Tax treatment of living benefits under life insurance policies.

Life insurance companies have recently developed and marketed insurance contracts that, under certain circumstances, dispense all or a part of a life insurance policy's face value before the death of the insured. These products provide both traditional death benefits as well as sundry forms of "living benefits," ostensibly designed to help policyholders cope with continually increasing medical care and long-term care costs. Historically, these "living benefits" have been known variously as accelerated death benefits (ADBs), living benefits, living needs and long-term care arrangements. Such payments can be divided into two categories: those associated with premature death (mortality) and those associated with various forms of disability (morbidity). Payments under the first category, accelerated death benefits, are triggered by the needs of terminally ill individuals who may incur substantial medical or living expenses before death. The second category of living benefits provides accident and health benefits on the occurrence of certain morbidity risks, such as conditions requiring long-term care in nursing homes or specified dread diseases.

Although policies of this type have been in existence for approximately 30 years, only in the past five years have they evolved and gained relatively wide acceptance.(1) At this time, the products offered vary widely in nature and, as a consequence, their tax treatment is uncertain. In December 1992, the Treasury promulgated proposed regulations on living benefits to provide guidance on their tax treatment to those selling policies, the policy owners and their tax advisers.

The payment of benefits under an insurance policy is triggered by a specific event or events. For example, the following categories of events have served as functional triggers of accelerated benefits, resulting in payment under the terms of the policy.(2)

1. Diagnosis of a terminal illness with the prognosis of death within a specified period. This requires that the life expectancy be severely limited. Policies marketed in recent years vary in the term of life expectancy necessary to trigger payment from six months to two years, but one year has been the most common.

2. Diagnosis of a dread disease or catastrophic illness. This trigger requires a diagnosis of a specified (listed) disease or illness, which is typically catastrophic in nature from a cost viewpoint.

3. A need for long-term care in a nursing home, for home health care, or the loss of the ability to perform certain necessary activities of daily living.

4. A need for confinement to a long-term custodial care facility with the prognosis that the insured's stay be of a lifetime duration.

The, proposed regulations allocate benefits related to these triggers into two categories: "qualified accelerated death benefits" and "additional benefits." The proposed regulations allow treatment of "qualified" ADBs as amounts paid by reason of death for purposes of Secs. 101 (a) and 7702, resulting in exclusion from income for the recipient. This "qualified accelerated death benefit" is specifically defined under the proposed regulations.(3)

The proposed regulations also address the treatment under Sec. 7702 of "additional benefits" that provide payments on the occurrence of a morbidity(4) risk of an amount determined by reference to all or a portion of the death benefit otherwise payable under an insurance contract. This is important because, as the IRS explained in the preamble to the proposed regulations, For purposes of section 7702, the benefit could be viewed as an amount paid upon surrender of a contract and accordingly would be included in the cash surrender value of the contract. The impact of this characterization would be to disqualify as life insurance under section 7702 many contracts providing these benefits.(5)

This article will compare the tax treatment of those living benefits deemed "qualified accelerated death benefits" as well as those deemed "additional benefits" under current law with their treatment if the proposed regulations are adopted. The article will also analyze the strengths and deficiencies of the proposed regulations and focus on a potential unexpected result of the receipt of ADBs.

Tax Treatment of ADBs

As noted above, under current law, the tax treatment of living benefits is uncertain. For example, living benefits might be treated as proceeds from a life insurance contract (and receive tax treatment under Secs. 101, 7702 and 7702A), as compensation for injuries or sickness (in which case the tax treatment would be governed by Secs. 104 and 213), or as amounts received from accident and health plans (which fall within the scope of Secs. 105 and 213). Obviously, the tax effect on the recipient taxpayer will vary depending on the assumed tax treatment. At one extreme, if living benefits are deemed to be disability payments from an employee-sponsored accident and health plan, they will be fully taxable to the recipient as ordinary income.(6) At the other end of the spectrum, if they are treated as amounts received under a life insurance contract that are paid by reason of the insured's death, they can be excluded from the taxpayer's gross income.(7)

The proposed regulations seem to indicate that the Treasury's position is that all living benefits are proceeds from life insurance contracts. Therefore, this article will concentrate on the tax consequences when mortality and morbidity payments are treated as proceeds from a life insurance contract.

* ADBs treated as life insurance proceeds under current law

Generally, Sec. 101(a) allows taxpayers to exclude from gross income amounts received under a life insurance contract if such amounts are paid by reason of the insured's death. Sec. 7702 provides that two rules must be met for a life insurance product to receive this favorable tax treatment. First, the "life insurance contract" must meet the definition of life insurance under applicable state law, and second, the life insurance product must satisfy either a cash value accumulation test or a guideline premium/cash value corridor test.

