Taxation of Life Insurance Products: Background and Issues

Publication Date: July 2003

Publisher: Library of Congress. Congressional Research Service

Author(s):

Research Area: Business

Type:

Abstract:

Owners and beneficiaries of life insurance contracts receive favorable treatment under the federal income tax laws. Before examining this tax treatment, this report provides an overview of the term life insurance and cash value life insurance products, including "whole" life insurance, "universal" life insurance, and "variable" life insurance. This discussion illustrates how cash value life insurance can operate as an investment vehicle that combines life insurance protection with a financial instrument that operates similarly to bank certificates of deposit and mutual fund investments.

Next, the income tax provisions that apply to the owners of life insurance are analyzed. Under the Internal Revenue Code, income measurement rules cause a portion of the investment income to not be taxed. In addition, the remaining investment income is not taxed contemporaneously, and may be totally exempt from taxation. This report provides a brief overview of Internal Revenue Code provisions that create these tax results, and the provisions that limit the favorable tax treatment.

The report then considers the current tax treatment justifications from a tax policy perspective. In this analysis, the report examines the principal arguments of supporters of the current tax treatment of the investment income credited to life insurance contracts and compares life insurance to other tax-preferred investment vehicles. The report also considers the limits on investment oriented uses of life insurance in terms of preventing inappropriate uses of life insurance as an investment.

Next, the report provides an overview of two distinct categories of life insurance: corporate-owned life insurance ("COLI") and split dollar life insurance. These arrangements are used as tax planning devices to provide tax benefits to corporations and their corporate executives and managers. In particular, the report examines the economics and tax restrictions that apply to "leveraged" COLI arrangements, in which the corporate owner of the life insurance contract borrows to pay a substantial portion of the insurance premiums. COLI has recently been the object of critical media articles, major litigation on behalf of the IRS, and a series of legislative proposals to revise the taxation of these life insurance products. Most recently, Representative Emanuel introduced H.R. 2127, which would generally repeal the exclusion of death benefits from taxation under many corporate-owned life insurance policies.

In the last section of the report, the structure and function of split-dollar arrangements are described. This section discusses the Internal Revenue Service's long-standing treatment of the traditional arrangement, and the report concludes with an analysis of the factors that led the IRS and the Treasury Department to reconsider this position and to issue new guidance concerning the tax treatment of split dollar arrangements. This report does not track current legislation and will not be updated.