Written by: Bill Bell, VP of Advanced Sales

Preserving the Three Threads of Life Insurance Taxation

Egon Spengler: There's something very important I forgot to tell you.
Peter Venkman: What?
Spengler: Don't cross the streams.
Venkman: Why?
Spengler: It would be bad.
Venkman: I'm fuzzy on the whole good/bad thing. What do you mean, "bad"?
Spengler: Try to imagine all life as you know it stopping instantaneously and every molecule in your body exploding at the speed of light.
Ray Stantz: Total protonic reversal.
Venkman: Right. That's bad. Okay. All right. Important safety tip. Thanks, Egon

- An Exchange from Ghostbusters circa 1984

For many clients, cash value life insurance can be a powerful/valuable financial option.  A key component of life insurance planning are the tax attributes associated with a policy. In fact, there are three primary tax attributes associated with cash value life insurance policies (tax-free death benefit*, tax-free distributions, and tax-deferred growth) that are often referred to as the three threads of life insurance. Now you may be asking, what does the above exchange from the movie Ghostbusters (which was released 40 years ago) have to do with life insurance taxation? The short and real answer is nothing.  But, since this is my blog and I can make silly analogies, I am going to compare the cutting of one of the three threads of life insurance taxation with crossing the streams of proton packs.  Yes, when you cut one of the three threads of life insurance taxation, you don’t risk total protonic reversal, but, you do risk substantial tax implications for your clients. So let’s look at these three threads individually to make sure you don’t actually cut one of them.

Thread 1 - Tax-Free Death Benefit

To quote every compliance analyst I have ever known, “The primary purpose of life insurance is death benefit protection” but there’s more to it, so let’s start with the thread.  Under Internal Revenue Code (IRC) Section 101(a), the death benefit of a life insurance policy is income tax-free. That is the general rule associated with life insurance and something that we always strive for when we are discussing life insurance planning. So you may be asking yourself, if tax-free death benefit is right in the IRC, how could it ever be taxed?  Well, like most tax rules there are exceptions and these are critically important when we are discussing life insurance:

A. Transfer-for-value – When a beneficial interest in a life insurance policy is transferred in exchange for valuable consideration, the portion of the death benefit that is transferred will be taxable. Most people think about this when a policy is sold and that is an obvious transfer-for-value. That said, there are other situations where it could come up such as a reciprocal promise (I will name you beneficiary if you name me beneficiary type of deal) or other valuable consideration being transferred. How do we avoid this? Well don’t transfer a policy in exchange for valuable consideration, unless, you can meet the exceptions to the rule (that’s right, there is an exception to the exception). Transfers to the insured of the life insurance policy, a partner of the insured, a partnership in which the insured is a partner, a corporation in which the insured is an officer or a shareholder or something called the carry-over basis rules are all exception to the transfer-for-value rule. So a prime example of a transaction that would meet one of these exceptions would be a transfer of a business- owned policy to an employee that is the insured on the policy. Bottom line is that in most cases, the transfer-for-value rule can be avoided.

B. IRC Section 101(j) – This only applies for employer-owned life insurance. The rule came into law in 2006 as part of the Pension Protection Act as a way to stop businesses from buying life insurance on the lives of non-key-employees. In order for an employer-owned life insurance policy to have a tax-free death benefit, two requirements must be met.  First, the insured must meet an exception to IRC Section 101(j)[1].  Additionally, before the insurance policy is issued, the business must provide written notice to the proposed insured that it intends to buy life insurance on the employee’s life and how much and the insured must consent in writing. Unless both requirements are met, the death benefit of the policy will be taxable. Here is the real kicker, there really isn’t a good fix if the life insurance policy is issued without those requirements being met. If you run into a situation where there is a potential 101(j) violation, the client needs to discuss the situation with their tax advisor ASAP. How do we avoid IRC Section 101(j) implications, well the road map is pretty clear; A) meet one of the exceptions and B) meet the notice and consent requirements.

C. The unholy triangle – This is a situation where you have three different parties as owner, insured, and beneficiary on a single life insurance policy[2].  We see this very frequently in situations where a business owns a policy on a key-employee but name the key-employee’s spouse as beneficiary (three different parties – count them up). We see this set up all the time and while the spouse would receive the death benefit, it would be taxable. How do we avoid this? Make sure two of the insured, owner and beneficiary are the same.  In our set-up above, the business should be the beneficiary and if the desire is to give the spouse a portion of the death benefit, do so via an endorsement split dollar arrangement[3].