The cash value accumulation test requires that, by the terms of the contract, the cash surrender value of the contract may not at any time exceed the net single premium that would have to be paid at that time to fund future benefits under the contract.(8) The guideline premium limitation provides that the premiums paid under the contract at any time must not exceed the greater of the guideline single premium or the sum of the guideline level premiums to that date.(9) Life insurance contracts qualifying under the guideline premium test must also satisfy the cash value corridor test, which specifies a minimum ratio of death benefits to cash surrender value.(10) For example, as long as the insured is not more than 40 years of age, the cash value corridor test requires that the death benefit be at least 250% of the contract's current cash value. As the insured ages, the minimum death benefit for a given cash value declines.(11) At age 45, for example, the minimum death benefit is only 215% of the contract's current cash value. If the contract fails to meet the definition of a life insurance contract, "income on the contract" is treated as ordinary income to the policyholder.(12)

Policies issued after June 21, 1988 must satisfy a third test if they qualify as life insurance contracts under Sec. 7702.(13) It requires that the sum of the actual premiums paid at any time during the first seven years not exceed the calculated seven-pay level premium(14) multiplied by the appropriate number of years.(15) For example, if the calculated seven-pay level premium were $3,000, the sum of all premiums paid could not exceed $3,000 at the end of the first year, $6,000 at the end of the second year, etc. Contracts that fail the seven-pay premium test are taxed as modified endowment contracts under Sec. 72(e).(16)

Distributions from contracts that qualify as life insurance contracts under Secs. 7702 and 7702A, but which do not qualify for exclusion from gross income under Sec. 101(a), fall under the purview of Sec. 72(c)(1). Thus, the taxpayer must include as ordinary income the amount of the distribution, less his investment in the contract.(17)

Because the Code does not currently offer any applicable rules for the exclusion of living benefits from gross income, three potential tax problems arise. If ADBs are treated as proceeds from a life insurance contract, the first problem arises because, until recently, the IRS has taken the unofficial position that accelerated benefit payments not attributable to death should be taxed under Sec. 72(e)(1) as amounts received under a life insurance contract.(18) Thus, ADBs would be includible in gross income to the extent that the distribution from the policy exceeded the policyholder's investment in the contract.(19)

Example 1: A, 45 years of age, owned a $150,000 insurance policy on his life. Due to a terminal illness, A received an ADB of $75,000. At the time of payment, A's investment in the policy was $50,000 and the cash value of the policy was $60,000. A would have taxable income of $25,000 ($75,000 distribution -- $50,000 investment in the policy).

If the ADB were deemed to satisfy Sec. 101 (a), a second problem could arise because payment of the ADB might cause the policy to fail either the cash value accumulation or guideline premium/cash value corridor tests. Changes in the terms of the life insurance contract, or in the benefits under the contract, require adjustments in determinations made under Sec. 7702 (e.g., the net single premium, the guideline premium limitation and the cash value corridor must be redetermined).(20) Thus, since payment of an ADB constitutes a reduction in death benefits, a contract that formerly qualified as a life insurance contract under Sec. 7702 might be disqualified, as demonstrated in the following example.

Example 2: A, from Example 1, received an ADB of $75,000 from a policy with total death benefits of $150,000. At the time the ADB was paid, the cash value of the policy was $60,000. Thus, the remaining death benefit would be $75,000. If there were no corresponding reduction in the cash value of the policy, the contract would obviously fail the cash value corridor test (i.e., $60,000 multiplied by 215% is greater than $75,000). If the policy had qualified under the guideline premium/cash value corridor test, A would have taxable income of $10,000 ($60,000 cash value -- $50,000 investment in the policy), nontaxable proceeds from a life insurance policy of $15,000 and a nontaxable return of capital of $50,000.

Finally, even if the ADB satisfied Secs. 101(a) and 7702, it could still run afoul of the seven-pay test of Sec. 7702A(b). For example, if the ADB were paid during the first seven years of the policy's existence, this would constitute a reduction in the death benefit. Thus, the seven-pay premiums would be redetermined as if the contract had originally been issued at the reduced benefit level and the new limitation would be applied to the cumulative amount paid under the contract for each of the first seven years.(21) If the contract failed to satisfy the seven-pay test for any prior contract year, the contract would be considered a modified endowment contract and the ADB would be taxed under Sec. 72(e)(10).

