or she may leave the decision to the beneficiary. Some choose to have the proceeds paid in a single lump sum. However, there are other options that might be more suitable to the needs of the surviving beneficiary or surviving family. These alternate payment options are known as settlement options and include the interest-only option, fixed-period option, fixed-amount option and life-income option.

Payment In One Sum

If the beneficiary, at the insured`s death, takes the policy proceeds in one lump sum, no part of the sum is includable in gross income.

Death Proceeds Paid Under Fixed-Period Option

If death proceeds are paid under a fixed-period option, the insurance company pays the beneficiary an equal amount of money—a combination of proceeds and interest earnings--over a specified period of years. The amount of each installment payment is determined by the length of the desired period of income. For tax purposes, the beneficiary includes the interest in gross income. The excludable portion of each installment payment is calculated as follows: (1) determine the amount the insurance company initially holds for the beneficiary (this is usually the amount to be received if payment were made in one sum), and (2) divide this amount by the number of installment payments. The quotient is the portion of each installment which represents principal and is exempt from tax. Only the balance of the payment is taxable. The portion of the guaranteed payment that is excludable, and the guaranteed portion taxable, never change, regardless of how long the payments continue [I.R.C. §101(d)(1), (2); Reg. §1.101-4(a)].

Death Proceeds Paid Under Fixed-Amount Option

With this option, the policy proceeds plus interest earnings are paid out regularly in specified amounts for as long as the proceeds last. The amount of each income payment is fixed; how long the payout period will last is determined by the amount of the payment. If the settlement plan calls for payments over a definite period of time (such as ten or twenty years), the number of installments (the denominator in the formula above) is readily ascertainable. Where the settlement provides for payments of a fixed amount until the proceeds are exhausted, insurance company tables assuming a guaranteed minimum rate of interest will disclose the minimum number of such payments. This number is divided into the lump-sum death proceeds to determine the excludable portion of each guaranteed installment [Reg. §1.101-4(g), Example (2)].

Death Proceeds Paid Under Life Income Option

Under a life-income option—of which there are several—the beneficiary receives a guaranteed income for life. Essentially, the proceeds are used to purchase a life annuity, the duration of which is based on the beneficiary`s lifetime. When payments are made under a life income option, the portion that will be excluded from gross income depends on the beneficiary`s life expectancy. If the insured died on or before October 22, 1986, the insurance company`s mortality tables can be used. If the insured died after October 22, 1986, unisex mortality tables prescribed by the IRS must be used [I.R.C. §101(d)(2)].

Straight Life Income

If the settlement plan calls for a straight life income, calculate the beneficiary`s life expectancy (in years) at the insured`s death. Then multiply the life expectancy by the number of payments to be made each year, and divide the lump-sum death proceeds by this product. The result is the excludable portion of each life income payment [Reg. §1.101-4(c)].

For a joint-and-survivor option, divide the lump-sum death proceeds by the beneficiaries` joint-and-survivor life expectancy to determine the annual amount that can be excluded [Reg. §1.101-4(d)(2); (g), Example (5)].

Period Certain

Where the proceeds are paid under a life-income option with a period certain, the tax-free portion of each payment is calculated as follows:

1. Determine the actuarial value of the period-certain feature (the present value of the contingent beneficiaries` interest at the insured`s death).

2. Subtract this value from the amount the company initially holds for the beneficiaries (the lump-sum death proceeds).

3. Multiply the primary beneficiary`s life expectancy by the number of payments to be made each year.

4. Divide the difference from step (2) by the result from step (3). The quotient is the excludable portion of each installment [Reg. §1.101-4(c) and (e); (g), Example (8)].

The balance of each installment is fully taxable.

As a result of the above adjustment, any period-certain payments received by a contingent beneficiary are tax-free, except for excess interest [Reg. §1.101-4(d)(3);(g), Example (8)].

Interest-Only Options

Under this option, the insurance company holds the proceeds in trust for a specified period of time and pays the beneficiary the interest earnings at regular intervals. The proceeds themselves are then paid out at the end of the specified period, either in cash or under one of the other settlement options. When insurance proceeds are left with the company under the interest-only option, the interest is taxable in full to the beneficiary who receives it [I.R.C. §101(c); Reg. §1.101-3]. The interest will be taxable in the first year that it can be withdrawn.

Payments under an interest-only option are fully taxable regardless of who elected the option [U.S. v. Heilbroner, 100 F.2d 379 (1938); Edith M.Kinnear, 20 B.T.A. 718], and regardless of whether or not the beneficiary can withdraw principal [Rubye R.Strauss, 21 T.C. 104 (1953)]. Of course, accumulating interest is not taxable to the beneficiary until he or she can withdraw it [Reg. §1.101-4(g), Example (1)].

Combination Of Options

If the insurance company retains death proceeds under an interest-only option, and later pays them under an installment or life-income option contained in the contract, the interest-only payments are fully taxable, and the later installment or life-income payments are taxed according to an exclusion ratio, as described above.

If the beneficiary receives installment payments for some years after the insured`s death, and then arranges a life-income settlement with the insurance company, the new payments are death proceeds, exempt to the extent provided in Code §101. They are not annuity payments [Jones v. Comm`r, 222 F.2d 891, rev`g 22 T.C. 407 (1954)].

Pre-1987 Tax Years—Surviving Spouse`s $1,000 Exclusion

The surviving spouse of an insured who died on or before October 22, 1986 can exclude up to $1,000 of the interest element received in any taxable year. This exclusion exempts both guaranteed and excess interest received under a fixed-period, fixed-amount or life-income option. However, it does not apply to interest payments received under an interest-only option. This exclusion is not available for deaths occurring after October 22, 1986

Payments To Contingent Beneficiary

If the company makes settlement under a fixed-period or fixed-amount installment option, and the primary beneficiary dies during the installment period, the contingent beneficiary takes the same general exclusion the primary beneficiary had. Thus, the exempt portion of each installment remains unchanged.

If the company makes settlement under a life-income option with period certain, and the primary beneficiary dies within that period, the contingent beneficiary receives the remaining period-certain payments tax-free, except for excess interest [Reg. §1.101-4(d)(3)]. In computing the primary beneficiary`s tax, an adjustment is made for this possibility.

Proceeds Received By Creditors

If a creditor holds a debtor`s policy as security for a loan, the tax treatment is different. The proceeds received by the creditor are viewed, not as insurance proceeds, but as the recovery of money on collateral security [Reg. §1.101-1(b)(4)]. Thus, the proceeds will be tax-free to the extent of recovery of the loan principal amount, and will be income to the creditor to the extent of any excess.

Where a creditor has a valid reason other than the debtor-creditor relationship for obtaining insurance on the debtor`s life, the death proceeds are exempt from income tax [I.R.C. §101(a)(1); Durr Drug Co. v. U.S., 99 F.2d 757 (1938)]. Similarly, if the proceeds are payable to a policy owner/creditor regardless of the amount or existence of a debt as of the death of the insured, the proceeds would be tax-free under §101. In such cases, the policy is not considered to be collateral security for a debt, but a payment to which the owner is entitled by virtue of premium payments [L.C. Thomsen & Sons, Inc. v. U.S.,484 F2d 954 (7th Cir. 1973)].