13. Insurance and Annuities

a. Life insurance policies; including single premium or investment-oriented policies

Present Law

Tax treatment of policyholders

Treatment of investment income

Life insurance contracts.-Under present law, the investment income (“inside buildup”) earned on premiums credited under a life insurance policy generally is not subject to current taxation to the owner of the policy.

The favorable tax treatment is available only if a life insurance contract meets certain requirements designed to limit the investment character of the contract. Under present law, a life insurance contract is eligible for favorable tax treatment to the policyholder if it meets either of two statutory tests: the "cash value accumulation" test, or the "guideline premium/cash value corridor" test. A contract generally meets the cash value accumulation test if the cash surrender value cannot exceed the net single premium that would have to be paid at that time to fund future benefits under the contract. A contract generally meets the guideline premium/ cash value corridor test if the premiums paid under the policy do not exceed certain guideline levels, and the death benefit under the policy is not less than a varying statutory percentage of the cash surrender value of the policy. Adjustment rules provide that cash distributions resulting from reductions in benefits in the first 15 years of the policy are subject to tax (up to a ceiling amount).

Under these rules, investment income on a life insurance policy that has too large an investment component is treated as ordinary income received or accrued by the policyholder during the year.

Annuity contracts.-Under present law, the investment income ("inside buildup") earned on premiums credited under an annuity contract held by an individual is not subject to current taxation in the hands of the owner of the contract.

Present law (as amended by the 1986 Act) provides, however, that the income on a deferred annuity contract for any taxable year is treated as ordinary income received or accrued by the contract owner, if the contract is held by a person who is not a natural person (such as a corporation). Certain exceptions are provided for such contracts that are held (1) under qualified plans, (2) as qualified funding assets under structured settlement arrangements, and (3) in certain other circumstances. The requirement of inclusion of income on a deferred annuity contract also does not apply to immediate annuities (generally, those annuities under which the annuity

starting date is no more than a year after the purchase of the annuity).

Thus, other than in the case of a deferred annuity held by a nonnatural person, tax generally is deferred on the inside buildup under an annuity contract. An immediate annuity offers a deferral of tax to the extent that the premium paid in any year exceeds the premium necessary to provide annuity income during that year. In the case of a deferred annuity contract held by an individual, deferral of tax on the investment income earned on the contract occurs throughout the period prior to the time that all obligations under the contract are satisfied.

Treatment of payments under insurance or annuity contracts Life insurance policies.-Under a life insurance contract, all death benefits are excluded from income, so that neither the policyholder nor the policyholder's beneficiary is ever taxed on the inside buildup if the proceeds of the policy are paid to the policyholder's beneficiary by reason of the death of the insured.

Distributions from a life insurance contract that are made prior to the death of the insured generally are includible in income, but only to the extent that the amounts distributed exceed the taxpayer's basis in the contract. Distributions are generally treated first as a tax-free recovery of basis, and then as income.

Annuity contracts.-In the case of an annuity contract (whether immediate or deferred), amounts received after the annuity starting date generally are includible in income. However, under such a contract, the individual's investment in the contract is recovered on a pro-rata basis over the individual's life expectancy.

By contrast, distributions under an annuity contract prior to the annuity starting date are treated as currently taxable to the extent of the previously untaxed income on the contract. Thus, income earned on the contract is subject to tax when distributed (or as it is earned, in the case of deferred annuities held by persons other than natural persons, such as corporations).

Borrowing under insurance or annuity contracts

Life insurance policies.-The inside buildup on a life insurance contract generally is not treated as distributed to the policyholder and subject to current taxation if the policyholder borrows under the policy or receives distributions under it, to the extent of the policyholder's basis in the policy, even though the policyholder has current use of the money.

Under present law, as amended by the 1986 Act, interest on amounts borrowed under a life insurance policy for personal expenditures is treated as nondeductible personal interest (subject to a phase-in rule for taxable years beginning in 1987 through 1990). Present law also treats as nondeductible the interest on debt with respect to policies covering the life of an officer, employee or individual financially interested in the taxpayer (to the extent the debt exceeds $50,000 per officer, employee or individual).

Policyholder loans at low or no net interest rates are not specifically subject to the below-market loan rules under present law.

Annuity contracts.-Amounts borrowed from a deferred annuity contract are treated as distributions under the contract and are treated as received first out of income on the contract.

Tax treatment of insurance companies

Under present law, a life insurance company generally is not subject to tax on the inside buildup on a life insurance or annuity contract because of the life insurance company reserve rules. Under these rules, a life insurance company is allowed a deduction for a net increase in life insurance reserves (taking into account both premiums and assumed interest credited to the reserves). Life insurance reserves are defined to include amounts set aside to mature or liquidate future unaccrued claims arising from life insurance, annuity, and noncancellable accident and health insurance contracts that involve, at the time with respect to which the reserve is computed, life, accident, or health contingencies.

The maximum reserve permitted under present law with respect to a contract equals the greater of (1) the net surrender value of the contract or (2) the Federally prescribed tax reserve. The assumed interest rate to be used to discount future obligations in computing the Federally prescribed reserve is the prevailing State assumed interest rate (generally, the highest rate for computing insurance reserves under the state insurance laws of 26 or more states). By contrast, under present law, tax reserves for unpaid losses of property and casualty insurance companies are subject to discounting by applying the applicable Federal rate (AFR) of interest (specifically, the average of the applicable Federal mid-term rates for the most recent 60-month period beginning after July, 1986).