* ADBs treated as life insurance proceeds under the proposed regulations

The proposed regulations rectify these problems by allowing "qualified" ADBs under an insurance contract to be treated as amounts paid "by reason of death" for purposes of satisfying Secs. 101(a) and 7702.(22) To be characterized as a qualified ADB, mortality payments paid before the insured's death must satisfy three conditions.

1. The insured must be terminally ill.(23) An individual is terminally ill if the insurer determines that the individual has an illness or physical condition that is reasonably expected to result in death within 12 months from the date of the ADB's payment.(24)

2. The amount of the ADB must be equal to or more than the present value of the reduction in the death benefit otherwise payable in the event of the insured's death.(25) The discount rate used to determine the present value of the reduction of the death benefit is the greater of the applicable Federal interest rate determined under Sec. 846(c)(2), or the interest rate applicable to policy loans under the contract, assuming that the death benefit would have been paid 12 months after the date of the ADB's payment.(26)

Example 3: B owns an insurance contract with a death benefit of $150,000. B becomes terminally ill. The policy loan rate is 10% and the applicable Federal loan rate determined under Sec. 846(c)(2) is 8%. B receives an ADB equal to the entire death benefit of the policy discounted by 10% for 12 months from the payment date and the contract terminates. The accelerated benefit is a qualified ADB and, therefore, can be excluded from gross income under Sec. 101(a)(1).

3. The ratio of the cash surrender value of the contract immediately after the payment of the ADB to the cash surrender value of the contract immediately before the payment of the ADB must be equal to or greater than the ratio of the death benefit immediately after the payment of the ADB to the death benefit immediately before the payment of the ADB.(27)

  CV-After   [is not greater than]  DB-After
  CV-Before                         DB-Before
  where CV-After        =           Cash surrender value immediately
                                    after the payment of
                                    the ADB.
        CV-Before       =           Cash surrender value immediately
                                    before the payment of
                                    the ADB.
        DB-After        =           Death benefit immediately
                                    after the payment of the
                                    ADB.
        DB-Before       =           Death benefit immediately
                                    before the payment of the
                                    ADB.

Example 4: C owns an insurance contract with a death benefit of $150,000 and a cash value of $60,000. C becomes terminally ill and receives an ADB equal to 50% of the death benefit (discounted in accordance with the rules discussed above). As a result of the payment of the ADB, the cash surrender value of the policy is reduced from $60,000 to $30,000 (i.e., by 50%). The accelerated payment is a qualified ADB because the ratio of the cash surrender value of the contract immediately after the payment of the ADB to the cash surrender value of the contract immediately before the payment of the ADB (30:60) is equal to the ratio of the death benefit immediately after the payment of the ADB to the death benefit immediately before the payment of the ADB (75:150).

Tax Treatment of Morbidity Benefits

Sec. 7702(f)(5) identifies the following additional insurance riders as "qualified additional benefits."

* Guaranteed insurability.

* Accidental death or disability benefits.

* Family term coverage.

* Disability waiver benefits.

* Other benefits designated by regulations. As such, the above riders can be excluded from gross income as life insurance benefits under Sec. 101(a)(1).

Before the proposed regulations for Secs. 101 (a), 7702 and 7702A were issued, neither ADBs nor living benefits resulting from the occurrence of certain morbidity risks were addressed in the Code. Thus, insurance contracts that provide both death benefits and morbidity benefits (e.g., benefits triggered by the occurrence of certain morbidity risks such as certain dread diseases or the need for home health care) ran the risk of falling prey to Sec. 7702. For instance, consider a life insurance contract that contains a living benefit that is determined by all or a portion of the death benefit. If payment of the living benefit were triggered, the benefit could be viewed as an amount paid in surrender of the contract. As a result, the contract might fail to qualify as a life insurance contract under Sec. 7702.

Example 5: D, age 55, is insured under a contract with a death benefit of $100,000 and a cash value of $60,000. The "net single premium" for purposes of Sec. 7702 is $65,000. D acquires a dread disease that requires a long-term stay in a nursing home. He receives a morbidity benefit equal to 75% of the death benefit and his rights under the contract are terminated. As a result of the payment of the morbidity benefit, the cash surrender value of the policy could be treated as being $75,000 instead of $60,000. Thus, the $75,000 morbidity benefit would cause the contract to fail both the cash value accumulation test and the cash value corridor test.

