Life insurance receives favorable tax treatment in the United States and in most other countries. This section will discuss some of the federal income, estate and gift tax treatments of life insurance. This is an ever-changing field, as evidenced by the enactment of the Economic Growth and Tax Relief Reconciliation Act of 2001. This tax act impacts the estate tax laws in particular, and also income taxation of gift and generation skipping (GST) taxes. These laws have been published as this text is being completed, so while every attempt has been made to take these laws into consideration in this text, there can (and probably will be) changes or clarifications to these laws in the near future. This act is over 175 pages and being written in IRS format, it is expected that it will take some time before everyone concerned can feel competent and confident in the application of these tax changes.
For those interested, the entire tax legislation can be obtained at
http://www.house.gov/rules/1836cr.pdf.
An excellent summary of pension provisions can be found at
http://www.cigna.com/professional/pdf/CPA_0601.pdf
Another excellent summary is presented by the Employee Benefits Ins. Assoc. (EBIA) at
http://www.ebia.com.weekly/articles/401k010531TaxAct.html
Premiums paid for life insurance policies and individually issued annuities are considered as a personal expense and are not income-tax deductible. With some limitations, contributions to a tax-qualified retirement program funded by annuities may be tax deductible, and premiums paid for medical expense and long-term-care insurance premiums are deductible to some degree.
Premiums paid to fund life insurance policies which are payable to a charity may be deductible as charitable donations, and premiums paid for life insurance, annuities and health insurance under an alimony agreement, may be deductible.
Premiums that are paid by employers for life insurance, health insurance and annuities for the benefit of their employees are usually deductible as a business expense.
The Internal Revenue Code Section 101(a)(1) is the tax code that states that death benefits from life insurance policies are exempt from federal taxation, provided that the death of the insured caused the contract to mature. For instance, proceeds from an annuity cash value or any other proceeds that are payable during the insured’s lifetime, do not qualify for this tax exemption. Death proceeds for the purpose of this code, includes the face amount of the policy, and any other insurance amounts, such as for accidental death, face amount of paid-up insurance or additional benefits because of a term rider.
While this law seems straight-forward, there are exceptions.
If a life insurance policy or any portion of a policy, is sold to another person, or transferred for consideration, the death benefits can lose the tax exemption. The amount that is taxed is derived by the formula: the excess of the gross death proceeds, over the consideration paid plus net premiums paid - would be taxable to the individual as ordinary income.
CONSUMER APPLICATION
Benny had a life insurance policy on his life for $100,000. He needed some cash for a down payment on a new SUV, so he sold the policy to his brother-in-law Sam, for $3,000. Nearly 10 years later, Benny passes on. By that time Sam had paid premiums of $12,000 (net of dividends).
Sam would receive the death benefit of $100,000. Since the total amount Sam paid for the policy (initial investment of $3,000 plus $12,000 premiums) was $15,000, Sam would receive $15,000 tax free, but would have to pay taxes on $85,000.
The death benefits collected because of a viatical settlement by a viatical firm, are subject to this rule.
Note that this rule does not apply in certain situations, such as when the transfer is to a partner of the insured, a corporation of which the insured is an officer or stockholder, transfer of a policy to the insured (corporation purchased plan transferred to insured employee) or a gift or transfer to a tax-free corporate organization.
The IRC Code Section 7702 defines life insurance for the purpose of deciding if a policy qualifies for favorable tax treatment.
In the 1970’s and 80’s, the tax-deferred savings that individuals could receive through life insurance, were accumulating at very high (at that time) interest rates. The tax savings under these projections were substantial, so the Tax Equity and Responsibility Act of 1982 (TEFRA) produced a definition of insurance for flexible-premium products, and the taxation of annuities was changed to reduce the incentives for using annuities for short-term investment vehicles.
The Deficit Reduction Act of 1984 expanded the TEFRA act, adding Section 7702, which provided a detailed definition of life insurance. (It also strengthened TEFRA rules on annuities used for a short-term investment).