Present law does not treat reserve deductions of insurance companies as an item of tax preference under the corporate alternative minimum tax.

Life insurance contracts

Possible Proposals

1. As proposed by the President in his 1985 tax reform proposal, the inside buildup on newly-issued life insurance policies could be included in the income of the policyholder. Thus, the policyholder would include in income for a taxable year any increase (other than through unrealized appreciation, in the case of variable contracts) during the year in the amount by which the policy's cash value exceeds the policyholder's investment in the contract.

Alternatively, the inclusion in income of the inside buildup on newly-issued life insurance policies could apply only to policies held by persons other than natural persons.

2. The definition of life insurance could be narrowed for newly issued policies to provide that significantly investment-oriented life insurance policies such as single-premium life insurance policies would not be treated as life insurance policies for Federal income tax purposes and, therefore, that investment earnings on the policy would be currently included in the policyholder's income. For example, if the amount of the premium in any year substantially exceeds the amount needed for level premium funding of the death

benefit, or the income earned on the contract is from high-risk or high-return investments, then the contract would not be treated as life insurance.

Alternatively, only the excess investment income could be taxed currently with respect to newly issued policies.

3. Distributions from newly issued life insurance policies prior to the death of the insured could be treated in the same manner as distributions under annuity contracts prior to the annuity starting date (i.e., income first).

Annuity contracts

1. As proposed by the President's tax reform proposal of May 1985, newly issued deferred annuity contracts held by natural persons could be treated the same as such contracts held by persons other than natural persons, so that income on the contract for any year would be treated as ordinary income received or accrued by the policyholder during the year.

2. The amount that a policyholder could invest in a newly issued deferred annuity contract on a tax-favored basis could be subject to a cap, such as $50,000. Inside buildup on amounts invested in excess of $50,000 could be currently taxable to the policyholder. Borrowing under life insurance contracts

1. New loans under life insurance policies could receive the same treatment as loans under annuity contracts (i.e., could be treated as distributions under the policy prior to the death of the insured). 2. Low or no net interest policyholder loans could be treated as below-market loans and the foregone interest on the loans could be treated as a distribution of income on the contract to the policyholder.

Treatment of insurance company

1. As proposed by the President's tax reform proposal of May 1985, a life insurance company could be prohibited from deducting increases to reserves for newly-issued life insurance or annuity contracts to the extent that the reserve exceeds the cash surrender value of a contract.

2. Life insurance companies could be prohibited from taking deductions for life insurance reserves (but not reserves for losses which have actually occurred) with respect to all newly issued insurance and annuity contracts, and instead could be permitted to deduct amounts only when a death or distribution creates a liability with respect to such contracts.

3. The deduction for life insurance reserves could be treated as an item of tax preference (i.e., not permitted as a deduction) under the corporate alternative minimum tax.

4. If deductions for life insurance reserves are not otherwise limited, the interest rate applicable in determining Federally prescribed tax reserves of life insurance companies could be conformed to the applicable Federal rate (AFR) (similar to the discount rate for other insurance companies).

Pros and Cons

Arguments for the proposals

1. The tax treatment of life insurance companies and their policyholders results in a total exemption from tax of a substantial amount of investment income. This exemption increases the unfairness and inefficiency of the tax system.

2. Life insurance companies have more favorable tax treatment with respect to their liabilities than other financial intermediaries because they can deduct liabilities that have not yet accrued under generally applicable tax accounting principles. Most companies are not allowed reserves for future expenses; even property and casualty insurance companies are not allowed a reserve deduction until a loss actually occurs (e.g., a disability occurs or a fire or theft takes place). Life insurance companies thus have an unfair tax advantage.

3. It is inappropriate to allow life insurance companies a deduction for amounts credited to policyholders until an amount is included in their income, as is the case with other financial intermediaries.

4. The deferral of tax on the inside buildup of life insurance policies primarily benefits higher-income taxpayers who are able to save yet who do not need a tax-motivated incentive to save. Present law thus reduces the progressivity of the income tax.

5. Tax-free inside buildup of life insurance policies and annuities, unlike tax-favored mechanisms for providing retirement benefits, is not subject to restrictions (such as nondiscrimination rules or contribution or income limits). Thus, continued allowance of tax advantages circumvents important rules applicable to qualified plans and IRAs.

6. Whole life insurance policies frequently are surrendered by the policyholder for their cash value or are encumbered by extensive borrowing which reduces death benefits and, therefore, do not serve a possible public policy of providing for dependents in the event of the insured's death. Thus, investment-oriented life insurance policies are inconsistent with Congressional intent to provide that death benefits are funded through tax-favored inside buildup. 7. In the 1986 Act, Congress expressed a policy concern about opportunities for tax sheltering, and restrictions on life insurance and annuities would be consistent with this concern by eliminating an opportunity for some taxpayers to shelter income by investing in single premium life insurance and deferred annuity contracts.

8. Loans from life insurance contracts often are substantively equivalent to a distribution from the contract prior to the death of the insured because loans are frequently not repaid by the policyholder. Thus, if distributions prior to the death of the insured are treated as a return of income first under the contract, then equivalent treatment is appropriate for policy loans.

9. Limiting the life insurance company reserves for any contract to the cash surrender value of the contract would prevent the overstatement of tax reserves. Cash surrender value is an objective measure of the reserve for policyholder claims, while reserves computed for State regulatory purposes are computed using conservative assumptions.