In general, proceeds paid under a life insurance contract by reason of the insured�s death are excludible from gross income for federal income tax purposes. Although there are exceptions to this general rule, the income tax treatment of life insurance death proceeds is generally favorable to taxpayers. On the other hand, the estate and gift tax treatment of policy proceeds is more troublesome and generally requires careful planning to minimize tax liability.

The basic requirement for the income tax exclusion for life insurance proceeds is that they be paid by reason of the death of the insured. Current law also extends the exclusion to certain qualified accelerated death benefits made on behalf of an insured who is terminally ill and expected to die within 24 months.

The most important exception to the general rule of exclusion for life insurance death proceeds is the "transfer-for-value" rule. Essentially, this rule provides that if a policy is transferred from one owner to another for valuable consideration, the income tax exclusion is lost. Upon the death of the insured in such cases, only the amount the transferee owner paid for the policy plus any premiums subsequently paid (that is, the transferee�s total consideration ) will be recovered income tax free by the policy beneficiary. The transfer-for-value rule is not limited to situations involving an outright sale of a policy; it may also apply where noncash consideration for a policy transfer can be inferred.

The transfer-for-value rule is an exception to the general rule of exclusion for policy proceeds. There are also exceptions to the exception (strangely enough, a common phenomenon in the tax law). Policy transfers that will not be jeopardized by the transfer-for-value rule are as follows:

It is worth noting that if a policy becomes subject to the transfer-for-value trap, the transfer-for-value "taint" can be removed by another transfer of the policy that falls within one of the exceptions just described.

The full exclusion for life insurance death proceeds depends in part on whether the policy itself meets the definition of life insurance under Sec. 7702 of the IRC. There are two alternative tests under this definition. A policy will qualify as life insurance for income tax purposes if it meets either of these two tests.

The first test is called the cash value accumulation test. This test will generally apply to more traditional cash value policies such as whole life policies. Under this test the cash value is generally limited to the "net single premium" that would be needed to fund the policy�s death benefit. The net single premium is calculated by the insurance company using an assumed interest rate and certain mortality charges.

The second test is two-pronged. Policies that are designed to pass the second test must qualify under both a "guideline premium" requirement and a death benefit requirement. The guideline premium requirement limits the total premium that can be paid into the policy at any given time. The death benefit requirement (the second prong of the test) is met if the contract�s death benefit exceeds a specified multiple of its cash value at all times. This multiple varies according to the insured�s attained age. Generally, universal life and other similar types of policies will be tested under this second two-pronged test.

The income tax exclusion for death proceeds can also be jeopardized by other factors. These include the issue of whether the policyowner has an insurable interest in the insured at policy inception, creditor-debtor relationships that involve life insurance, and various situations involving corporate-owned life insurance. (These topics are not covered in detail in this chapter.)

Death proceeds of life insurance may be paid in a lump sum or in a series of payments under a settlement option. Payments under a settlement option generally include an element of interest earned, which is taxable, on the death benefit. However, the principal portion of a settlement option payment still qualifies for the income tax exclusion if a lump-sum payment under the same contract would have so qualified. Common settlement options include the installment option, the life-income option, the fixed-amount option, and the interest-only option. The amount of each payment under a settlement option that is attributable to the face amount of the policy is received tax free. The portion that represents interest on the policy proceeds is generally taxable. The portion representing the death benefit is calculated by prorating the face amount over the option�s payment period. This is the excludible portion. Any excess amount of each payment represents interest. If the interest-only option is used, all interest paid or accrued will be taxable. If the fixed-amount option is used, the payment period is calculated by determining the number of fixed payments needed to exhaust the policy�s face amount at its guaranteed interest rate. If the life-income option is used, the present value of any refund or period-certain feature is subtracted from the excludible amount to be prorated.

As previously stated, the interest element of a payment under a settlement option is generally taxable. However, with respect to policies covering insureds whose date of death is prior to October 23, 1986, an annual exclusion for the first $1,000 of interest received annually is still available. The exclusion is available only to surviving spouse beneficiaries and only for settlement options whose payments represent a combination of interest and principal. Therefore no interest exclusion would be allowable under the interest-only option. It is important to remember that no interest exclusion is available with respect to policies covering insureds whose date of death is after October 22, 1986.