Tax treatment of life insurance premiums, proceeds, and MECs

Correct answer: Not deductible, because they are a personal expense

Premiums an individual pays for personal life insurance are a personal expense and are not deductible. The trade-off is that the death benefit is generally received income-tax-free.

Correct answer: They are excluded from Maria's gross income

Life insurance proceeds paid to a beneficiary because of the insured's death are generally excluded from the beneficiary's gross income when taken as a lump sum.

Correct answer: The interest paid is taxable, while the $300,000 principal remains tax-free

When proceeds are left with the insurer under a settlement option, the principal stays tax-free, but the interest the insurer pays on that principal is taxable income to the beneficiary.

Correct answer: The 7-pay test

Under 26 U.S.C. § 7702A(a), a modified endowment contract is a contract meeting section 7702 that was entered into on or after June 21, 1988 and fails the 7-pay test of subsection (b).

Correct answer: $17,000

Cost basis is premiums paid minus dividends received tax-free: $40,000 minus $5,000 equals $35,000. The surrender gain is $52,000 minus $35,000, or $17,000, taxable as ordinary income.

Correct answer: Tax-deferred, not taxed as it accrues

The inside buildup of a policy that qualifies as life insurance under federal law is not taxed as it accrues. Gain can become taxable later, for example on a surrender, or on a withdrawal or loan from a policy that has become a modified endowment contract, but it is not taxed year by year.

Correct answer: The loan is not taxable income while the policy stays in force

A policy loan from a life insurance contract that is not a MEC is not taxable income while the policy remains in force, because a loan is not income.

Correct answer: It is taxable as ordinary income and is also subject to a 10% additional tax

MEC distributions are taxed gain first as ordinary income. Under 26 U.S.C. § 72(v)(1), the taxable portion of any amount received under a MEC also carries a 10% additional tax unless an exception applies.

Correct answer: The death benefit is still generally received income-tax-free by the beneficiary

A MEC is still life insurance: inside buildup stays tax-deferred and the death benefit is still income-tax-free. MEC status changes only the treatment of living distributions, and it is permanent.

Correct answer: A distribution attributable to the taxpayer becoming disabled

26 U.S.C. § 72(v)(2) lists three exceptions to the MEC additional tax: distributions on or after age 59½, distributions attributable to disability, and substantially equal periodic payments for life or life expectancy.

Correct answer: 59½

Under 26 U.S.C. § 72(v)(2)(A), the 10% additional tax does not apply to distributions made on or after the date the taxpayer attains age 59½.

Correct answer: It is a MEC, because it was received in exchange for a MEC

26 U.S.C. § 7702A(a)(2) defines a MEC to include any contract received in exchange for a MEC. Once a MEC, always a MEC.

Correct answer: The test is reapplied as if the policy had originally been issued at the reduced benefit level

Under 26 U.S.C. § 7702A(c)(2)(A), a reduction in benefits within the first 7 contract years means the 7-pay test is applied as if the contract had originally been issued at the reduced benefit level.

Correct answer: The policy is treated as a new contract entered into on the date of the change, and the 7-pay test applies again

Under 26 U.S.C. § 7702A(c)(3)(A), a material change is treated as a new contract entered into on the day the change takes effect, with adjustments for the existing cash surrender value.

Correct answer: It is treated as paid by reason of death and generally excluded from income

26 U.S.C. § 101(g)(1)(A) treats amounts received under a life insurance contract on the life of a terminally ill insured as paid by reason of death, so the death benefit exclusion applies.

Correct answer: As an amount paid by reason of the insured's death, so it is generally excluded from income

Under 26 U.S.C. § 101(g)(2)(A), when a terminally or chronically ill insured sells or assigns a policy to a viatical settlement provider, the amount received is treated as paid under the contract by reason of the insured's death.

Correct answer: $50,000

The cost of the first $50,000 of employer-paid group term life coverage is not taxable to the employee; the cost of coverage above $50,000 is taxable income.

Correct answer: The cost of the $100,000 of coverage above $50,000 is taxable income to her

The cost of employer-paid group term coverage above $50,000 is taxable income to the employee. Dana has $100,000 of excess coverage.

Correct answer: Premiums are not deductible, and the death benefit is generally received income-tax-free

When a business pays premiums on a policy naming itself beneficiary, the premiums are not deductible. Because the corporation met the notice-and-consent rules for employer-owned policies and insured a highly compensated employee, the death benefit comes back to the business generally income-tax-free, mirroring the individual rule.

Correct answer: Total premiums paid, minus dividends and other amounts already received tax-free

Cost basis is the owner's investment in the contract: total premiums paid, reduced by dividends and other amounts already received tax-free.