F Failure of a life insurance policy to meet the definition of an insurance policy under Section 7702, results in the treatment of a life insurance policy as a combination of term insurance and a side fund (which is taxable).
Universal life policies had their own problems. Traditional insurance policies had an actuarial relationship between the death benefits, the cash value and the premiums. However, some UL policies had cash values that were substantially more than the amount that would be actuarially required to fund future policy charges. Therefore, it was much more like an investment than life insurance (if it walks like a duck and quacks like a duck…).
Congress rose to the task again, and mandated that for life insurance policies to be considered as life insurance for tax reasons, they must be considered life insurance under the applicable state law. In addition, it must meet one of two tests:
The cash-value accumulation test was applied mostly to traditional cash-value policies, and it required that the cash surrender value cannot at any time exceed the net single premium that would be required to fund future contract benefits. There were stipulations as to mortality tables and interest rate in the calculations.
For universal life and other interest-sensitive policies, the policy must meet a guideline premium requirement and a cash value corridor requirement. (This is also discussed under the Interest Sensitive Life Insurance section.) There were stipulations as to mortality tables and interest rates in the calculations of the guideline premium (either guideline single premium or guideline level premium). The cash value requirement is met if the death benefit of the policy is at least equal to a stipulated percentage multiple of the cash value.
Failure to meet these requirements means that the cash value will not be treated as a death proceed but the net amount at risk will meet the qualifications under Section 101(a)(1).
If there is no insurable interest at the time of policy issue, that makes the policy a “wager” and policy proceeds would be taxed as ordinary income.
Life insurance death benefits received under a qualified pension or profit-sharing plan can create a taxable situation, as can policy proceeds received by a creditor on the insured/debtor’s life. Policy proceeds that are received as compensation (discussed under Business Uses of Life Insurance) or dividends from a corporation; received as alimony; or received as restitution for embezzled funds can be taxed.
The Alternative Minimum Tax is discussed in the Business Uses of Life Insurance section as it affected death proceeds that are payable to a corporation. This tax was devised as a “catch-all” as it makes sure that no taxpayer with substantial income is able to avoid tax liability.
Life insurance benefits that are received by a corporation, and any increase in the policy cash value, are items that can create an alternative minimum tax situation.
NOTE: At the time this text was being prepared, Congress was seriously debating the repeal of the alternative minimum tax and while it will probably be passed in the House, the Senate may or may not pass it at this time. If this tax is repealed, references to this tax should just be ignored as a factor in this discussion.
The favorable tax treatment of life insurance proceeds is not affected when settlement options are elected, with the exception that income taxes may be due on any interest paid on the proceeds. Therefore, under the interest option, interest received by the beneficiary is taxable as ordinary income.
Under life income settlement options and installment options, every payment is considered to be comprised of principal and interest. The part that is considered return of principle is not taxed. Amounts that are more than the annual prorated principal are considered as interest and taxable interest.
Under the fixed-period option, the amount held by the insurer is divided by the number of the installments within that fixed period, and the excess of each payment over this amount is considered as taxable interest. Under the life income settlement option, the amount held by the insurer is divided by the recipient’s life expectancy. The methods used to determine the “amount held by the insurer” is detailed and beyond the scope of this discussion. It is furnished to the policyowner or beneficiary by the insurer.
“Living proceeds” include dividends, cash values, matured endowments, policy loans and accelerated death benefits.
The Modified Endowment Contract (MEC) has been discussed earlier in the Chapter on Interest Sensitive Life Insurance. To reiterate, a MEC is a life insurance policy that was issued after June 20, 1988, and meets the IRC Section 7702 definition of life insurance, but fails to meet the seven-pay test, or other test, as described earlier. The IRC Code was amended because of the practice of many insurers to sell single-premium life insurance policies as a tax-deferred instrument, instead of providing protection against premature death.
Dividends are usually considered a nontaxable return of excess premium. Exceptions are if the policy is an MEC (or fails to meet the IRS definition of life insurance), or if the dividends received (under a policy other than MEC) exceeds the total of the premiums paid, then this excess will constitute ordinary income.
