The flexibility inherent in
“Distributions under the contract” include nonannuity living benefits (as described above), policy loans, loans secured by the policy, loans used to pay premiums, and dividends taken in cash. “Distributions under the contract” generally do not include dividends used to pay premiums, dividends used to purchase paid-up additions, dividends used to purchase one year term insurance, or the surrender of paid-up additions to pay premiums.
1. An increase in premium payments during the first seven contract years may push the cumulative premiums above the amount permitted under the “seven-pay test.”4
2. A reduction in the death benefit during the first seven contract years triggers a recomputation of the seven-pay test. The seven-pay test is applied retroactively as of the original issue date as if the policy had been issued at the reduced death benefit.
3. A “material” increase of the death benefit at any time triggers a new seven-pay test which is applied prospectively as of the date of the material change.
A policy will fail the seven-pay test if in any year, the cumulative premiums paid to that year exceed the sum of the seven-pay guideline annual premiums to that year. For example, assume the guideline annual premium is $10,000 based on the original death benefit. The policyowner pays $9,000 each year for the first six years. In year seven, the policyowner reduces the face amount which “forces out” $18,000 of the cash value. The recomputed guideline premium is $8,000. The policy now fails the seven-pay test and is a MEC since cumulative premiums paid in just the first year, $9,000, (and through year six as well) exceed the sum of the recomputed guideline annual premiums of $8,000. The $18,000 will be taxable to the extent of any gain in the policy. In addition, unless the policyowner is over age 59½ or disabled, a ten percent penalty will be imposed on the taxable portion of the distribution.
Any reduction in death benefits attributable to the nonpayment of premiums due under the contract will not trigger a recomputation of the seven-pay test if the benefits are reinstated within 90 days after being reduced.6
The term “material” change is not defined in the statute. However, the statute states that it “includes any increase in death benefit under the contract,”7 but not increases attributable to dividends (for paid-up additions), interest credited to the policy’s cash surrender value, increases necessary to maintain the corridor between the death benefit and the cash surrender value required by the definition of life insurance8 or cost-of-living adjustments. Increases in death benefits that require evidence of insurability will generally be considered material changes that invoke a new seven-pay test. See Appendix D for more information.
SL is treated in the same manner as other types of insurance for income tax purposes. Death benefits are paid tax free. If the policy is not classified as a modified endowment contract (MEC), nonannuity distributions or withdrawals will be taxed on the “cost recovery” or first-in first-out basis. That is, amounts received will be treated as tax-free recovery of investment in the contract until the entire cost basis is recovered. Once basis is recovered, any further amounts will be taxed at ordinary rates as gain in the policy. Annuity distributions will be taxed as a combination of tax-free recovery of cost basis and taxable interest or gain as described in Code section 72. Loan proceeds are not taxable and, in general, interest paid on policy loans will be treated as nondeductible consumer interest.1
If an SL policy is treated as a MEC, lifetime distributions and loans are essentially taxed under the “interest-first” rules applicable to annuities.2 In addition, if amounts are received prior to age 59½, a 10-percent penalty is imposed on the taxable portion of the distribution. However, in the typical case where an SL policy is part of an estate plan that makes maximum use of the unlimited marital deduction to defer estate taxes until the second death, MEC status may be almost immaterial. In these cases, there is little incentive to withdraw cash values since it could jeopardize the plan. In cases where it is unlikely cash values will be withdrawn prior to the second death, tax treatment of the SL policy as a MEC will be of little consequence.
Consequently, it may be advantageous if sufficient cash is available to pay up the policy as quickly as possible, even if it will result in the policy being treated as a MEC. However, care should be taken to avoid MEC status if the plan contemplates borrowing from the policy to pay premiums. Also, MEC status could lead to adverse consequences if borrowing becomes necessary to finance premiums because dividends are lower than projected and/or term rates are higher than projected in a plan using a large portion of term insurance.
SL policies provide a significant income tax advantage while both insureds live when the policy is used in a split dollar arrangement with an employer. In the basic split dollar plan with a single-life policy, the employee pays the pure term cost of the insurance as measured by the lesser of the P.S. 58 rates or the actual term rates used. If the employer pays the entire premium, the employee must include the pure term cost in taxable income.
If a SL policy is used (typically naming the employee and his or her spouse as the insureds), joint and survivor rates based on U.S. Table 38 are typically used to measure the pure term cost. The Table 38 rates are significantly lower than the P.S. 58 rates. As Figure 15.1 shows, assuming the spouse is 5 years younger than the employee, the single-life P.S. 58 rates are 210 times greater than the survivorship life Table 38 rates when the employee is age 45. The differential declines at older ages but P.S. 58 rates are still 20 times larger than the Table 38 rates when the employee reaches age 75.
After the first death, the single-life P.S. 58 rates apply, not the Table 38 rates.
