Death Benefits (IRC Section 101(a))

General Rule: Income Tax-Free

Death Benefits to Beneficiaries

• Tax-free: Death benefits received by beneficiaries are not subject to income tax
• Full amount: Beneficiary receives full face amount without income tax reduction
• Key advantage: One of life insurance's greatest benefits
• IRC § 101(a): Internal Revenue Code provision

Example:

Policy face amount: $500,000
Beneficiary receives: $500,000
Income tax owed: $0
Full benefit: $500,000 (100% tax-free)

Interest on Death Benefits

• Interest taxable: If death benefit paid in installments, interest is taxable
• Principal tax-free: Original death benefit amount remains tax-free
• Income to beneficiary: Interest reported as ordinary income

Example:

Death benefit: $500,000
Paid over 10 years with interest
Annual payment: $60,000 ($50,000 principal + $10,000 interest)

Tax treatment:
- Principal ($50,000): Tax-free
- Interest ($10,000): Taxable as ordinary income

Transfer-for-Value Rule

Exception to tax-free death benefits:

The Rule

If a life insurance policy is transferred for valuable consideration (sold), the death benefit becomes taxable to the new owner.

Taxable Amount

Taxable Gain = Death Benefit - (Purchase Price + Premiums Paid by Buyer)

Example:

Original owner sells policy for: $50,000
Buyer pays additional premiums: $20,000
Death benefit: $500,000

Buyer's tax basis: $50,000 + $20,000 = $70,000
Taxable amount: $500,000 - $70,000 = $430,000

Buyer owes income tax on $430,000

Exceptions to Transfer-for-Value

Transfers that do NOT trigger tax:

1. To the insured: Transfer to person whose life is insured
2. To a partner of the insured: Business partner
3. To a partnership: Partnership in which insured is partner
4. To a corporation: Corporation in which insured is shareholder/officer
5. Transfer with carryover basis: Gift or transfer where basis carries over

Example - Safe Transfer:

Partner A owns policy on Partner B
Sells to Partner B (the insured) for $30,000

Exception applies: Transfer to insured
Death benefit remains: 100% tax-free
No taxable gain

Cash Value Accumulation

Tax-Deferred Growth:
- Inside buildup: Cash value growth not taxed annually
- No 1099: No annual tax reporting of gains
- Compounds tax-free: Earnings reinvested without tax
- Major advantage: Like qualified retirement account

Taxed only when:
- Withdrawn (distributions)
- Policy surrendered
- Policy lapses with outstanding loan

Policy Loans

Not Taxable Income:
- Loans are tax-free: Borrowing against cash value not taxable
- No 1099: No tax reporting
- Interest not deductible: Interest paid on loan not tax-deductible (personal interest)
- Exception: Business-owned policy interest may be deductible in limited cases

Example:

Cash value: $100,000
Loan: $50,000

Income tax on loan: $0
Tax reporting: None
Interest paid: Not deductible (personal)

Policy Lapse with Outstanding Loan

Taxable event if policy lapses:

Taxable Gain = (Cash Value + Loan Balance) - Total Premiums Paid

Example:

Total premiums paid: $80,000 (basis)
Cash value: $120,000
Outstanding loan: $100,000
Policy lapses

Total value: $120,000 + $100,000 = $220,000
Basis: $80,000
Taxable gain: $220,000 - $80,000 = $140,000

Tax owed: On $140,000 (at ordinary income rates)
Cash received: $20,000 ($120,000 CSV - $100,000 loan)

Problem: Taxed on $140,000 but only received $20,000!

Withdrawals and Surrenders

Taxable to Extent of Gain:

FIFO Basis (First-In, First-Out)

For non-MEC policies:
- Premiums first: Withdrawals treated as return of premiums (tax-free)
- Then earnings: After recovering all premiums, withdrawals are taxable
- Basis tracking: Must track total premiums paid

Example - Partial Withdrawal:

Total premiums paid: $100,000
Cash value: $150,000
Withdraw: $80,000

Tax treatment:
- First $80,000: Tax-free (return of premium)
- Remaining basis: $20,000 ($100,000 - $80,000)

Withdraw another $50,000:
- First $20,000: Tax-free (remaining basis)
- Next $30,000: Taxable (gain)

Policy Surrender

Complete termination:

Taxable Gain = Cash Surrender Value - Total Premiums Paid

Example:

Cash value: $200,000
Surrender charge: $10,000
Cash surrender value: $190,000
Total premiums paid: $120,000

Taxable gain: $190,000 - $120,000 = $70,000
Ordinary income tax on: $70,000

Modified Endowment Contracts (MECs)

Special tax treatment for overfunded policies:

What Is a MEC?