The interest credited to a life insurance policy’s cash value is not taxable if the policy meets the IRS definition of a life insurance policy (which also applies to MECs)
For a lump-sum cash value surrender payment on life policies, the cost recovery rule is invoked, whereby the amount to be included in the policyowners gross income after surrender is the excess of the gross proceeds received over the cost basis. The cost basis usually is the sum of paid premiums less the sum of any dividends received in cash (or credited against the premium). Gross proceeds are the amounts paid on surrender, including the cash value of paid-up additions and dividends accumulated at interest.
Losses that may arise upon the surrender of a life insurance policy, usually cannot be deducted as a loss for tax purposes.
It is important to be familiar with Section 1035 (IRC Section 1035) exchanges as with fluctuations in interest rate and the development of new policies, policies are frequently being exchanged for other life insurance policies. If Section 1035 is not strictly applied, there can be important tax consequences.
As important as this tax code is, it is relatively simple. To qualify for the Section 1035 policy exchange, there are three criteria:
The exchange must be of
When a Section 1035 exchange occurs, any gain on the old policy is “rolled into” the new policy and there is no gain for tax purposes. The new policy’s cost basis is adjusted to include the basis of the old policy.
As simplistic (comparatively speaking, considering other tax legislation) as this tax code is, there is not always a clear distinction between an exchange – and a surrender and purchase. However, as a result of several IRS “private letter rulings” it is accepted that the contract that will be replaced should be assigned to the replacing insurance company, without the policyowner actually receiving any surrender values.
CONSUMER APPLICATION
Bob has a life insurance policy that was issued in 1968, and the cash value grows at an astounding 3.5% and he has no flexibility. Therefore, his brother-in-law convinces him that he should replace his old policy with a new Variable Universal Life policy. Bob agrees, but notes that he has cash values of $23,000 in his old policy. Therefore he requests that the surrender values of $23,000 be sent directly to him and then he will determine how much he wants to pay for the new policy – after all, he needs a down payment for a new SUV.
However, his brother-in-law points out that if he does that, the transfer will no longer be tax-protected under Section 1035, and he could have a sizeable taxable gain.
At one time, Endowment contracts were popular as a retirement-income vehicle. They are no longer popular, however there are many endowments that are maturing. The proceeds are taxed the same as if the policy were surrendered, if the policy meets the IRC definition of a life insurance policy. (Note that some older policies have been “grandfathered” and while not meeting the definition, the cost recovery rule will apply). The cost basis is subtracted from the gross proceeds to arrive at the taxable income.
Policyowners can obtain policy loans from a life insurance policy using the cash value as security. The interest rate that is charged is stated in the contract.
Policy loans interest paid by individuals is not tax deductible, but interest paid on a policy that is owned by a business and covering the lives of key persons (officers and 20% owners) may be deductible, subject to certain conditions. Deductions must be only on loans on policies that cover key persons and the loan amount cannot be for more than $50,000 per insured individual. The key persons may not be less than 5, or the lesser of 5 percent of the total officers, or 20 individuals.
This deduction does not work under the 4-in-7 exception wherein a deduction is allowed if no part of at least 4 of the first 7 annual premiums due on the policy is paid through borrowing either from the policy or from other sources. If, during the first seven years, the borrowed amount exceeds more than 3 years premiums regardless of when the borrowing takes place, this test is “violated”
Generally, taking a loan from an insurance policy does not create a taxable action. Of course if the contract is a MEC or an annuity, loans are taxable as income in proportion to the excess of the cash value exceeds the cost basis. There is a 10 percent penalty tax if the loan is taken out before the insured reached age 59 ½.
Since policy loans reduce a policy’s cost basis, a policy with a large outstanding loan, the net cash surrender value, which is the cash surrender value less the loan, can be quite small. Therefore, if the policyowner surrendered the policy, the check could be for a smaller amount than expected. However, the owner could face an extremely large tax bill because of the negative cost basis. Unfortunately, many surrenders occur because the policyowner faces financial difficulties, and the addition of a large tax bill could be disastrous.