Correct answer: $40

Policy dividends are a return of excess premium and are not taxable until total dividends exceed premiums paid. Ravi's $2,800 of total dividends is well below his $18,000 of premiums, so the dividend is not income, but interest earned on dividends left to accumulate is taxable when credited.

Correct answer: $20,000 is taxable as ordinary income, plus a $2,000 additional tax

MEC distributions are last in, first out: the $30,000 gain comes out first, so the full $20,000 is ordinary income. Under 26 U.S.C. § 72(v)(1), 10% of the includible amount, $2,000, is added as additional tax.

Correct answer: Last in, first out, with gain coming out first

Living distributions from a MEC, including policy loans, are taxed last in, first out: gain comes out first as ordinary income before any tax-free return of basis.

Correct answer: Policy loans are treated as taxable distributions to the extent of gain

The only change MEC status makes is to living distributions: loans and withdrawals are taxed gain first, with a possible 10% additional tax. Death benefit and inside buildup treatment are unchanged.

Correct answer: It is a MEC, because the $25,000 paid in year 1 exceeds the $10,000 cumulative limit at that time

Under 26 U.S.C. § 7702A(b), a contract fails the 7-pay test if the accumulated amount paid at any time during the first 7 contract years exceeds the sum of the 7-pay premiums due by that time. At the end of year 1 the limit is $10,000.

Correct answer: No, because the $30,000 paid by year 3 does not exceed the $30,000 cumulative limit

The 7-pay test of 26 U.S.C. § 7702A(b) compares the accumulated amount paid with the sum of the 7-pay premiums due by that time. By year 3 the owner has paid $30,000 against a $30,000 limit, which is not an excess.

Correct answer: June 21, 1988

26 U.S.C. § 7702A(a)(1)(A) applies the MEC definition to contracts entered into on or after June 21, 1988.

Correct answer: The income on the contract is treated as ordinary income received by the policyholder each year

Under 26 U.S.C. § 7702(g)(1)(A), if a contract that is life insurance under applicable law fails the section 7702 definition, the income on the contract for each year is treated as ordinary income received or accrued by the policyholder.

Correct answer: $420,000

Under the transfer-for-value rule, a buyer may exclude only the price paid plus later premiums: $50,000 plus $30,000 equals $80,000. The remaining $420,000 is taxable.

Correct answer: A sale to a partner of the insured

Exceptions to the transfer-for-value rule include transfers to the insured, to a partner of the insured, and to a partnership or corporation in which the insured is a partner or shareholder.

Correct answer: Exchange a life insurance policy for another life policy or an annuity without recognizing gain

A Section 1035 exchange lets an owner exchange one life insurance policy for another life policy, or for an annuity, without recognizing gain.

Correct answer: The proceeds are income-tax-free to his daughter but are included in Gary's gross estate

Income tax and estate tax are separate. The death benefit is generally income-tax-free to the beneficiary, but it is included in the insured's federal gross estate when the insured held any incident of ownership at death.

Correct answer: The withdrawal is taxable to the extent of gain, but the 10% additional tax does not apply

Under 26 U.S.C. § 72(v)(2)(A), the 10% additional tax does not apply to distributions on or after age 59½. The gain-first income tax still applies.

Correct answer: The taxable portion is ordinary income, but the 10% additional tax does not apply

Under 26 U.S.C. § 72(v)(2)(C), distributions that are part of a series of substantially equal periodic payments for the taxpayer's life or life expectancy are exempt from the 10% additional tax. The taxable portion is still ordinary income.

Correct answer: Ordinary income

When a policy is surrendered, the amount received above the cost basis is taxable as ordinary income.

Correct answer: To keep tax-free access to cash value through policy loans and basis-first withdrawals

MEC status changes only living distributions. Avoiding it preserves non-taxable policy loans and basis-first withdrawals, and avoids the 10% additional tax before age 59½.

Correct answer: A return of excess premium, not taxable until total dividends exceed premiums paid

Policy dividends are treated as a return of excess premium and are not taxable until total dividends received exceed total premiums paid. They reduce cost basis.

Correct answer: The guideline premium and cash value corridor test

A contract qualifies as life insurance under federal law by passing either the cash value accumulation test or the guideline premium and cash value corridor test. Only then is its inside buildup tax-deferred.

Correct answer: It will be a MEC, so the death benefit stays income-tax-free but loans and withdrawals are taxed gain first

A single premium large enough to pay the policy up immediately will typically exceed the cumulative 7-pay limit in year 1, failing the test of 26 U.S.C. § 7702A(b). The policy remains life insurance, so only living distributions are affected.