Taxation of Life Insurance and Annuities

1. Taxation of Life Insurance and Annuities Al Kingan, JD, LLM, CLU, ChFC Director, Estate & Business Planning University of Nebraska School of Law 2006 Estate & Business Planning Program May 12, 2006 # 078730-000

2. Disclosure This presentation is not written or intended as specific tax or legal advice and cannot be relied upon for purposes of avoiding any federal tax penalties. MassMutual, its employees and representatives are not authorized to give tax or legal advice. You are encouraged to seek advice from a qualified tax or legal advisor.

3. Life Insurance Tax Basics • Premiums are not tax deductible • Death benefits are income tax exempt • Cash values are tax-deferred Life Insurance

4. No Deduction for Premiums • IRC 264 – life insurance premiums are not tax deductible expenses. • John cannot deduct the premiums he pays on his personal life insurance policy. • John’s business or employer cannot deduct the premiums it pays on an insurance policy it owns on his life (e.g., key person insurance). Life Insurance

5. Tax-Free Death Benefits • IRC 101(a) “… gross income does not include amounts received under a life insurance contract, if such amounts are paid by reason of the death of the insured.” • Must be a life insurance policy • Must be paid because the insured died • Any type of policy (Term, WL, UL, etc.) • To any beneficiary (individual, trust, business) Life Insurance

6. IRC 7702 Definition of Life Insurance • Product must meet Sec. 7702: • Must be a life insurance contract under applicable law (state or foreign), and • Must meet either of two tests: • Cash Value Accumulation Test • Guideline Premium Test • Also, Mortality & Expense charges must be reasonable Life Insurance

7. IRC 7702 Failure If a policy is a life insurance contract under state or foreign law, but does not qualify under IRC 7702: • Investment gain on failed contracts are taxable each year as ordinary income • Otherwise, Investment gain is tax deferred • Income tax-free if received as death proceeds Life Insurance

8. Taxation of Life Insurance (non-MECs)Policy Distributions Favorable taxation - generally, return of basis first • Dividend distributions - reduce “investment in the contract” • Special Rule for Withdrawals/Partial Surrenders During 1st 15 Years • Pre-7702 (pre-January 1, 1985) • reduce “investment in the contract” • 7702 Contracts • Distribution may be treated as income on contract • Separate formulas for years 1-5, 6-10 and 11-15 Life Insurance

9. Taxation of Life Insurance (non-MECs)Policy Distributions (cont.) • Policy loans • Not a distribution • Loan can be repaid out of death proceeds with No tax • Policy lapse with loan in excess of basis is taxable • Full Surrenders • Amount received (including loan forgiveness) in excess of basis is taxable ordinary income • Distributions in excess of basis • Taxable as ordinary income Life Insurance

10. Taxation of Life Insurance Modified Endowment Contracts (MECs) Section 7702A -(applies on or after June 21, 1988) • Policy that fails the 7-pay test (but passes definition of life insurance test of Section 7702) • Policy’s total premiums exceed the premium limits defined in the legislation: • During first 7 years • At the date of a “material change”, or • At the date of loss of “grandfather” status Life Insurance

11. Taxation of Life Insurance Modified Endowment Contracts (MECs) “Material Changes” • Term rider attachments • Conversion of Dividend Accumulations to Paid-up Additions • Death Benefit Increases • Certain Universal Life corridor increases Life Insurance

12. Taxation of Life Insurance Modified Endowment Contracts (MECs) Policy Distributions - Section 72(e) • Dividends/Withdrawals/Partial Surrenders • Taxed Income out first • Full Surrenders • Amount received (not including loan forgiveness) in excess of basis is taxable ordinary income • Loans and Collateral Assignments • Taxed same as a surrender or withdrawal • Repayment of loan increases “investment in the contract” Life Insurance

13. Taxation of Life Insurance Modified Endowment Contracts (MECs) Policy Distributions (cont.) • Premature Distributions • Additional 10% penalty tax applies to taxable income on distributions from a MEC • Exceptions: • Policyowner has attained age 59 1/2 • Policyowner has become disabled • Distributions taken as a series of substantially equal periodic payments (at least annually) over life expectancy of owner and owner’s beneficiary Life Insurance

