Tax Implications of Joint Life (First to Die) LIfe Insurance

Taxes come in many forms, even in life insurance. This article breaks down the taxes involved with Joint Life (JL) policies that should be considered before purchasing this kind of policy.

General Income Taxation

JL is taxed in the same manner as other life insurance for income tax purposes. Death benefits are generally received income tax-free. As long as the policy is not classified as a Modified Endowment Contract (MEC), cash values build without current taxation. Withdrawals or distributions during the “before a death” claim generally are taxed under the “cost recovery” rule. That is, amounts are treated as tax-free recovery of principal or basis (generally, net premiums paid) until the policyowner has fully recovered basis in the policy, and only then as taxable gain on the policy. However, also similar to other types of insurance, withdrawals or distributions within the first fifteen policy years that are coupled with a reduction in the policy’s death benefits may trigger recognition of income. Subject to a statutory ceiling, all income or growth in the cash surrender value may be deemed to have been received by the policyowner if such withdrawals or distributions occur within the first fifteen years.

Income Taxation of Split Dollar Arrangements

In a pure vanilla split dollar arrangement, the economic benefit of a single life policy generally is measured by the cost of the pure insurance element of the policy (the difference between the face amount of coverage and the cash surrender value). This cost generally is based upon the lesser of the Table 2001 rates or the term rates actually used by the company, if clearly identifiable. If the company pays the entire premium, the economic benefit so measured is taxable income to the policyowner. In theory, the economic benefit should be measured in a similar way for JL policies using joint life first-to-die rates rather than single Table 2001 rates or term rates, but the matter has not yet been resolved. For example, is the economic benefit for each insured in a two-life JL policy where each insured is the beneficiary if the other dies first the other insured’s single life Table 2001 or term cost? This is not an unreasonable assumption because the insurance company will have to pay the benefit if either or both die within the year. Therefore, the insurer’s term cost should be equal to the sum of the individual term costs.

In the case of JL policies with three or more insureds, the argument is that the economic benefit of each insured would be equal to the sum of the term rates for the other insureds times his or her respective share of the pure death benefit.

Corporate Owned Life Insurance

Because corporations frequently own JL and they use it for business purposes such as key person insurance or stock redemption buy-sell plans, the corporate alternative minimum tax may be a consideration in its use. For AMT purposes, a corporation must adjust its tax base to take into account certain items. The net death proceeds from a life insurance contract are one such adjustment. The maximum effective alternative minimum tax rate is 15 percent. In some cases where the AMT applies, the strategy is to gross up the amount of insurance to pay the expected AMT. In any event, any payment of AMT becomes a credit available in future years to offset a portion of a corporation’s regular tax liability.

Estate and Gift Taxation

Similar to other life insurance, issues of ownership are critical in determining how the policy will be treated for estate and gift tax purposes. When companies use JL in a business application, they should take great care to avoid adverse estate and gift tax consequences. This issue is addressed in the question and answer section below.

Estate Inclusion When Policy Owned By Corporation

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 or her estate.

Reproduced with permission.  Copyright The National Underwriter Co. Division of ALM

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