The Accelerated Death Benefit, as discussed earlier, allows an insured to collect part or all of the death benefits if the insured is terminally ill (or chronically ill). There is a difference, as the accelerated death benefits paid in connection with a terminally ill insured will be treated as if the insured had died, so there is no taxation. Similar to a viatical settlement, a physician has to attest that the insured is expected to die within 24 months.
Annuities are not discussed in detail in this text, however it should be noted that for taxation purposes, generally speaking, interest credited to the cash values of individually owned annuities accumulate on a tax deferred basis. For taxation of annuity payments, the rules are the same as stated for settlement options.
Life insurance proceeds can be subject to estate taxation. In addition, using life insurance for estate planning requires a knowledge of federal estate tax laws. The new 2001 tax act affects the estate taxation substantially, at least for the next 10 years (unless changed again). A later Chapter on Life Insurance in Financial and Estate Planning will detail the uses of insurance for planning purposes.
The federal estate tax is the tax on a person’s right to transfer property on his/her death. It is calculated on the value of the property, and must be filed and estate taxes paid within nine months of the death of any US citizen or resident who leaves a gross estate above a specified amount. This amount was $600,000 for many years, prior to the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). (For details on EGTRRA 2001 go to page 113)
In order to calculate the estate tax due, the first step is to measure the value of the gross estate, which is the value of all property or interests in property owned and/or controlled by the decedent.
Next, allowable deductions such as funeral and administration expenses, debts of the decedent, bequests to charities and the surviving spouse, are determined, and subtracted from the gross estate to form the adjusted gross estate.
To the taxable estate is added adjusted taxable gifts which then determines the tentative tax base. Then the appropriate tax rate is applied to the tentative tax base to form the tentative federal estate tax.
From this tentative federal estate tax is subtracted certain gifts and other taxes paid, including the unified credit which is a tax credit that can be applied to offset estate and gift taxes.
NOTE: Gift Tax Exemptions and Rates are identical to Estate Tax Exemptions and Rates, except in the exempt amount remains at $1,000,000 from 2002 to perpetuity(?), and the Rate in 2010 and thereafter is 35%. This is explained further later in the text.
The IRC provides that the values of 4 classes of gifts must be included in the gross estate.
If annuity benefits continue after death of the annuitant, the present value of the survivor benefits might be included in the gross estate. If the decedent paid NO part of the premium of the annuity, then the entire value of the survivor benefits are excluded from the gross estate. The cash value of an annuity during the accumulation period is included in the decedent’s estate to the extent that the decedent made contribution to its purchase.
For property held by 2 or more persons during the lifetime of the decedent, the decedent’s interest is included in the decedent’s gross estate. If the property is held in joint tenancy with right of survivorship and the ownership interest passes automatically to the survivors in the case of the death of one of the owners, then 100% of the value of the property is included in the decedent’s estate, less the amount that the survivors contributed to the purchase of the property.
CONSUMER APPLICATION
Four golfing buddies decided to each invest in a small golf club repair and manufacturing business, and each person put in $100,000. Abe, the older of the golfers, made a hole-in-one and became so excited, he had a heart attack.
In determining the value of Abe’s interest in the business, it was proven by the partnership papers that each person owned 25% of the business. The business had done much better than expected, and from the original $400,000 investment, the value was now $1 million.
25%, Abe’s percentage of the business, or $250,000, was included in his estate.
Property owned by spouses is a joint ownership that provides a right of survivorship. However, the property is considered to be owned 50% by each spouse, thus 50% of the property is included in the estate of the first spouse to die.
This is a joint ownership where each member owns his/her share outright, therefore the decedent’s estate would include his/her proportionate share.
In community property states, property acquired during marriage is the property of each marriage “community.” Upon the death of the first spouse to die, 50% of the property value is included automatically in the decedent’s estate, regardless of how much of the property was paid for by the decedent.
