Taxation of Proceeds

Taxation of Proceeds
In most instances, Code Section 101 provides that the death proceeds under a group term insurance contract do not result in any taxable income to the beneficiary if they are paid in a lump sum. If the proceeds are payable in installments over more than one taxable year, only the interest earnings attributable to the proceeds are included in the beneficiary's income for tax purposes.

Under certain circumstances, the proceeds are not exempt from income taxation if the coverage was transferred (either in whole or in part) for a valuable consideration. Such a situation arises when the stockholder-employees of a corporation name each other as beneficiaries under their group term insurance coverage as a method of funding a buy-sell agreement. The mutual agreement to name each other as beneficiaries is the valuable consideration. Under these circumstances, any proceeds paid to a beneficiary constitute ordinary income to the extent that the proceeds exceed the beneficiary's tax basis, as determined by the Internal Revenue Code.

In many cases, benefits paid by an employer to employees or their beneficiaries from the firm's assets receive the same tax treatment as benefits provided under an insurance contract. This is not true for death benefits. If they are provided other than through an insurance contract, the amount of the proceeds represents taxable income to the beneficiary. For this reason, employers are less likely to use alternative funding arrangements for death benefits than for disability and medical expense benefits.

Under Code Section 2042, the proceeds of a group term insurance contract, even if paid to a named beneficiary, are included in an employee's gross estate for federal estate tax purposes as long as the employee possessed incidents of ownership in the coverage at the time of death. However, no estate tax is levied on any amounts, including life insurance proceeds, left to a surviving spouse. In addition, taxable estates of $675,000 or less are generally free of estate taxation regardless of the beneficiary.

When an estate would otherwise be subject to estate taxation, an employee may remove the proceeds of group term insurance from his or her taxable estate by absolutely assigning all incidents of ownership to another person, usually the beneficiary of the coverage. Incidents of ownership include the right to change the beneficiary, to terminate coverage, to assign coverage or, to exercise the conversion privilege. For this favorable treatment, however, the Internal Revenue Code requires that such an assignment be permissible under both the group term insurance master contract and the laws of the state having jurisdiction. The absolute assignment is usually in the form of a gift, which is not without its own tax implications. The amount of insurance is considered a gift made each year by the employee to the person to whom the absolute assignment was granted. Consequently, if the value of the gift is of sufficient size, federal gift taxes are payable.

The assignment of group term life insurance also results in the inclusion of some values in the employee's estate. If the employee dies within three years of making the assignment, the full amount of the proceeds are included in the employee's estate. If death occurs more than three years after the assignment is made, only the premiums paid within the three years prior to death are included in the employee's taxable estate. In the past, a problem arose if the employer changed group insurance carriers, thus requiring the employee to make a new assignment and again be subject to the three-year time limit. However, the IRS now considers this type of situation to be a continuation of the original assignment as long as the amount and provisions of the new coverage are essentially the same as those of the old coverage.

As of 1997, the tax treatment of accelerated death benefits was added to the Internal Revenue Code. If certain requirements are satisfied, benefits paid to persons who are either terminally or chronically ill will receive favorable tax treatment. Benefits received because of a terminal illness are treated as income-tax-free death benefits as long as a physician has certified that the insured has an illness or physical condition that can reasonably be expected to result in death within 24 months or less after the date of certification. If a group contract provides accelerated death benefits to other categories of individuals, benefits can also be received with favorable tax treatment if a person is chronically ill and the coverage qualifies as a long-term care insurance contract.

Treatment of Added Coverages
Supplemental life insurance can be written as either a separate contract or as part of the contract providing basic group term life insurance coverage. If it is a separate contract and if the supplemental group life insurance meets the conditions of qualifying as group term insurance under Section 79, the amount of coverage provided is added to all other group term insurance for purposes of calculating the Uniform Premium Table I cost. Any premiums the employee pays for the supplemental coverage are included in the deduction used to determine the final taxable income. In all other ways, supplemental life insurance is treated the same as group term insurance.

Many separate supplemental contracts are noncontributory, and the cost for each employee's coverage does not exceed the Table I cost. In this case, the supplemental contract does not qualify as group term life insurance under Section 79. As a result, the value of the coverage is not included in an employee's income.

When supplemental life insurance coverage is written in conjunction with a basic group life insurance plan, employers have the option of treating the supplemental coverage as a separate policy of insurance as long as the premiums are properly allocated among the two portions of the coverage. There is no advantage in treating the supplemental coverage as a separate policy if it would still qualify by itself as group term insurance under Section 79. However, this election minimizes taxable income to employees if the cost of the supplemental coverage is paid totally by the employees and all employees are charged rates at or below Table I rates.

Premiums paid for accidental death and dismemberment insurance are considered to be health insurance premiums rather than group term insurance premiums. However, as are group term life insurance premiums, these are deductible by the employer as an ordinary and necessary business expense. Benefits paid to an employee under the dismemberment portion of the coverage are treated as benefits received under a health insurance contract and are free of income taxation. Death benefits received under the coverage are treated like death benefits received under group term life insurance.

Employer contributions for dependent life insurance coverage are fully deductible by the employer as an ordinary and necessary business expense if the employee's overall compensation is reasonable. Employer contributions do not result in taxable income to an employee as long as the value of the benefit is de minimis. This means that the value is so small that it is administratively impractical for the employer to account for the cost on a per-person basis. Dependent coverage of $2,000 or less on any person falls into this category. If more than $2,000 of coverage is provided for any dependent from employer contributions, the cost of the entire amount of coverage for that dependent (as determined by Uniform Premium Table I rates) is considered taxable income to the employee.

Death benefits are free of income taxation and are not included in the dependent's taxable estate for estate tax purposes.

State Taxation
In most instances, state tax laws affecting group term insurance are similar to the federal laws. However, two major differences exist: In most states, the payment of group term insurance premiums by the employer does not result in any taxable income to the employee, even if the amount of coverage exceeds $50,000. In addition, death proceeds receive favorable tax treatment under the estate and inheritance tax laws of most states. Generally, the proceeds are at least partially, if not totally, exempt from such taxation.