• Overfunded policy: Too much premium paid too quickly
• Seven-pay test: Fails seven-pay test (IRC § 7702A)
• Investment treated: Treated more like investment than insurance
• Punitive taxation: Less favorable tax treatment

Seven-Pay Test

Policy is MEC if:
Cumulative premiums paid in first 7 years exceed cumulative seven-pay limit

Seven-pay limit: Amount that would fully pay up policy in 7 level annual payments

Example:

Policy issued: Age 45
Seven-pay limit: $10,000/year
Owner pays: $70,000 in year 1

Exceeds seven-pay limit: Yes
Policy becomes: MEC (permanently)

MEC Tax Treatment

Loans and withdrawals from MECs:

LIFO Basis (Last-In, First-Out):
- Earnings first: Distributions treated as earnings first (taxable)
- Then premiums: After all gain withdrawn, return of premium (tax-free)
- Opposite of non-MEC: Less favorable

10% Penalty:
- Before age 59½: 10% penalty on taxable portion
- Exceptions: Death, disability, substantially equal payments
- Like IRA: Similar to retirement account early withdrawal penalty

Example - MEC Withdrawal:

MEC policy:
Total premiums: $100,000
Cash value: $150,000
Gain: $50,000
Withdraw: $60,000
Owner age: 50

Tax treatment (LIFO):
- First $50,000: Taxable gain
- Next $10,000: Tax-free return of premium

Income tax: On $50,000 (ordinary income)
10% penalty: $5,000 (10% of $50,000)
Total tax + penalty: Depends on tax bracket + $5,000

Death Benefit - Still Tax-Free

Important: Even MECs have income tax-free death benefits
- No penalty: Death benefit to beneficiary fully tax-free
- Only loans/withdrawals affected: Living distributions taxed unfavorably

Premium Deductibility

Generally Not Deductible:
- Personal insurance: Premiums not deductible for personally-owned policies
- Personal expense: Considered personal expense
- No deduction: Cannot deduct on individual tax return

Exceptions:
- Alimony: Life insurance required by divorce decree (pre-2019 divorces)
- Business insurance: Some business-owned policies (limited)

Dividends

Not Taxable:
- Return of premium: Dividends considered return of excess premium
- Not income: Not taxable income
- No 1099: No tax reporting

Interest on dividends:
- Taxable: If dividends left on deposit earning interest
- Interest portion: Only the interest is taxable, not dividend itself

Example:

Dividend received: $500 (not taxable)
Left on deposit earning interest
Interest earned: $25 (taxable)

Tax reporting:
Dividend: $0 tax
Interest: $25 taxable

Inclusion in Gross Estate

IRC Section 2042:

Death benefit included in insured's estate if:

1. Payable to estate: Proceeds paid to insured's estate, or
2. Incidents of ownership: Insured possessed incidents of ownership at death

Incidents of Ownership

Any rights in policy:
- Change beneficiary
- Assign or transfer policy
- Borrow against policy
- Surrender policy
- Revocable beneficiary: If beneficiary revocable

Avoiding Estate Inclusion

Strategies:

Transfer ownership:
- Gift to spouse/children: Transfer all ownership rights
- Irrevocable Life Insurance Trust (ILIT): Trust owns policy
- No incidents: Insured retains no ownership rights

Three-Year Rule:
- Look-back period: If insured dies within 3 years of transfer
- Brought back: Death benefit pulled back into estate
- IRC § 2035: Prevents deathbed transfers

Example:

Insured transfers $1M policy to ILIT: January 2024
Insured dies: June 2025 (18 months later)

Within 3 years: Yes
Estate inclusion: $1,000,000 included in gross estate

If died: February 2027 (3+ years later)
Estate inclusion: $0 (successfully removed from estate)

Estate Tax Calculation

When included:

Gross Estate includes:
- All assets owned at death
- Life insurance (if incidents of ownership)
- Other includible property

Estate Tax Exemption (2024): $13.61 million per person

If gross estate > exemption:
Estate tax rate: 40% on excess

Example:

Gross estate: $20 million
Includes life insurance: $5 million
Estate tax exemption: $13.61 million

Taxable estate: $20M - $13.61M = $6.39 million
Estate tax: $6.39M × 40% = $2.556 million