If an individual has the right to dispose of property that it not owned by the individual, this is called a general power of appointment and the value of that property is included in the gross estate
If the individual has a general power of appointment and if the individual’s right to any of the property is limited by requiring the individual to meet certain standards, the property will not be included in the gross estate.
A special power of appointment is where the individual has the power to appoint another person other than the decedent, his estate or creditors to receive the property. In this situation, the property would not be included in the gross estate.
CONSUMER APPLICATION
Cecil Worth III is the recipient of a large trust established by his grandfather, under which he receives a lifetime income of $100,000 per year. Cecil has the power to withdraw all of part of the trust fund (trust corpus) during his lifetime. Cecil elects to receive only the income from the trust and he does not withdraw any of the trust fund.
At Cecil’s demise, he would be considered to have a general power of appointment, and the entire value of the trust would be included in his estate.
Had his grandfather set up the trust to pay Cecil $100,000 a year if he becomes an attorney and remains a member of the bar in good standing, then the value of the trust would NOT be included in his gross estate.
If the grandfather had stipulated that Cecil could appoint others to receive property from the trust, for instance, Cecil appointed his son as beneficiary of the trust if Cecil should precede his son in death, then the value of the trust would NOT be included in his gross estate.
Life Insurance in the Gross Estate
Life insurance is not included in the gross estate, unless
If the estate is the beneficiary, death proceeds are included in the gross estate even if the insured was not, in fact, the policyowner. An excellent reason why the beneficiary should never be the insured’s estate. It also points out why there should be sufficient contingent beneficiaries.
The second part, incidents of ownership, is a little more difficult as the insured must not own ANY incidents of ownership – such as right to change beneficiary, surrender the policy, assign the policy, obtain policy loan, or any other policy right. Just the ownership of one of these policy rights makes the proceeds includible in the gross estate.
If a policy is sold or transferred or given to another person by means of absolute assignment, then the proceeds would not be included in the gross estate. However, if the policy is a gift, and the gift is given within 3 years of death, it would be considered as a gift “in anticipation of death” and would not still be included in the gross estate.
From the gross estate, deductions as discussed earlier, plus unreimbursed losses, charitable transfers, and a special deduction for family-owned business are subtracted.
The marital deduction is perhaps the most important deduction. The value of property left to a surviving spouse may be deducted, and if all property is left to the spouse, the value of the estate is zero. However, only the property that would be included in the surviving spouse’s estate qualifies for the marital deduction, an interest in property only during the lifetime of the spouse would not qualify for the deduction. There are exceptions to this rule, provided the surviving spouse is entitled to a lifetime income payable from the property (must be paid at least annually): no one can give, or in any way divert, any part of the property to anyone except the spouse during the lifetime of the spouse; and the executor makes an irrevocable election to have the marital deduction apply.
After certain adjustments, the Federal Estate Tax is determined by certain credits:
The gift tax is another “transfer tax” levied against a party that transfers property to another person. Where the estate tax comes into play after a person dies, the gift tax is applicable when a person is alive. A lifetime gift to an individual incurs a federal gift tax basically at the same rate as the estate tax as indicated earlier.
The federal gift tax law is not designed for the usual holiday, birthday and other family gifts, and therefore there is an exclusion of $10,000 per person per year, by one person. For instance, a married couple could give $10,000 each to their son (total of $20,000) every year without paying a gift tax. The gift must be of a present interest, i.e. they must have possession of the property immediately instead of at some time later in the future. Gift splitting is when one spouse makes a gift to someone other than his spouse, it is considered as being one-half made by each spouse.
The gift tax marital deduction allows for tax-free exchanges between spouses, and is allowed with no limit.
If the insured assigns any of his/her rights under the policy to another person, the taxability question depends upon whether the rights have been assigned for less than adequate compensation. The value of the policy for gift tax purposes is its market value, which is the cost of replacement. This value is determined by a rather technical formula which basically is that the value of the gift is composed of the terminal reserve at the time of the gift plus the unearned premium.
