C—Taxation Of Proceeds Payable During Life

The tax treatment of life insurance proceeds and endowment policies payable during the life of the insured depends largely upon how the proceeds are paid.

Thus, whether the proceeds are payable in a lump sum or under one of the various policy optional settlements will determine how they are taxed. In addition, even if proceeds are not actually paid to an insured, such proceeds may still be subject to tax if they were "constructively received," as discussed below in more detail.

Finally, consideration must also be given to whether the proceeds consist of endowment proceeds at maturity or of cash surrender values.

In addition to the lifetime payment of life insurance and endowment proceeds, this subdivision also discusses the tax treatment of accelerated death benefit payments. Accelerated death benefits have become an important source of income for the terminally ill. In 1996, Congress enacted the Health Insurance Portability and Accountability Act, which for the first time clarified the tax treatment of accelerated death benefits. As a result of this legislation, a terminally or chronically ill individual can exclude accelerated death benefits received from an insurance contract from gross income.

In General

The taxation of life insurance proceeds or endowment policy proceeds payable during the insured`s lifetime is governed by Code §72, the same section that governs the taxation of the payments received under annuity contracts. Thus, where proceeds are payable under a fixed-amount, fixed-period or life income option, the payments are taxable under the regular annuity rules. For a detailed explanation of these rules, see Section 19.2.

In the case of matured endowments, the general rule of constructive receipt must be applied before the application of the appropriate annuity rule. Therefore the rule of constructive receipt, and an important statutory exception to its application, will be discussed next.

The Constructive Receipt Rule

Where the proceeds of a policy are payable during life a taxpayer may be deemed to have constructively received income. According to the constructive receipt doctrine:

"Income although not actually reduced to a taxpayer`s possession is constructively received by him in the taxable year during which it is credited to his account, set apart for him, or otherwise made available so that he may draw upon it at any time, or so that he could have drawn upon it during the taxable year if notice of intention to withdraw had been given. However, income is not constructively received if the taxpayer`s control of its receipt is subject to substantial limitations" [Reg. §1.451-2(a)].

However, the cash value of a policy is not considered to be "made available" merely because one can receive it at any time by surrendering the policy. The rationale is that re-incurred loading charges would prevent the cash value of the surrendered policy from being used to purchase a new policy of comparable or greater value.

There is, however, one exception to the constructive receipt doctrine. If, before any payments are made and within sixty days after a lump sum becomes payable, the payor and payee irrevocably agree upon an installment or life income settlement, the regular annuity rules apply [I.R.C.§72(h); Reg. §1.72-12].

With the above doctrine and its exception in mind, we shall consider the various situations presented by the maturity, surrender, sale, or exchange of an insurance policy during life.

Payment Of Proceeds In A Lump Sum

Where the proceeds of an endowment or surrendered policy are paid during life in a lump sum, any excess of such proceeds over the cost of the policy is taxable income [I.R.C. §72(e); Reg. §1.72-11(d)]. The gain is considered ordinary income and not capital gain. See also Section 19.2, Subdivision B.

If the policy is a participating contract and gross premiums were paid, with the dividends left to accumulate at interest, then the total benefits at maturity (policy face plus accumulated dividends and untaxed interest), less the gross premiums paid by the insured, would establish the profit and the taxable income in the year of maturity.

Borrowing money to pay premiums does not change the cost computation. Interest paid on such loans is not part of the policy`s cost [Chapin v. McGowan, 271 F.2d 856 (2nd Cir. 1959)].

Policy Loans

Often, an insurance policy contains a provision allowing the insured to borrow from the policy. If a loan is taken from a life insurance policy which is not a modified endowment contract (MEC), the loan is not includable in income [I.R.C.§72(e)(5)]. However, if a loan is taken from a modified endowment contract, it is considered a distribution and will be included in gross income to the extent the cash value of the contract immediately before the distribution exceeds the investment in the contract. In addition, a 10 percent penalty tax will also be imposed unless the distribution is made (a) after the taxpayer becomes disabled, (b) after the taxpayer reaches age 59 1/2, or (c) as part of a series of substantially equal periodic payments over the taxpayer`s life or life expectancy or the joint lives or joint life expectancies of the taxpayer and beneficiary.

Endowment Proceeds Left at Interest

Where the proceeds of an endowment policy are left with the insurance company under the interest option, the interest payments will be taxable income to the payee when received or credited [I.R.C. §72(j); Reg. §1.72-14(a)].

Under some circumstances, taxation of the proceeds can be postponed, provided the interest-only option is elected before maturity or surrender without reserving the right to withdraw proceeds. Thus, where the insured irrevocably agreed, before her endowment matured, to let the interest accumulate, a Federal Court of Appeals held that the interest did not become taxable to her when it was credited to her account. Tax liability would not arise until she could withdraw the interest [Fleming v. Comm`r, 241 F.2d 78 (5th Cir. 1957)].

However, if the insured retains the right of withdrawal, the proceeds are treated as constructively received when they first become available [Reg. §1.451-2]. For example, in a case involving a 15-year endowment policy, the insured designated himself as the beneficiary five days before the maturity date and elected to leave the proceeds with the insurance company under the interest option, retaining withdrawal rights in whole or in part on any monthly interest payment date. The court held that the insured constructively received the proceeds not at maturity but rather on the first date of interest payment under the option elected [Blum v. Higgins, 150 F.2d 471 (2nd Cir. 1945)].