Thread 2 - Tax-Free Distributions

A key-component to life insurance planning is that you can take distributions from the cash value through properly structured loans and withdrawals.  This is a critically important tax attribute of life insurance that has heightened importance when a life insurance policy is used as a supplemental retirement vehicle or in many business planning strategies. Of course, there are exceptions to this rule too:

A. Modified Endowment Contracts (MECs) – Life insurance policies that are funded with premiums that fail something called the “7 pay test” become what are known as MECs.  MECs are still considered life insurance with a tax-free death benefit (unless you violate a rule that would make the death benefit taxable).  When a life insurance policy is a MEC, the policy is in a gain position (i.e. cash value exceeds basis), distributions are taxable to the extent there is gain in the policy.  Additionally, distributions will be subject to a 10% penalty unless an exception is met[4].   How do we avoid this?  Well, it is pretty simple, if there is any chance the policyholder will access the cash value of the life insurance policy, don’t create a MEC. Most life insurance carrier’s illustration systems will test for MECs so plan accordingly.

B. Surrenders or lapses where cash value plus outstanding loans exceed basis – This one becomes challenging. If a policy is surrendered or even more worryingly lapses, and if the gross cash value of the policy exceeds basis, the difference will be taxable. Early in my career, I got a call from a financial professional that was working with a 93 year old woman that had a policy with a substantial loan and substantial gain that was going to lapse in less than a year. Ouch. Life insurance policies must be administered and monitored properly and the failure to do so can create situations like this one.

C. The Boot Rule – This is a topic for an entire blog.  It comes up when a policy with an outstanding loan is 1035 exchanged to a new policy and the loan isn’t carried over to the new policy.  Look for that blog later in 2024.

Thread 3 - Tax-Deferred Growth

We always discuss that life insurance has tax-deferred growth of the cash value, but, can you tell me what IRC section that tax treatment is provided by? Go ahead, look it up, I will wait. Still looking? Okay, time is up. There isn’t an IRC section that provides for that. It is a generally accepted tax principal. In fact, our good friends at Finseca would say that life insurance cash values are taxed appropriately. For many years, the growth of cash value life insurance policies were a line item on the federal government’s tax expenditures list right alongside the mortgage interest deduction and employer sponsored health insurance. Several years ago, it was removed from the list and it hasn’t reappeared, yet. Bottom line, as long as a policy meets the definition of life insurance under IRC Section 7702, the cash value should grow on a tax-deferred basis. While it is technically possible to have a policy that doesn’t meet the 7702 requirements, I don’t know of a reputable life insurance carrier that would issue such a contract.

So why did I even bring up this tax attribute? $34,505,505,250,865. That was the national debt at the minute I wrote this sentence (going up rapidly every hour). While the growth of the cash value of life insurance policies isn’t currently on the tax expenditure list, there is nothing stopping the feds from adding it back as the search for sources of revenue to help pay back some of this $34 trillion and change.  Making sure our elected representatives understand the importance that life insurance and life insurance planning have on American families is critically important for everyone within the life insurance industry.

Life insurance is an important financial vehicle for many American families and businesses in part because of these three tax threads. Cutting (i.e. violating the provisions) can make the planning associated with a policy much less effective. While total protonic reversal isn’t on the table when we are talking about life insurance planning, an unexpected tax bill is also a very poor result and something that can be planned around in almost all cases. If you would like information on any or all of these tax threads and how they might apply to your clients, please reach out to Penn Mutual’s Advanced Sales Team for assistance. Connect with us via email at advancedsales@pennmutual.com or give us a call at 800-818-8184, option 8.

^{* For federal income tax purposes, life insurance death benefits generally pay income tax-free to beneficiaries pursuant to IRC Sec. 101(a)(1). In certain situations, however, life insurance death benefits may be partially or wholly taxable. Situations include, but are not limited to: the transfer of a life insurance policy for valuable consideration unless the transfer qualifies for an exception under IRC Sec. 101(a)(2)(i.e. the transfer-for-value rule); arrangements that lack an insurable interest based on state law; and an employer-owned policy unless the policy qualifies for an exception under IRC Sec. 101(j).}

^{© 2024 The Penn Mutual Life Insurance Company, Philadelphia, PA 19172, www.pennmutual.com}                                                                                                                                                                           

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^{[1] Those exceptions are: a shareholder who owned more than 5% of the company stock at any time during the preceding year, earned compensation of $150,000 (for 2024 – it indexed for inflation) in the preceding year,  one of the five highest paid officers, or, among the highest paid 35% of all employees.}

^{[2] In gifting situations, this is known as the Goodman Triangle and it has gift-tax implications rather than income tax implications.  Could be a set-up such as husband is insured, wife is owner and adult children are beneficiary.  In that case, it would be viewed that wife gave a gift of the death benefit to adult kids should the insured die.}

^{[3] Please contact Penn Mutual’s Advanced Sales Team for more information on endorsement split dollar arrangements.}

^{[4] The exceptions are - A policyholder over 59 1/2, 2 a distributions due to a qualifying disability of the policyholder, or as part of substantially equal periodic payments made for the lifetime of or based upon life expectancy of the taxpayer.}