If the policy is a single premium policy or annuity, or a paid-up policy or annuity, then the replacement cost is the single premium that an insurance company would charge for a comparable contract issued at the insured’s (or annuitant’s) attained age.
If a person makes a gift of insurance premiums on a policy that the person does not own, then that premium is considered as a gift. Premiums paid by a beneficiary on a policy that he/she owns are not gifts.
Life insurance proceeds are usually not considered as “gifts.” There can be an instance of the proceeds being a gift when one person owns the policy, another person is the insured, and yet another person is the beneficiary. In this case, the proceeds would be considered as a gift from the owner of the policy to the beneficiary. If a spouse owns a policy on the other spouse, and the children are beneficiaries, even though there is no intent to have a gift made, in effect there is a gift from the spouse that owns the policy to the children.
In order to “plug a hole” in the tax laws, the IRS created the generation-skipping transfer tax(GST), which is levied when property is transferred to persons who are two (or more) generations younger than the person transferring the property. The purpose is to keep very wealthy persons who attempt to avoid a generation of taxes by passing property to another generation (the “skip” generation). Life insurance death benefits can be subject to GST taxes if they are paid to one of the “skip” persons. This can be avoided by not including the death proceeds in the insured’s estate through the appropriate use of life insurance trusts (discussed in the following chapter).
The EGTRRA of 2001 has made substantial changes in estate and gift taxation, and in the generation-skipping tax.
This tax act has many features that affect estate planning, however many people have (wrongly) assumed that since many of estate planning features are gone, they will not have to worry about trying to avoid probate, transferring their estate after death to the chosen heirs, protection of assets after death, etc. These can be considered as “non-tax” issues, and the tax act has no bearing on these factors and there is little change, if any, in estate planning to alleviate these concerns.
This act changes Estate and Generation Skipping Tax (GST) and rates, with the exempt amount presently of $675,000 increasing to $3,500,000 in 2009 and becoming unlimited in 2010. The tax rates decrease from the present 55% to 0% in 2010. But don’t applaud yet (the fat lady hasn’t sung) because the act itself expires on Jan. 1, 2010. There are no guarantees that Congress will renew the bill at that time.
First, Tables showing the changes in Estate and GSP Tax Exemptions and rates.
TABLE ONE
Scheduled Changes in Estate and GST Tax
Exemptions & Rates (Gift Taxes Not Included)
Year Rate Exempt Amount
2001 55% 675,000*
2002 50% 1,000,000
2003 49% 1,000,000
2004 48% 1,500,000
2005 47% 1,500,000
2006 46% 2,000,000
2007 45% 2,000,000
2008 45% 2,000,000
2009 45% 3,500,000
2010 0% Unlimited
'Unchanged from prior law
The top rate for estate and GST taxes decrease in a series of annual steps through 2007.
The estate tax united credit exemptions and the generation skipping tax exemptions, increase to $3.5 million in 2009. The exempt amount is the value of the estate that is free of any estate taxes for the year that is shown. And, as stated earlier, this tax disappears totally in 2010.
The top rate for estate and GST taxes decrease through 2007. The percentage that is shown in the previous Table, is the maximum tax rate (estate or GST) for the year shown, and the minimum is still 37%. So, the amounts that hit the exempt amount will be taxed at 37%, and amounts of estates over that amount will be taxed at the rate shown.
As mentioned earlier and often, estate taxes and GST taxes are repealed as of January 1, 2010. As Art Linkletter, well into his 80’s, recently stated, he now has reason to live for 10 more years, so that he can make sure that the money that he has worked so hard for, for so many years, can now go to the people that he wants it to go to, and not to the Federal Government. Most people with estates large enough to be concerned with estate planning, will second that with a resounding “Amen!”
For the estate planner, this is a mixed blessing. There really is more need for an active estate planner now as thanks to the political and tax ramifications, estate planners should stay busy by frequent reviewing estate plans.