14. Taxation of Annuities Inside Build-up • Generally, Tax Deferred • Exception, Deferred Annuities held by Non-natural persons • Beginning with investment contributions after 2/28/86 - Sec. 72(u) Annuities

15. Taxation of Annuities Deferred Annuities • Withdrawals/Partial Surrenders (Amounts not received as an annuity) • Taxed as distribution of income on the contract first • Full Surrender/Loans/Collateral Assignments • Amount received in excess of basis is taxable ordinary income • Gifts of Annuity Contract • Treated as a disposition triggering tax on gain • Except between spouses or incident to a divorce Annuities

16. Taxation of Annuities Deferred Annuity Distributions (cont.) • Premature Distributions • Additional 10% penalty tax applies to taxable income on distributions from a Deferred Annuity • Exceptions: • Contract holder has attained age 59 1/2 • Contract holder has become disabled • Distributions taken as a series of substantially equal periodic payments (at least annually) over life expectancy of owner and owner’s beneficiary Annuities

17. Taxation of AnnuitiesDeath of Contract Holder - Sec. 72(s) • If Surviving Spouse named as Beneficiary • Spouse replaces Contract holder • Mandatory distributions • Before Annuity Starting Date • Distribute entire amount within 5 years • Over life of beneficiary (beginning w/in 1 year) • On or After Annuity Starting Date • At least as rapidly as method of distributions prior to holder’s death Annuities

18. Exchanges of Insurance and Annuity Contracts - Section 1035 No Gain or Loss Recognized Old Basis Carries over to new contract (unless exchange involves taxable “boot” Permissible Exchanges: • Life Insurance for Life Insurance, Endowment or Annuity • Endowment for Endowment or Annuity • Annuity for Annuity • Note, Endowment Contracts are no longer available Exchanges

19. Exchanges of Insurance and Annuity Contracts - Section 1035 Special Rules • Contracts must have the same Insured or Insureds • Generally believed that owner must be same • Exchange may involve multiple contracts • New Life Policy will not become a MEC as a result of exchange unless old policy was a MEC • Amount transferred from old contract not treated as a premium payment under MEC test • It does, however, lower premium limit that would otherwise apply to new policy Exchanges

20. Exchanges of Insurance and Annuity Contracts - Section 1035 Life Insurance Exchanges - Boot Anomaly • Sec. 1035 refers to 1031 for operational instructions • Under Sec. 1031, any debt forgiveness is “boot” • Under Sec. 72, no gain on life policy until distributions exceed basis • Apparent conflict in IRC? (nah?, can’t be?) • Insurance Carriers generally take position that forgiven loan is taxable (preserves business/prevents penalties) • Problem can be avoided by first doing a partial surrender that eliminates loan (step transaction?) Exchanges

21. Life Insurance Death ProceedsTransfer for Value Death Proceeds Income Tax Free Unless Transfer for Value Rule Applies • Transfer for Value - In the case of a transfer for valuable consideration by assignment or otherwise, of a life insurance contract or any interest therein, proceeds in excess of basis are taxable. Life Insurance

22. Transfer for Value Section 101(a)(2) Transfer for Value Exceptions: • Transfer to Insured • to Partner of Insured • to Partnership in which Insured is a Partner • to Corporation in which Insured is a shareholder or officer • Transfer where basis in hands of transferee is same as in hands of transferor Life Insurance

23. Transfer for Value Caution: Broad application of Transfer for Value Rules - Examples: • A, B and C own Corp; they buy policies on each other for Buy/Sell funding • A dies • B & C collect death proceeds, and buy stock from A’s estate • B buys A’s interest in policy on C’s life • C buys A’s interest in policy on B’s life • Transfer for Value? Life Insurance

24. Transfer for Value Examples: • A and B are brothers; they own XYZ Corp. • Each owns a life insurance policy on his own life • Each names his brother as beneficiary of his life insurance policy • Transfer for Value? Life Insurance

25. Transfer for Value Examples: • Mom gifts life insurance policy to daughter. Policy has outstanding loan. • Premiums paid $ 8,000 • Outstanding loan $ 5,000 • Net Cash Surrender Value $10,000 • Transfer for Value? Life Insurance

