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NextGen Magazine


A CPA’s Guide to Life Insurance

Chad L. Reyes
Published Date:
Apr 1, 2014

Even during the depths of the Great Depression, the U.S. Supreme Court noted that life insurance for dependents is “kept up very often at the cost of painful sacrifice, and abandoned only under dire compulsion” (Burnet v. Wells). Because of the socially beneficial role life insurance plays in families that have lost a loved one, it has been afforded very favorable tax treatment by the IRC. For example—

  • Death benefits paid to the beneficiary are free of income tax [IRC section 101(a)(1)].
  • Increases in the cash surrender value are not includable for income tax purposes until distributions and/or a surrender of the contract occurs 
    [IRC section 72(e)].
  • The transfer of an insurance contract to another like kind insurance contract (life insurance to life insurance, annuity to annuity, or life insurance to annuity) is allowed, without triggering a taxable event (IRC section 1035 exchange).

A life insurance contract ordinarily enjoys favorable income tax treatment if the policy meets the IRC definition of life insurance and does not become a modified endowment contract (MEC). Cash value policies issued after Dec. 31, 1984, must satisfy one of the two actuarial tests in order to meet the IRC’s definition of life insurance: the cash value accumulation test (measures the amount of cash value relative to the amount of death benefit) or the guideline premium test (measures the amount of premiums paid relative to the amount of death benefit). A MEC policy is subject to income tax rules during the insured’s lifetime that differ from those applicable to a non-MEC policy; however, the tax treatment of the death benefit is unaffected. The main effect of a MEC policy is the taxation of the cash value upon the funds being distributed from the contract.

Employer-Owned Life Insurance Policies

IRC section 101(j) was enacted on Aug. 17, 2006, as part of the Pension Protection Act, which included new rules related to the taxation of death benefit proceeds of an employer-owned life insurance policy. Specifically, IRC section 101(j) subjects death benefits on employer-owned life insurance policies to income taxation, to the extent that they exceed the employer’s basis in the policy, unless a valid exception applies and notice and consent requirements are satisfied.

The following constitute valid exceptions:

  • The insured is an employee at any time during the 12-month period before the employee’s death or is, at the time the contract is issued, a director or a highly compensated employee.
  • The death benefit is paid to a member of the insured’s family, a beneficiary designated by the insured, a trust for a family member or designated beneficiary, or the insured’s estate.
  • The death benefit is used to buy an equity interest in the employer/business from a family member, a designated beneficiary, a trust for a family member or designated beneficiary, or the insured’s estate.

In order to satisfy the notice and consent requirements, the employer must notify the employee/proposed insured of the following prior to the issuance of the policy: that the employer intends to insure the employee’s life, the maximum amount for which the employee could be insured, and that the employer will be the beneficiary of the death proceeds. Thereafter, the employee must provide written consent to being insured.

Utilizing Life Insurance

Life insurance is a unique product that taxpayers purchase for numerous reasons. Along with its favorable tax treatment, life insurance can help provide taxpayers with peace of mind. The following are some of the ways life insurance can be utilized:

  • Estate liquidity—provides cash so that assets do not have to be sold
  • Human life value protection—provides full economic replacement value to the beneficiaries in the event of a premature death of the insured
  • Permission slip—provides financial confidence in knowing that assets can be fully utilized while alive because there is a permanent death benefit that will replenish the assets to the heirs when the insured passes away
  • Transferring concentrated stock positions to heirs—making sure that heirs do not have to sell stock at the wrong time
  • Employee stock ownership plan liquidity—provides funds to be able to cash out participants’ accounts
  • Estate equalization—when other assets are not being distributed equally, life insurance can be used to equalize the amounts among all the beneficiaries (e.g., when one beneficiary gets property, such as a business interest, that is worth far more than the assets left to distribute among the other beneficiaries)
  • Income with respect to a decedent—prevents erosion of assets, such as various retirement accounts or royalties, that are subject to income taxes and estate taxes after death
  • Create tax-advantaged income—provides an income stream by converting non-income-producing assets into income-producing assets, usually coordinated with charitable-planning strategies
  • Business continuity—ensures the business will be able to continue by providing funds needed in the event of the deaths of senior management through key person insurance or by funding business transfer agreements
  • Address multiple marriage issues—provides for children from more than one spouse and for a spouse, especially for children and a spouse in conjunction with each other

Conducting a Policy Check-Up

Life insurance has traditionally been viewed as a commodity that could largely be ignored once coverage was obtained, but it is a complex financial instrument with so many moving parts. It may be affected by changes within the industry, the economy, and most importantly by personal circumstances. Close attention and monitoring of a taxpayer’s life insurance policies will ensure that there are no issues or difficulties in the future. Such policies should be reviewed as regularly as all of the taxpayer’s other assets.

A policy check-up will provide an assessment of existing coverage details, costs and benefits associated with the policy. Most taxpayers do not truly understand what type of coverage they have or how the policy actually functions. In addition, policy costs are usually not clearly stated, making it very difficult for taxpayers to see the true cost of ownership of their existing policies.

Furthermore, a policy check-up can help review the financial strength of the taxpayer’s current insurance carrier. This is important because the policy contract is a promise to pay at some point in the future. The financial viability of each insurance company can vary, and it is prudent to review their financial strength on an annual basis.

During a policy-check up, tax advisors can identify guarantees of the policy—or the lack thereof. The insurance industry, like many other sectors, has been affected by the low interest rate environment the country has been experiencing.As a result, some of the products that were projected to perform in a certain way might not have accomplished their intended objectives, which may leave taxpayers with unintended consequences.

A policy check-up can also project future premium obligations at various different funding levels, along with stress tests for each projection. In an ideal world, all projections would be 100% accurate; however, this is not always the case. A stress test should include worst-case scenarios, middle-of-the-road scenarios, and best-case scenarios.

Taxpayers’ situations do change, and so do their planning needs. If they purchased life insurance in the past, they might need to update their beneficiaries. As it pertains to ownership, their estate might have grown to the point where they might benefit from having the ownership of the policy be an irrevocable life insurance trust. A policy check-up reviews current ownership and beneficiary designations relative to wealth creation, protection, and transfer-plan objectives.

Chad L. ReyesChad L. Reyes is President and CEO of Wealth and Legacy Group, a boutique life insurance firm which has a deep focus in the business continuity and estate and wealth transfer space. WLG predominantly focuses on a collaborative basis with CPA firms, trust and estate law firms and wealth management firms who serve the HNW and UHNW. WLG’s team has over 50 years of combined experience working with families of wealth and the trusted advisors who serve these families. The firm routinely delivers CPE for CPAs. Chad can be reached at 646-402-6300 Ext. 301 or creyes@wealthandlegacygroup.com.