The Gift Tax unified credit exemption amount for lifetime gifts will increase to $1 million in 2002, and then it will stay there until changed by subsequent law. There is no “sunset” for gift taxes – they do not expire in 2010.
However, as seen in the Table 2, gift tax rates will decrease through 2010 and the rate changes are the same as the estate and GST rate changes. However, the gift tax is not repealed in 2010 and a final rate is set at 35% in 2010.
TABLE TWO
Scheduled Changes in Gift Tax
Exemptions and Rates
Year Rate Exempt Amount
2001 55% $ 675,000*
2002 50% 1,000,000
2003 49% 1,000,000
2004 48% 1,000,000
2005 47% 1,000,000
2006 46% 1,000,000
2007 45% 1,000,000
2008 45% 1,000,000
2009 45% 1,000,000
2010+ 35% 1,000,000**
* Unchanged from prior law
** Permanent – it is hoped.
Starting in 2010, the step-up in basis in estates will be limited to a maximum of $1.3 million step-up in addition to the estate’s original basis when it is passed to a non-spouse and $3 million if it is passed to a surviving spouse. Before 2010, the estate will have an unlimited step-up in basis. There are several rules and provisions set forth in this tax act, which are beyond the purview of this discussion.
While the federal estate taxes are being phased out, the step-up in basis will be partially lost.
CONSUMER APPLICATION
Bertram had spent $500,000 for his property that would be included in his estate when he died. At his time of death, the estate was valued for fair market value, at $3.5 million, or an appreciation in the estate of $3 million. Since the estate was not left to a spouse, the additional step-up in basis allowed was only $1.3 million, therefore there was capital gain taxes due on $1,700,000.
CONSUMER APPLICATION
Franklin left his estate to his wife, his surviving spouse. Franklin had paid $500,000 for the property in the estate, but the estate had a fair market value of $3.5 million when he died, so the estate had appreciated $3 million. Under the 2001 tax act, since it was left to the spouse, $3 million additional basis was allowed, therefore there was no capital gain.
The 2001 tax act limits the step-up in basis by shifting the taxation from estate taxes to capital gains taxes for the larger and more valuable estates. The result of this is that this partial loss of step-up basis will create capital gains taxes which will be paid by many heirs. Remember that capital gains taxes only occur upon sale of property, so if inherited property is not sold, there are no capital gains taxes (at that time).
The capital gains taxes will be created because heirs will want to sell the decedent’s real estate, investments and other such taxable assets. The estate will get the decedent’s basis in these assets, plus up to $1.3 million for non-spouses and $3 million for spouses. The practical effect is that an estate worth only $1.5 million could very well be subject to considerable capital gains taxes when the heirs sell the assets.
There are also scheduled changes in the size of the deduction allowed for state death taxes:
TABLE THREE
EGTRRA Changes in Size of
Estate Taxes
Year Loss of Deduction
2002 25%
2003 50%
2004 75%
2005 & thereafter 100%
The federal credit given to estates for payment of the estate’s death taxes at the state level will be reduced as shown in the above table. As to how this will affect state death taxes, is anybody’s guess, as it is almost certain that some states will change their death tax laws soon, either to increase taxation or to better integrate with the new federal law. In some states, this will not make any difference in the total amount of estate taxes paid, but in others it will increase the amount of estate taxes paid.
Some experts are predicting that states will find that since taxes are not being paid to the federal government at the same rate that they have been in the past, this will open the doors for politicians at the state level to see this as an opportunity to increase the state death taxes. After all, people are used to paying large death taxes, so they should not scream too loudly if the money goes to the state instead of the federal government. Anyway, the thinking of many politicians probably is that this would affect only the wealthiest citizens and there are not too many of them, and besides, they will not really be aware of it as they will be dead when their estate is plundered (taxed).
Presently, an estate where a family-owned business exists, has a total estate tax deduction of $1.3 million. This will be repealed, but since the total exempt amount is raised to $1.5 million in 2001, there is little effect, one way or the other.