26. Transfer for Value Examples: • Mom gifts life insurance policy to daughter. Policy has outstanding loan. • Premiums paid $20,000 • Outstanding loan $25,000 • Net Cash Surrender Value $12,000 • Transfer for Value? Life Insurance

27. Transfer for Value Examples: • Policy on A owned by A’s Irrevocable Trust • A, concerned about one of trust beneficiary’s ability to handle money, wants to change trust Can A create new trust to buy the life insurance policy from old trust? Life Insurance

28. Transfer for Value Examples: • Can A’s New Trust buy life policy from Old Trust? • Under Grantor Trust rules, all assets of New Trust are treated as owned personally by A for income tax purposes • The Transfer for Value Rule is an Income Tax rule • A transfer directly to A (the Insured) is exempt • IRS, after refusing to rule for many years, has issued a number of favorable letter rulings: • PLR 200228019 PLR 200247006 PLR 200606027 • PLR 200518061 PLR 200514001 IRS Private Letter Rulings are opinions rendered by staff of the IRS relating to a specific case. These opinions do not set legal precedent but do provide some insight concerning the IRS’ attitude toward the relevant tax issue. PLRs cannot be relied on as can published rulings (Revenue Rulings). Life Insurance

29. Transfer for Value Examples: • Getting A’s Policy from A’s Old Trust to A’s New Trust • Any Other Options? Life Insurance

30. Transfer for Value Getting A’s Policy from Old Trust to New Trust • The Super Conservative Solution: • A creates Family Limited Partnership • A Transfers FLP interests to New Trust • New Trust buys policy form Old Trust • Trustee should sell for greater than cash value • Avoid any Breach of Fiduciary Duty argument • Results: • Partner of the Insured Exception Applies • No Transfer for Value Problem/No Sec. 2042 Problem Life Insurance

31. Transfer Value of a Life Insurance PolicyRev. Proc. 2005-25; TD 9223 Regulations New Insurance Valuation Rules apply to Transfers of Life Insurance from: • Employer to Employee • Distribution or Purchase from a Qualified Plan Value to be used is the Fair Market Value, not the: • Cash Value • Cash Surrender Value, or • Interpolated Terminal Reserve (gift tax value) Life Insurance

32. Transfer Value of a Life Insurance PolicyRev. Proc. 2005-25; TD 9223 Regulations Rev. Proc. 2005-25 valuation safe harbor for Universal Life policies is the greater of: • The Statutory Reserve • The product of the PERC amount and the Average Surrender Factor (ASF) Life Insurance

33. Transfer Value of a Life Insurance PolicyRev. Proc. 2005-25; TD 9223 Regulations PERC Definition: Aggregate of : • Cumulative premiums paid • Plus earnings credited on contract • Minus mortality charges and other reasonable charges actually charges • Minus any distributions, withdrawals or surrenders taken prior to valuation date Life Insurance

34. Transfer Value of a Life Insurance PolicyRev. Proc. 2005-25; TD 9223 Regulations • Average Surrender Factor (ASE) is an adjustment to account for surrender charges. • Expressed as a number between .70 and 1.00 • Employment Based Transfers - subject to IRC 79, 83 or 402(b), the ASE is 1.00 • Note: No surrender charges can be taken into account in a transfer from employer to employee • Qualified Plan Based Transfers- the ASE is greater of a) .70, or b) fraction of CSV/PERC as if surrender was on first day of policy year Life Insurance

35. Transfer Value of a Life Insurance PolicyRev. Proc. 2005-25; TD 9223 Regulations For Whole Life Type Products, the safe harbor value is the greater of: • Interpolated Terminal Reserve • Plus Unearned Premium, etc. • product of the PERC and the ASE • (no ASE adjustment if the distribution is from employer to employee) Life Insurance

36. Gift Tax Value of Life Insurance Gift Value is Interpolated Terminal Reserve • In early years - close to premiums paid • In later years, equal to Cash Surrender Value Probably the Account Value of a UL or VUL policy Life Insurance

37. Estate Tax Inclusion of Life Insurance Section 2042 Death Proceeds includable in Decedent’s Taxable Estate if: • Payable to Decedent’s Estate • Payable to Others, and decedent possessed at his death any of the policy’s incidents of ownership, exercisable alone or in conjunction with any other person. This is a summary only of the tax issues related to federal gift and estate laws and is not intended as tax or legal advice. Specific advice should obtained from a qualified professional. Life Insurance

