HS 311 - Lesson 4

Betty owns a $150,000 whole life participating insurance policy that she purchased ten years ago. She has paid premiums of $4,000 each year since she bought the policy and the current cash surrender value is $60,000. Betty has received $10,000 in paid dividends since the policy inception. Which of the following statement(s) is/are correct regarding Betty's policy? 1. If Betty surrenders the policy now, she will have a taxable gain of $30,000 taxed as ordinary income. 2. The dividends that were paid on Betty's policy were subject to ordinary income tax treatment. a. 1 only b. 2 only c. Both 1 and 2 d. Neither 1 nor 2

a. 1 only Explanation: The ordinary taxable gain on the surrender of Betty's policy is $30,000. Premium payments of $40,000, less $10,000 of paid dividends, leave an adjusted basis of $30,000. The taxable gain is $30,000 ($60,000 -$30,000).

A cross purchase agreement will increase the income tax basis of survivors/owners. a. True b. False

a. True

A life insurance policy sold from a shareholder in a corporation to the corporation (the business entity) is an exception to the transfer for value rule, allowing the corporation to receive the death benefit income tax-free. a. True b. False

a. True

A secular trust can provide the employee with protection against employer insolvency as well as against a change in ownership or management. a. True b. False

a. True

A way to receive tax-free benefits from a whole life policy during one's life is by taking a loan against the death benefit amount. a. True b. False

a. True

An employer receives a current income tax deduction for contributions to a qualified retirement plan. a. True b. False

a. True

If a terminally ill insured with a $100,000 life insurance policy receives accelerated death benefits of $70,000, the remaining $30,000 of death benefit will be paid to his or her named beneficiary at the death of the insured. a. True b. False

a. True

If your chronically ill client sells his life insurance policy and uses the proceeds to pay for a vacation rather than medical expenses, those proceeds, to the extent they exceed the client's basis in the policy, will be subject to income tax. a. True b. False

a. True

Premiums paid on life insurance policies are rarely tax deductible. a. True b. False

a. True

The FIFO method of accounting is preferable to the LIFO method because income tax is deferred until the distributed amount exceeds basis. a. True b. False

a. True

The number of policies for five equal partners in cross-purchase arrangement to buy-sell is 20. a. True b. False

a. True

How are withdrawals from the cash value of a permanent life insurance policy typically taxed? a. Using the "first in, first out" (FIFO) method in which withdrawals up to the policyowner's basis are withdrawn tax-free and any additional withdrawals are taxed at ordinary income rates. b. Using the "last in, first out" (LIFO) method in which gains above the policyowner's basis are withdrawn first and taxed at ordinary income rates. c. Such withdrawals are generally not subject to taxation unless the policy is a Modified Endowment Contract (MEC). d. Withdrawals of cash value are not permitted; to access the cash value, policyowners may take tax-free policy loans or surrender the policy.

a. Using the "first in, first out" (FIFO) method in which withdrawals up to the policyowner's basis are withdrawn tax-free and any additional withdrawals are taxed at ordinary income rates. Explanation: The policyowner's basis in the policy may be withdrawn without triggering tax consequences.

An insured's life insurance policy has been classified as a modified endowment contract (MEC). When the insured passes away, the policy's death benefit is subject to which of the following tax treatments? a. the beneficiary receives the death benefit tax-free. b. the death benefit is subject to ordinary income taxation c. the death benefit is subject to capital gains taxation d. the sum of all premiums paid are received as a tax-free return of basis while the remainder of the death benefit is subject to capital gains taxation

a. the beneficiary receives the death benefit tax-free. Explanation: Whether a policy is classified as a MEC does not affect the tax treatment of that policy's death benefit: the death benefit is still received tax-free by the beneficiary.

With regard to employer-paid group term life insurance, the employee is free from income tax liability for the first __________ of term life insurance protection. a. $25,000 b. $50,000 c. $75,000 d. $100,000

b. $50,000 Explanation: The first $50,000 of death benefit protection received by the employee is tax-free.