Letter Ruling 9106050(28) reflects the Service's initial position on living benefits. The taxpayer requested a ruling on the tax treatment of a long-term care rider in a qualified life insurance contract. The IRS ruled that since the long-term care rider was not listed as a qualified additional benefit under Sec. 7702(f)(5), it did not qualify for favorable tax treatment under Sec. 7702. Instead, benefits from the long-term care rider would fall under Sec. 72(e).

The proposed regulations alleviate these problems. They adopt an approach under which the assumption is made that a life insurance contract and an accident and health insurance contract that could be sold separately should be allowed to be sold together, without endangering the contract's qualification as a life insurance contract under Sec. 7702. Thus, under the proposed regulations, for contracts offering both benefits, amounts payable as additional benefits (other than qualified accelerated death benefits) may be excluded from cash value if --the benefits are paid solely on the occurrence of a morbidity risk; --the charges for the benefits are separately stated and currently imposed by the insurer; and --the charges are not included in premiums taken into account in the determination of the investment in the contract under Sec. 72, and are not taken into account in the determination of premiums paid under Sec. 7702(f)(1).(29)

If these three conditions are not met, the additional benefit will not be excluded from cash value under Sec. 7702.

If the three conditions are met, the insurance policy will be treated as a contract with both a potential death benefit and a potential living benefit that is paid as the result of a morbidity risk. The living benefit is considered to be comprised of two elements:

1. A payment on the partial or full surrender of the life insurance contract for part or all of the cash value, and

2. A payment on the occurrence of a morbidity event of an additional accident and health benefit equal to the difference between the total payment received and the amount received by the policyholder on the full or partial surrender of the contract.

Example 6: E is insured under a contract with a death benefit of $100,000 and a cash value of $60,000. E acquires a dread disease that requires a long-term stay in a nursing home. He receives a morbidity benefit equal to 75% of the death benefit (i.e., $75,000) and his rights under the contract are terminated. The policy complies in every way with Prop. Regs. Sec. 1.7702-2(f). Accordingly, $60,000 is treated as cash value payable on complete termination of the contract. The remaining $15,000 ($75,000 -- $60,000) is treated as a morbidity payment under the terms of the contract. Thus, the entire morbidity benefit of $75,000 may be excluded from gross income.

Tax practitioners should be aware of two additional items in the proposed regulations. First, if a life insurance contract is not terminated on the payment of a qualified ADB or morbidity benefit, any change in benefits or in the terms of the contract is an adjustment event under Sec. 7702(f)(7).(30)

Second, the proposed regulations state that if certain mortality or morbidity benefits were added to an existing life insurance contract, they would have no effect on the date of the policy's issuance for Sec. 7702A purposes, nor would they constitute a material change in the policy.(31) Thus, so long as these additions fall within certain parameters, no redetermination of the seven-pay premiums would be required.

An area of dispute that may surface involves the literal reading of Sec. 101(a), which excludes amounts received from a life insurance contract from gross income "if such amounts are paid by reason of the death of the insured." (Emphasis added.) The Treasury's unofficial position on this issue seems to be that "living benefits" and "death benefits" are synonymous. This may be close to the truth in the case of ADBs distributed due to a terminal illness, but one must extrapolate further to apply this logic to morbidity benefits. Obviously, a better solution would be to amend the Code.

During 1991, five members of the Senate Finance Committee cosponsored a bill that addressed long-term care benefits and ADBs. First, the bill defined long-term care services as a medical expense under Sec. 213(d). Under this treatment, long-term care benefits, like other medical expenses, would be deductible to the extent they exceeded 7.5% of adjusted gross income.(32) The bill would also have amended Sec. 101 so that "any amount paid or advanced to an individual under a life insurance contract on the life of an insured who is a terminally ill individual shall be treated as an amount paid by reason of the death of such insured."(33) Unfortunately, a bill of this nature could hardly be revenue neutral, so in this period of "deficit cutting," its passage may not be feasible.

Effective Date of the Proposed Regulations

Generally, the proposed regulations would apply to contracts entered into after the date the final regulations are published.(34) However, for certain benefits or loans payable due to terminal illness or solely in the event of a morbidity risk, the regulations direct that the benefit or loan not be treated as cash value, and that it have no effect on the date of the policy's issuance, for purposes of Sec. 7702. Further, the treatment described in the preceding sentence is extended to additions of ADBs as well as morbidity benefits to existing policies.(35)

Conclusion

In an area fraught with uncertainty, an understanding of the tax treatment of living benefits under life insurance policies is of enormous importance for sellers and purchasers of such products, and tax and financial planning advisers. Although the proposed regulations have no legal standing until they become final, they provide guidance on the Treasury's thinking. They are often deferred to by the courts because of the perceived expertise of the IRS in tax matters.

