LLQP Taxation of Insurance Products 5 — Questions and Answers
Question 1: A corporation purchases a life insurance policy on a key executive and pays all premiums. Under what circumstance would the premiums be deductible as a business expense?
- When the corporation is the named beneficiary
- When the policy is used as collateral for a business loan
- When the executive is the sole beneficiary and the policy is part of a nonqualified deferred compensation plan
- Premiums on corporate-owned life insurance are never deductible when the corporation is the direct or indirect beneficiary (Correct answer)
Correct answer: Premiums on corporate-owned life insurance are never deductible when the corporation is the direct or indirect beneficiary
Under IRC Section 264, premiums paid on a life insurance policy where the corporation is the direct or indirect beneficiary are not deductible as a business expense.
Question 2: An annuitant receives monthly payments from an annuity and uses the exclusion ratio to determine the taxable portion. If the exclusion ratio is 40%, what portion of each payment is taxable?
- 40%
- 60% (Correct answer)
- 100%
- 0%
Correct answer: 60%
The exclusion ratio represents the return of cost basis, so if 40% is excluded from tax, the remaining 60% of each annuity payment is subject to ordinary income tax.
Question 3: For federal estate tax purposes, which of the following would cause a life insurance death benefit to be included in the deceased insured's gross estate?
- The insured named a spouse as beneficiary
- The insured transferred ownership of the policy to an ILIT more than 3 years before death
- The insured retained incidents of ownership in the policy at the time of death (Correct answer)
- The policy was a term life insurance policy with no cash value
Correct answer: The insured retained incidents of ownership in the policy at the time of death
Under IRC Section 2042, life insurance proceeds are included in the insured's gross estate if the insured possessed any incidents of ownership at the time of death.
Question 4: A deferred annuity owner surrenders her contract before annuitization and receives $85,000. Her cost basis (total premiums paid) is $60,000. How much of the surrender proceeds is subject to income tax?
- $85,000
- $60,000
- $25,000 (Correct answer)
- $0
Correct answer: $25,000
Upon surrender, the gain (excess of proceeds over cost basis) is subject to ordinary income tax; here, $85,000 − $60,000 = $25,000 is taxable.
Question 5: Which of the following best describes the tax treatment of dividends received from a participating whole life insurance policy?
- Dividends are always taxable as ordinary income in the year received
- Dividends are taxable only to the extent they exceed the total premiums paid
- Dividends are considered a return of premium and are not taxable until they exceed the cost basis (Correct answer)
- Dividends are subject to capital gains tax when received
Correct answer: Dividends are considered a return of premium and are not taxable until they exceed the cost basis
Policy dividends from participating life insurance are treated as a return of premium (basis) and are not taxable until they exceed the total premiums paid into the policy.
Question 6: A surviving spouse inherits a traditional IRA from her deceased spouse. Which option is NOT available to a surviving spouse who inherits an IRA?
- Roll the inherited IRA into her own IRA
- Treat the inherited IRA as her own
- Take distributions based on the deceased spouse's life expectancy using the 10-year rule (Correct answer)
- Remain as beneficiary and take distributions based on her own life expectancy
Correct answer: Take distributions based on the deceased spouse's life expectancy using the 10-year rule
The 10-year rule for inherited IRAs applies to non-spouse beneficiaries; a surviving spouse has more flexible options including treating the IRA as their own or rolling it over.
Question 7: Under a nonqualified deferred compensation plan, when are benefits generally subject to income tax for the employee?
- When the employer makes contributions to the plan
- When the employee's right to benefits becomes vested
- When benefits are actually paid or made available to the employee (Correct answer)
- When the plan is initially established
Correct answer: When benefits are actually paid or made available to the employee
Nonqualified deferred compensation plan benefits are generally taxed as ordinary income when they are actually or constructively received by the employee.
LLQP Taxation of Insurance Products 5
A corporation purchases a life insurance policy on a key executive and pays all premiums.
Under what circumstance would the premiums be deductible as a business expense?