If insurance owned by ILIT:
Gross estate: $15 million
Taxable estate: $15M - $13.61M = $1.39 million
Estate tax: $1.39M × 40% = $556,000

Savings: $2 million in estate tax

Unlimited Marital Deduction

No estate tax on transfers to spouse:
- Unlimited: Any amount to surviving spouse
- Defers tax: Postpones estate tax until second death
- U.S. citizen spouse: Must be U.S. citizen

Example:

First spouse dies
Estate: $30 million (includes $10M life insurance)
All to surviving spouse

Estate tax: $0 (marital deduction)

Second spouse dies
Estate: $30 million
Estate tax: Calculated then

Premium Payments as Gifts

If policy owned by someone other than payor:

Annual Exclusion:
- 2024: $18,000 per recipient per year
- No gift tax: Gifts under annual exclusion
- No reporting: If under exclusion

Example:

Father owns policy on his life
Transfers to son (gift)
Cash value: $50,000

Gift tax:
Value of gift: $50,000
Annual exclusion: -$18,000
Taxable gift: $32,000

Uses lifetime exemption: $32,000
Out-of-pocket gift tax: $0 (unless exemption exhausted)

Crummey Trust Powers

Allow premium payments to qualify for annual exclusion:
- Withdrawal rights: Beneficiaries have limited right to withdraw
- Qualifies as present interest: Meets annual exclusion requirement
- ILIT structure: Common in irrevocable life insurance trusts

GST Tax:
- Applies: When property passes to grandchildren or later generations
- Skip persons: Beneficiaries 2+ generations below transferor
- Same exemption: $13.61 million (2024)
- Rate: 40% (same as estate tax)

Example:

Grandfather's ILIT
Insured: Grandfather
Beneficiaries: Grandchildren (skip persons)
Death benefit: $5 million

GST tax: May apply if exceeds exemption
Planning: Allocate GST exemption to trust

Key Person Insurance

Tax treatment:
- Premiums: Not deductible by business
- Death benefit: Income tax-free to business
- Cash value growth: Tax-deferred

Buy-Sell Agreements

Cross-purchase:
- Owners pay premiums: Not deductible
- Death benefits: Income tax-free to surviving owners
- Step-up in basis: Survivors get stepped-up basis in purchased interest

Entity purchase:
- Business pays premiums: Not deductible
- Death benefits: Income tax-free to business
- No step-up: Surviving owners don't get basis step-up

Split-Dollar Arrangements

Employer-employee sharing:
- Complex taxation: IRS has specific rules
- Economic benefit regime: or
- Loan regime: depending on structure
- Potential taxable income: To employee

$50,000 Exclusion:
- First $50,000: No taxable income to employee
- Over $50,000: Imputed income based on IRS Table I
- Employer deducts: Employer can deduct premiums

Example:

Group term life: $200,000
Employee age: 45
Table I cost (age 45-49): $0.15 per $1,000 per month

Taxable coverage: $200,000 - $50,000 = $150,000
Monthly cost: ($150,000 / $1,000) × $0.15 = $22.50
Annual imputed income: $22.50 × 12 = $270

Employee reports: $270 as taxable income

• Death benefits = income tax-free: IRC § 101(a) - not subject to income tax
• Interest on death benefits = taxable: Interest portion taxable as ordinary income
• Transfer-for-value rule: Sale of policy makes death benefit taxable (with exceptions)
• Exceptions to TFV: Transfer to insured, partner, partnership, corporation, carryover basis
• Cash value growth = tax-deferred: Inside buildup not taxed annually
• Policy loans = not taxable: Borrowing against cash value not taxable
• Loan interest = not deductible: Personal interest on policy loans not deductible
• Withdrawals = FIFO for non-MECs: Premiums first (tax-free), then gain (taxable)
• MEC = LIFO taxation: Gain first (taxable), then premiums (tax-free)
• MEC = 10% penalty: Before age 59½ on taxable portion
• Seven-pay test: Determines MEC status - cumulative premiums vs. seven-pay limit
• Premiums = not deductible: Personal life insurance premiums not deductible
• Dividends = not taxable: Return of premium, not income
• Estate inclusion: If payable to estate OR insured has incidents of ownership
• Three-year rule: Transfers within 3 years of death brought back to estate
• Gift tax: Premium payments for policy owned by another may be gifts
• Annual exclusion: $18,000 per person (2024)
• Group term $50,000 rule: First $50,000 not taxable; excess is imputed income
• Table I: IRS table for calculating imputed income on group term over $50,000