A final note of caution to estate planners: It is possible that accelerated death benefit or morbidity payment riders could be considered a reversionary interest for purposes of Sec. 2042(2). In this event, some value for the rider might be included in the gross estate of the deceased, even though a gift of ownership of the policy had been made in compliance with Secs. 2035 and 2042. In addition, any proceeds from a living benefit in the possession of the deceased at the time of death would be included in the deceased's gross estate. (1) Carney, Morrison and Sullivan, "Accelerated Life Insurance Benefits--The More Multifaceted the Rider, the More Complicated the Financial Consequences," paper presented it the Western Risk and Insurance Association annual meeting, Phoenix, Ariz., Jan. 1992. (2) Strategic Research Department, "Accelerated Death Benefit Products: Results of a Study," American Council of Life Insurance Companies (Dec. 1990). (3) Prop. Regs. Sec. 1.7702-2(d)(1). (4) Note that Prop. Regs. Sec. 1.7702-2(f)(1) relates "other additional benefits" to the occurrence of a morbidity risk. In the insurance industry, the risks commonly known as morbidity risks are those associated with various forms of disability. Although it is not clear, since the IRS did not define morbidity in the proposed regulations, apparently benefits paid as a result of triggers 2-4 are those addressed as "additional benefits." (5) Proposed TD FI-25-92 (12/15/92). (6) Sec. 105(a). (7) Sec. 101(a). (8) Sec. 7702(b). The net single premium is the amount of money the insurer must have on hand (discounted for the time value of money and other factors) to generate cash values and pay the mortality charges for the death benefit specified in the contract. (9) Sec. 7702(c). The guideline single premium amount equals the one-time premium paid by the policy owner to fund all future benefits under the contract (Sec. 7702(c)(3)(A)). The guideline level premium is a periodic amount that funds the benefits under the contract until the insured attains at least age 95 (Sec. 7702(c)(4)). (10) Sec. 7702(d). (11) Sec. 7702(d)(2). (12) For any given year, "income on the contract" is equal to (1) the increase in the net surrender value during the year plus (2) the cost of the insurance protection provided during the year less (3) the premiums paid during the year (Sec. 7702(g)(1)(A) and (B) and (f)(2)(B)). Note also that if the contract previously satisfied the requirements of Sec. 7702 but failed to meet the requirements in the current tax year, the increase in cash value and the cost of term insurance for all prior years is also treated as ordinary income in the current year (Sec. 7702(g)(1)(C)). (13) Sec. 7702A(a)(1). (14) The seven-pay premium is the annual level premium required to be paid over seven years to fund the policy until the maturity date using reasonable mortality and interest factors. (15) Sec. 7702A(b). (16) Sec. 7702A(a) defines a modified endowment contract, for purposes of Sec. 72, as any contract entered into after June 21, 1988 that meets the requirements of Sec. 7702 but fails the seven-pay test of Sec. 7702A(b). (17) Sec. 72(e)(5)(A) and (C); Regs. Sec. 1.72-11(d)(1). (18) Sullivan and Canning, "Life Benefits From Insurance May Be Taxable," 49 Taxation For Accountants 38 (July 1992). Presumably, this treatment would be afforded to contracts that still meet the requirements of Sec. 7702. (19) See note 17. (20) Sec. 7702(f)(7). (21) Sec. 7702A(c)(2). (22) Prop. Regs. Sec. 1.101-8. (23) Prop. Regs. Sec. 1.7702-2(d)(1)(i). (24) Prop. Regs. Sec. 1.7702-2(e). (25) Prop. Regs. Sec. 1.7702-2(d)(1)(ii). (26) Prop. Regs. Sec. 1.7702-2(d)(2). (27) Prop. Regs. Sec. 1.7702-2(d)(1)(iii). (28) IRS Letter Ruling 9106050 (11/16/90). (29) Prop. Regs. Sec. 1.7702-2(f)(1). (30) Prop. Regs. Sec. 1.7702-2(g). An adjustment event is one that requires recalculation of the test parameters used in Secs. 7702 and 7702A. (31) Prop. Regs. Sec. 1.7702A-1(b). (32) Sec. 213(a). (33) S 1693, 102d Cong., 1st Sess. (1991). (34) Notice 93-37, IRB 1993-25, 17. (35) Prop. Regs. Sec. 1.7702-2(j).

Authors' note: The authors would like to acknowledge financial support for this project from the First Interstate Bank Institute for Business Leadership, University of Nevada, Las Vegas.