38. Estate Tax Inclusion of Life Insurance Section 2035 Death Proceeds includable in Decedent’s Taxable Estate if: • Decedent transferred or relinquished an interest in property (including any incidents of ownership in a life insurance policy on Decedent’s life) during the 3 year period ending on the date of decedent’s death. This is a summary only of the tax issues related to federal gift and estate laws and is not intended as tax or legal advice. Specific advice should obtained from a qualified professional. Life Insurance

39. Life Insurance Tax Traps Goodman Triangle Problem • Dad doesn’t want to pay legal fees to create a trust • He names responsible Child A as owner of his life insurance policy • Child A and Child B are policy beneficiaries • Dad dies – Child A is deemed to have made a taxable gift of ½ of the death proceeds to Child B This is a summary only of the tax issues related to federal gift and estate laws and is not intended as tax or legal advice. Specific advice should obtained from a qualified professional. Life Insurance

40. Life Insurance Tax Traps Life Insurance Owned by Multiple Individuals: Present Interest Exclusion Issue • Dad doesn’t want to pay legal fees to create a trust • He names both Child A and Child B as owners of his life insurance policy • Dad pays all policy premiums • Dads premium payments are all taxable gifts – They do not qualify for the annual gift tax exclusion This is a summary only of the tax issues related to federal gift and estate laws and is not intended as tax or legal advice. Specific advice should obtained from a qualified professional. Life Insurance

41. Life Insurance Tax Traps Life Insurance Owned by Multiple Individuals: Present Interest Exclusion Issue • Joint owners must all consent to exercise any policy rights • Therefore, no individual owner is deemed to have a present interest in a policy gifted to multiple parties • Same with the payment of premiums on a policy owned by multiple parties Life Insurance

42. Life Insurance Tax Traps Life Insurance Owned by a Credit Shelter Trust Could be a Great Idea, unless: • Insured is named Trustee • Insured is given a Limited Power of Appointment over the Credit Shelter Trust Life Insurance

43. Life Insurance Tax Traps Corporate Owned Policy Payable to a Personal Beneficiary: • Death Benefit may be taxed as a dividend • Death Benefit may be taxed as compensation • Death Benefit will be deemed to have been constructively paid: • First to corporation • Then from corporation to Deceased Employee, • Then from Deceased Employee to named beneficiary • Depending upon beneficiary, could also be a Transfer for Value Life Insurance

44. Perspective • Primary purpose is to provide cash to beneficiary at death of the insured. • Income to help support a family, put children through college, pay off mortgages, pay estate taxes, fund a buy-sell plan, or make a charitable bequest. • Secondarily, permanent life insurance policies also build up tax deferred cash values. • May be used to reduce/skip premiums, help provide cash for emergencies, even help supplement retirement income. • Congress provides certain tax benefits for life insurance as a public policy due to its value to society. Let’s keep things in perspective as abusive uses of the tax benefits can lead to loss of those benefits.

45. Why Life Insurance? • Provides funds on-time, during period of greatest need, regardless of when death occurs • Income tax free death proceeds • Potentially Estate tax free death proceeds (with appropriate estate planning) • Income tax deferred cash value growth • Favorable basis recovery of lifetime distributions • Cash value loans in excess of basis also income tax free Life Insurance

46. Common Uses of Life Insurance Proceeds • Estate tax transfer costs • State death transfer costs • Family income maintenance • Payment of mortgages and debts (both personal and business) • Educational needs for children/grandchildren • Equalization of inheritances • “Special Needs” situations Life Insurance

47. Uses of Life Insurance (cont.) • Multiple marriage situations • Income tax issues on Qualified Plans and other IRD items • Wealth replacement of assets transferred directly (or indirectly) to charitable institutions Life Insurance

48. MassMutual Financial Group is a marketing designation (or fleet name) for Massachusetts Mutual Life Insurance Company (MassMutual) and its affiliates. Massachusetts Mutual Life Insurance Company and affiliates, Springfield, MA 01111-0001 • www.massmutual.com