Endowment Proceeds Paid Under Annuity Option

Any amount received as an annuity under an endowment contract must be included in the annuitant`s gross income [I.R.C. §72(a)]. An exclusion ratio for such amount based on the same ratio that the investment in the contract bears to the expected return is then given to the annuitant [I.R.C. §72(b)]. For a detailed discussion of income reporting under the annuity method of Code §72, see Section 19.2, Subdivision A.

Investment In The Contract

As in the case of endowment proceeds paid under a fixed-amount or fixed-period option (previously discussed), the investment in the contract (as of the cost computation date) is computed by taking the aggregate consideration paid and subtracting the aggregate amount received under the contract (as of the same date), to the extent that the amount was not included in gross income previously [I.R.C. §72(c)(1)].

If the policyholder delays 60 days after the maturity of the contract to elect a policy option, he or she will be taxed on any gain and the matured amount will be used to compute the exclusion ratio [Reg. §1.72-11(d), (e) and §1.72-12].

If the annuity option provides for period-certain or refund payments, the value of such payments as of the annuity starting date also must be subtracted from the aggregate consideration paid.

Expected Return

The expected return under an annuity option for either a single annuitant or joint and survivor annuitants is computed by reference to prescribed actuarial tables.

Once the exclusion ratio has been obtained, it will apply to any amount received as an annuity, regardless of how long the annuitant or annuitants live.

Accelerated Death Benefits and Viatical Settlements

During the last decade, accelerated death benefits and viatical settlements have become an important source of income for people suffering from AIDS and other terminal illnesses, as well as for chronically ill individuals. Before the enactment of the Health Insurance Portability and Accountability Act of 1996 (HIPAA), the tax treatment of these benefits was uncertain. However, the HIPAA explicitly provides that accelerated death benefits are excludible from income.

Accelerated Death Benefits

Under Code §101(g), if certain requirements are met, accelerated death benefits received from a life insurance contract on the life of a terminally or chronically ill insured can be excluded from gross income. Likewise, if a life insurance contract is assigned or sold to a viatical settlement provider, the amounts received from the provider are excludable from income as well. As a result, if a person suffering from a terminal illness obtains the proceeds of a life insurance policy or assigns the benefits to a viatical settlement provider, he or she need not pay taxes on the proceeds, even though the proceeds are not paid by reason of death as is otherwise required by the Code [I.R.C.§101]. These rules apply to amounts received after 1996 [HIPAA § 331(b)].

A "terminally ill individual" is a person who has been certified by a physician as having an illness or physical condition which can reasonably be expected to result in death within 24 months after the date of certification [I.R.C.§101(g)(4)(A)]. A "chronically ill individual" is defined as any person certified within the preceding 12-month period by a licensed health care practitioner as (1) being unable to perform, without substantial assistance, at least two activities of daily living for at least 90 days, (2) having a similar level of disability, as designated by regulations, or (3) requiring substantial supervision to protect the person from threats to health and safety because of severe cognitive impairment [I.R.C.§§101(g)(4)(B) and 7702B(c)(2)(A).

Special rules apply to chronically ill insureds. For example, a chronically ill individual can exclude accelerated death benefits, but only if the amount is paid under a rider or other contract provision which is treated as a qualified long-term care insurance contract under Code § 7702B. In addition, amounts paid to a chronically ill individual are subject to the same limitations applicable to benefits paid under long-term care contracts. Thus, amounts received can be excluded if the payment is for actual costs incurred by the payee that are not compensated for by insurance or otherwise for qualified long-term care. Payments that are made on a per diem or other periodic basis without regard to actual expenses are still excludable, but are subject to the dollar cap applicable to similar long-term care insurance contracts. For 2001, the dollar cap is $200 per day ($73,000 per year) limit on benefits. This limit is adjusted annually for inflation [I.R.C.§7702B(d)(4)].

There is, however, one exception to the general rule permitting the exclusion of amounts received as accelerated death benefits. The exception deals with business-related policies. If amounts are paid to a taxpayer other than the insured and (1) the taxpayer has an insurable interest in the insured`s life because the insured is a director, officer or employee of the taxpayer, or (2) the insured is financially interested in any trade or business of the taxpayer, the accelerated death benefits are not excludable [I.R.C.§101(g)(5)].

Viatical Settlements

If any part of a life insurance contract on the life of a terminally or chronically ill individual is sold or assigned to a viatical settlement provider, the amounts received from the provider are excludible from income [I.R.C. §101(g)(2)(A)]. As with accelerated death benefits, this rule is only applicable to amounts received after 1996. [HIPAA § 331(b)].

A viatical settlement provider is any person regularly engaged in the trade or business of purchasing or accepting assignment of life insurance contracts on the lives of terminally or chronically ill insureds. In addition, to qualify as a viatical settlement provider, the provider must be licensed in the state in which the insured lives. However, if the insured lives in a state which does not require licensing, the person must meet certain requirements of the Viatical Settlements Model Act of the National Association of Insurance Commissioners (NAIC) [I.R.C. §101(g)(2)(B)].

As with accelerated death benefits, there is an exception for certain business-related policies. Thus, if amounts are paid to a taxpayer other than the insured and (1) the taxpayer has an insurable interest in the insured`s life because the insured is a director, officer or employee of the taxpayer, or (2) the insured is financially interested in any trade or business of the taxpayer, the viatical settlement amount is not excludable [I.R.C.§101(g)(5)].

Gain Or Loss On Surrender Or Sale

The surrender or sale of a life insurance policy, can result in a gain or loss to the policyowner. Generally, any gain is taxable as ordinary income. Rarely is there a deductible loss. Gain or loss on surrender or sale of a life insurance policy is discussed in detail in Section 19.1, Subdivision D.