IRS reviews life insurance benefits paid to terminally ill.

The IRS is reviewing tax issues relating to life insurance benefits paid to the terminally ill under a relatively new form of life insurance. The Service is questioning whether distributions from these new policies meet the requirements for exclusion from gross income under Sec. 101(a) and, more importantly, whether the policies are "life insurance contracts" as defined in Sec. 7702.

The life insurance products in question go by various names - life insurance for the living, living needs policies and accelerated death benefits. Like traditional life insurance, living needs policies pay beneficiaries on the death of the insured. However, they also provide for a predeath payment to the insured if the insured meets certain health-related conditions.

In general, Sec. 101(a) provides that proceeds of life insurance contracts paid by reason of the death of the insured are not included in gross income. Because of the need to pay amounts by reason of death, it seems likely that amounts paid by reason of pending death will not be excludible.

Sec. 7702 defines "life insurance contract" for Federal tax purposes. This is important for purposes of the Sec. 101 exclusion, but more importantly for the tax treatment of contract earnings (Sec. 7702(a)). To meet the Sec. 7702 definition, a contract must be a life insurance contract under the applicable state or foreign law and must - meet the cash value accumulation (CVA) test of Sec. 7702(b); or - meet the guideline premium requirements of Sec. 7702(c) and fall within the cash value corridor of Sec. 7702(d).

A life insurance policy with a living needs option may not satisfy the CVA test. The accelerated death benefit payment could represent a cash value that will cause the policy to fail the CVA test. Before purchasing a policy with this option, clients should be aware of the tax risk associated with them.