The present gift tax law remains the same, i.e., one can give a tax-free gift to another person of $10,000 each year, as can spouses. It is indexed for inflation, so this amount will increase by $500 increments to compensate for inflation.
After the year 2009, gift donors will be required to provide information about the gift property, such as fair market value and the basis of the gift. A donor who does not make such a report is subject to a penalty.
The $250,000 per spouse capital gains exemption on personal residences will be applied to the estate for the benefit of the heirs. If an estate, an heir or a qualified trust sells a decedent’s principal residence within three years of the decedent’s death, the seller will be able to use the two-out-of-five-year rule for the decedent’s use of the residence while still alive. Where it is applicable, the seller then can claim a capital gain exclusion of $250,000, on top of any step-up in basis under the new tax act that may have been added to the residence’s original basis.
STUDY QUESTIONS
Chapter 6
1. Premiums paid
A. for life insurance are tax deductible.
B. by an employer for group life insurance are income tax deductible.
C. for a Variable life insurance policy are deductible except for the money going into the separate account.
2. Death benefits
A. from Term policies are treated differently by the Internal Revenue Code then from Whole life policies.
B. collected because of a viatical settlement are tax exempt.
C. from life insurance policies are usually exempt from federal taxation.
3. When a beneficiary of a life insurance policy receives the death benefit
A. as a lump sum the entire benefit is tax exempt.
B. under an interest only settlement option, the proceeds are tax-free.
C. under a life income settlement option all proceeds are taxed as ordinary income.
4. Individual policyowners
A. can borrow from their Term life insurance policies.
B. can borrow from their Whole life insurance policies.
C. can borrow from their Whole life insurance policies interest free.
5. If there is an Accelerated Death Benefit provision in the life insurance policy
A. the insured can collect the death benefit before death.
B. and the insured collects the death benefit it is taxed as ordinary income.
C. and the insured becomes disabled the insurance company will make the payments for him/her.
6. The federal estate tax
A. has been eliminated.
B. must be paid on April 15 following the year of death.
C. is a tax on a person’s right to transfer property at his/her death.
7. Life insurance proceeds are
A. always included in a decedent’s gross estate.
B. included in the gross estate, if the estate is the beneficiary.
C. taxable even if the beneficiary is an individual and not the estate.
8. The marital deduction
A. applies to property left to a surviving spouse.
B. applies even if the property would not be included in the surviving spouses estate.
C. would apply to a life insurance policy whereby the spouse is beneficiary.
9. Gifts between spouses are tax free because of
A. gift splitting.
B. the gift tax marital deduction.
C. the annual exclusion.
10. Under the Economic Growth and Tax Relief Reconciliation Act 2001
A. income taxes are no longer applicable after 2010.
B. the gift tax in the year 2010 will be zero.
C. the estate tax decreases to 0% in 2010.
11. If a life insurance policy is sold or transferred
A. the death benefits can loss the tax exemption.
B. the beneficiary cannot be charged.
C. the tax exemption, on the death benefit does not change.
12. If the policyowner had no insurable interest in the insured,
A. at the time of the insured’s death, the insurance company will not pay the death benefit.
B. at the time the policy was issued, the death benefits will be taxed as ordinary income.
C. when the insured died, the death benefits are taxable.
13. If an individual borrows from their life insurance policy
A. the loan is interest free.
B. and pays interest on the loan, the interest is tax deductible.
C. the loan is expected to be repaid.
14. The Gift Tax
A. rates are the same as Estate Tax rates.
B. is imposed on all transfers of property, if there is no consideration paid to the donor.
C. is payable by the donee, the one that received the property.
15. Property owned by spouses jointly, with the right of survivorship is called
A. tenancy by the Entirety.
B. tenancy in Common.
C. joint tenancy with the right of survivorship.
Answers to Chapter Six Study Questions
1B 2C 3A 4B 5A 6C 7B 8A 9B 10C 11A 12B 13C 14A 15A