Accelerated death benefits.

Life insurance companies have developed new types of contracts that dispense all or part of a policy's face value before the insured's death. In addition to traditional death benefits, such policies provide "living benefits" that help policyholders deal financially with medical care and long-term-care costs. Such living benefits, also known as "accelerated death benefits," fall into two categories: mortality benefits, or those associated with premature death (and the medical or living costs of terminally ill individuals), and morbidity benefits, those associated with various forms of disability (for example, accident and health benefits on the occurrence of specified diseases or conditions requiring long-term nursing care).

TAX TREATMENT

Even though such policies have existed for many years, the tax treatment of their benefits is uncertain. If treated as proceeds from a life insurance contract paid on the insured's death, they can be excluded from taxpayers' gross income. If deemed to be amounts received from an accident and health plan, they can be fully taxable to the recipient as ordinary income. Recently proposed Internal Revenue Service regulations on the treatment of benefits under these policies may provide some much-needed guidance in this area.

TRIGGERING EVENTS 

Payments of insurance policy benefits are triggered by a specific event or events. For accelerated benefits, the triggers traditionally used have been the following:

* Diagnosis of a terminal illness, with the insured's life expectancy severely limited.

* Diagnosis of a catastrophic illness specifically listed in the insurance policy.

* The need for long-term care in a nursing home, for home health care or the loss of the ability to perform certain necessary activities for oneself.

* The diagnosed need for life-time confinement to a long-term custodial care facility.

TREATMENT OF LIFE INSURANCE PROCEEDS

To be excluded from taxpayers' gross income, amounts received under a life insurance contract must be paid on the insured's death. To receive such treatment, life insurance contracts must meet these requirements:

1. They must meet the definition of life insurance under the applicable state law.

2. They must meet one of two value tests based on their cash surrender value.

3. Policies issued after June 21, 1988, also must satisfy a premium test; the sum of the actual premiums paid at any time during the first seven years may not exceed a specific amount.

Distributions from contracts that qualify as life insurance contracts but do not meet these tests are includable as ordinary income in the amount of the distribution less the investment in the contract.

ACCELERATED DEATH BENEFITS

Under the proposed regulations, accelerated death benefits will be treated as life insurance proceeds if they satisfy three conditions.

1. The insured must be terminally ill. He or she must have a condition or illness reasonably expected to result in death within 12 months from the date of payment.

2. The amount of the benefit must be equal to or more than the present value of the reduction in the death benefit otherwise payable.

3. The ratio of the contract's cash surrender values after and before payment must be the same or greater than the ratio of the death benefits after and before payment.

MORBIDITY BENEFITS

Under the proposed regulations, life insurance contracts that offer both types of benefits may be sold without endangering their status as life insurance contracts. Amounts payable as additional benefits may be excluded from cash value if the benefits are paid solely on the occurrence of a morbidity risk, if the charges are separately stated and currently imposed by the insurer and if the charges are not included in determining the investment in the contract or the premiums paid.

For a detailed discussion of this subject, see "Tax Treatment of Living Benefits Under Life Insurance Policies," by Jim Swayze and Don Harigree, in the November 1993 issue of The Tax Adviser.