SL is treated in the same manner as other types of insurance for estate tax purposes, with certain special consideration because there are two insureds and death proceeds are paid only upon the second death. There may or may not be estate tax consequences as of the first death depending on who owns the policy. (Throughout the following discussion, it should be kept in mind that insurance proceeds received by an insured’s estate are also generally included in the insured’s estate under Code section 2042 even if the insured is not the policyowner.) Basically, the policy may be owned in one of three ways:
1. A third party may own the policy.
2. The policy may be owned exclusively by one or the other insured.
3. The policy may be owned jointly by both insureds.
Similar to any other insurance policy, if neither insured has any incidents of ownership in the policy and they have not transferred ownership within three years of death, it will not be included in the gross estate of either insured. However, under the three-year rule of Code section 2035, the policy will be included in the estate of the second to die if and only if both spouses die within the three-year period after the policy is transferred and the transferor spouse is the last to die. If both spouses die within the three-year period and the transferor spouse is the first to die, there should be no inclusion of the proceeds under Section 2035.3 If the transferor is the first to die, the policy would not have been included in his gross estate under Section 2042 or any of the other specified code sections had the transfer not been made. Therefore, the policy proceeds do not fall within the scope of Section 2035 and should not be included in the gross estate of either insured if the transferor is the first to die within the three-year period following a transfer of the policy.
Under Section 2033, an insurance policy owned by the decedent on the life of another is included in his gross estate at the replacement cost of comparable policies of the issuing company or the interpolated terminal reserve.4 If the policy is owned jointly by both insureds, the deceased’s portion of the policy’s value (which is arguably best determined as the actuarial value of his probable survivorship benefits estimated as if he had not died) is included in his gross estate. If the policy is transferred by will to the surviving insured who is the decedent’s spouse, the transfer qualifies for the marital deduction. In this case, there will be no estate tax at the first death. If the surviving insured becomes the owner of the policy when the first insured dies and continues to own the policy until the second insured’s death, the proceeds of the policy will be included in the second insured’s gross estate. However, if the first-to-die policyowner transfers the policy by will to someone other than the surviving insured, the proceeds will generally not be included in the gross estate of the surviving insured when the surviving insured dies. The proceeds would be included only if the three-year rule of Section 2035 discussed above applied or if the surviving insured retained an incident of ownership in the policy.
If the second insured dies within 6 months after the policyowner and the policyowner’s executor elects to have the assets of the estate valued as of the alternate valuation date, the proceeds of the policy will be included in the policyowner’s estate. The death benefits will not be included in the estate of the second to die (assuming he was not the policyowner at any time within three years of his death and proceeds are not received by his estate).
If the insured who does not have any incidents of ownership in the policy dies first, nothing will be included in his estate since the policy proceeds are not payable at his death and such insured has no ownership rights in the policy. At the owner-insured’s later death, the proceeds will be includable in the owner-insured’s gross estate, unless he has transferred the policy more than three years before his death and has retained no incidents of ownership.
If a key employee/controlling stockholder of a corporation dies and the corporation has complete control over the policy or at least the right to borrow against the policy, the employee/stockholder will be treated as having sufficient incidents of ownership for the policy to be included in his estate.5
Gift taxation becomes an important planning issue when a married couple wants a very large policy to be owned by a third party so it will not be included in their estates and also wants to make gifts of premiums at minimal gift tax cost. If the policy is owned outright by a son or daughter for instance, the parents may make tax-free joint gifts of up to $20,000 (as indexed for inflation in 1999) each year under the annual gift tax exclusion. If annual gifts in excess of the annual gift tax exclusion amount are necessary, the parents will have to use up part of their unified gift and estate tax credit.
The amount qualifying for the annual gift-tax exclusion can be leveraged by making gifts to multiple beneficiaries, which is most appropriate if the parents have several children. However, as more independent donees are included in the arrangement the risk increases that the gifts will not be used as intended to pay the required premiums. Also, outright ownership of the policy by the parents’ children presents other related problems. The parents have no assurance that the children will not raid cash values and essentially undermine their not-so-well-laid-out plans.
These problems are often avoided by using an irrevocable life insurance trust to own the policy. Through proper planning and use of the Crummey withdrawal rights6, the parents can provide up to $20,000 (as indexed for inflation in 1999) of annual premium gift-tax free to the trust for each primary and contingent beneficiary of the trust.7 In addition, they can put certain restrictions on how trust assets are used for the benefit of the beneficiaries and when principal passes to the beneficiaries.
The Internal Revenue Service has published proposed regulations8 addressing the mortality charges that must be used in applying the federal income tax definition of life insurance found in Code section 7702.9 Although the regulations provide three safe-harbor methods for determining acceptable mortality charges for single-life policies, they are inapplicable for any multiple life policy, including survivorship life and joint life policies. Consequently, the mortality charges for SL policies must be tested for reasonableness under the regulations’ general rule. However, the general rule, which provides that the mortality charges must not exceed the charges a company actually expects to impose at future dates, is vague and unpredictable, according to many experts.
The authors feel relatively certain that the final reasonable mortality regulations will not be so restrictively written that SL contracts will have difficulty meeting the statutory definition of life insurance. However, we do feel the probability that SL contracts may be treated similar to modified endowment contracts or annuities for income tax purposes is not insignificant. In cases where SL is used primarily for estate planning purposes and pre-death access to cash values is relatively unimportant, such classification may have little relevance. However, such classification could make SL less viable in other applications, such as key person insurance or in split dollar plans, where access to cash values may be an important, if not primary, element of the policy’s attractiveness.