Life insurance is one of the most tax-favored vehicles in the Code - death benefits are excluded from income, inside build-up compounds tax-free, and loans against the policy are not taxable. But the favorable treatment is conditioned on the contract meeting specific statutory requirements. Violate those requirements - by funding the policy too rapidly (creating a MEC) or failing the §7702 definition tests - and the tax treatment deteriorates sharply. For businesses using corporate-owned life insurance (COLI), additional rules under §264(f) and §101(j) apply.
1. Death benefit: Excluded from gross income of the beneficiary under IRC §101(a). No income tax on the death benefit regardless of the policy's cash value or the premiums paid.
2. Inside build-up: Investment earnings inside the policy accumulate without current income tax. The policyholder pays no tax on dividends, interest, or gains credited to the cash value each year.
3. Policy loans: Borrowing against the cash value is not a taxable event. The loan is repaid from the death benefit or surrender proceeds.
4. 1035 exchange: A life insurance policy can be exchanged for another life insurance policy, an annuity, or a long-term care policy under IRC §1035 without recognizing gain on the exchange.
Under IRC §101(a)(1), gross income does not include amounts received under a life insurance contract paid by reason of the death of the insured. This exclusion applies regardless of the policy's cash value and regardless of whether premiums were paid with pre-tax or after-tax dollars. The entire death benefit - including all inside build-up - passes to the beneficiary income-tax free.
The exclusion has two significant limitations: First, if a policy is sold or transferred for valuable consideration (the "transfer for value" rule under §101(a)(2)), the death benefit is taxable to the transferee to the extent it exceeds the consideration paid plus subsequent premiums. Several exceptions apply - transfers to the insured, to a partner of the insured, to a partnership in which the insured is a partner, and to a corporation in which the insured is a shareholder or officer. Second, for employer-owned life insurance, §101(j) imposes additional requirements (see COLI section below).
Not all contracts called "life insurance" qualify for the §101 exclusion. IRC §7702 requires that a contract meet one of two tests to constitute "life insurance" for federal tax purposes: (1) the Cash Value Accumulation Test (CVAT), which requires that the death benefit always exceed the net single premium needed to fund the contract's future benefits, or (2) the Guideline Premium Test plus the Cash Value Corridor Test (GPT/CVC), which limits total premiums and requires that the death benefit always exceed the cash value by a specified percentage.
Overfunding a policy - paying more premiums than the §7702 tests allow - causes the contract to fail the life insurance definition. The consequences: all inside build-up becomes taxable in the year the contract fails, and future income growth is currently taxable. OBBBA P.L. 119-21 made the 2020 interest rate revision to §7702 tables permanent, which increased the premium capacity for new policies issued after 2020 - allowing more premium to be paid before a contract risks failing the §7702 test.
Even if a contract qualifies as life insurance under §7702, it may still be classified as a Modified Endowment Contract (MEC) under §7702A if it is funded too rapidly. The 7-pay test: a contract is a MEC if cumulative premiums paid in any of the first seven policy years exceed the cumulative 7-pay premium for that year - the amount that would fund the contract over seven years in equal installments. Once a contract becomes a MEC, the classification is permanent and follows the contract through exchanges.
The consequence of MEC status: distributions (including loans) are taxed on a last-in-first-out (LIFO) basis - income first, basis last - and are subject to a 10% penalty if taken before age 59½. This eliminates the tax-free loan benefit that makes whole life and universal life attractive. An annuity already has LIFO treatment; a MEC makes a life insurance contract function like an annuity for distribution purposes without any of the death benefit exclusion advantages being affected.
Corporations frequently purchase life insurance on employees and executives, naming the corporation as beneficiary. Two Code sections govern the tax treatment.
IRC §264(f): Limits the deductibility of interest on policy loans for business-owned life insurance. For policies issued after June 8, 1997, interest on loans against COLI policies is generally not deductible except for a narrow exception for key persons (maximum of five). The pre-1997 COLI strategies that created large interest deductions against COLI cash value are essentially eliminated.
IRC §101(j): For employer-owned life insurance contracts entered into after August 17, 2006, the death benefit exclusion applies only if: (1) the insured is a director, highly compensated employee, or other specified category; (2) the insured employee was notified in writing that the employer would be the beneficiary; and (3) the employee consented in writing before the policy was issued. If these requirements are not met, the death benefit is taxable to the employer to the extent it exceeds the employer's basis in the contract. These are permanent requirements - missing them on any individual policy cannot be cured retroactively.
A life settlement is the sale of a life insurance policy to a third party (the "life settlement company") for consideration exceeding the surrender value. Under Rev. Rul. 2009-13, the tax treatment of the gain on sale is bifurcated: (1) the excess of the sale proceeds over the policy basis (adjusted for the cost of pure insurance protection) is ordinary income to the extent of inside build-up; (2) any remaining gain above the total premiums paid is long-term capital gain. The life settlement buyer - who will eventually collect the death benefit - holds the policy as an asset and can currently deduct nothing for the purchase price. When the insured dies, the death benefit is taxable to the life settlement company to the extent it exceeds its basis, because the §101(a)(2) transfer-for-value rule applies to commercial purchasers (no exception covers life settlement companies).