Cameron paid $50,000 in premiums on a whole life policy with a $500,000 death benefit. The policy has paid a dividend of $500 per year for the past 5 years. If he surrenders the policy today for its cash value of $55,000, what will be the amount of gain subject to taxation? a. $0 b. $7,500 c. $50,000 d. $55,000

b. $7,500 Explanation: The cost basis is equal to the total premiums paid less the dividends received. $50,000 − $2,500 = $47,500 The gain upon surrender is $55,000 − $47,500 = $7,500.

A viatical settlement company purchased a $250,000 policy for $160,000. It paid additional premiums of $7,000 (in total)over the next three years before the insured died. What income must the viatical company report from the policy proceeds in the year of the insured's death? a. $0 b. $83,000 ordinary income c. $83,000 capital gain d. $90,000 ordinary income

b. $83,000 ordinary income Explanation: The viatical company must report the gain as ordinary income. The amount of the viatical settlement plus the additional premiums are costs and are deducted from the proceeds in determining the gain.

Which of the following is false regarding a deferred compensation plan that is funded utilizing a rabbi trust? 1. Participants have security against the employer's unwillingness to pay 2. Rabbi trust provide the participant with security against employer bankruptcy 3. Rabbi trusts provide tax deferral for participants 4. Rabbi trusts provide the employer with a current tax deduction a. None, they are all true b. 2 and 4 c. 1, 2, and 4 d. 1, 2, 3, and 4

b. 2 and 4 Explanation: Rabbi trusts do not provide security against employer bankruptcy or a current tax deduction for the employer.

The number of policies for five equal partners in an entity approach to buy-sell is 20. a. True b. False

b. False Explanation: An entity appraoch requires that the entity purchase one policy per owner, therefore, 5 policies are required.

Dividend distributions from life insurance policies are taxable to the policy owner. a. True b. False

b. False Explanation: Dividend distributions are a tax-free return of premium unless the total amount of dividends distributed to the policy owner exceeds the total premiums paid.

If the insured dies while owning the life insurance policy, the value of the policy is not includible in his or her estate for estate tax purposes. a. True b. False

b. False Explanation: If the insured dies owning a policy on his orher own life, the death benefit is income tax free but will be included in the gross estate for estate tax purposes.

If your terminally ill client sells his life insurance policy and uses the proceeds to pay for a vacation rather than medical expenses, those proceeds, to the extent they exceed the client's basis in the policy, will be subject to income tax. a. True b. False

b. False Explanation: If the insured was terminally ill at the time of the sale, no gain on the sale of the policy is realized, regardless of what the money is actually used for.

The premiums paid for a life insurance policy to fund a cross purchase agreement are tax deductible to the payer. a. True b. False

b. False Explanation: Premiums paid for life insurance to fund any type of buy-sell agreement are not tax deductible.

If a client exchanges a policy for a like-kind policy, there is no income tax due at the time of the exchange; rather the basis is carried over to the new policy and it is not increased by additional premium payments. a. True b. False

b. False Explanation: There is no income tax due, and the basis carries over, but additional premiums increase basis.

When the policy owner no longer has need for the death benefit protection and sells the policy to another party, the acquiring owner will receive an income tax-free death benefit upon the death of the insured. a. True b. False

b. False Explanation: When a policy is transferred in exchange for value (as when it is sold to someone else), the acquiring owner is purchasing the policy an investment and will be taxed (at ordinary income rates) on the amount of death benefit received in excess of their cost basis.

Non-qualified deferred compensation plans allow the employer to take a current tax deduction for compensation expense while the employee can defer the income tax on the compensation. a. True b. False

b. False Explanation: With a non-qualified deferred compensation plan, the employer may take a compensation deduction in the same year the deferred compensation is taxed to the employee.

If a terminally ill insured with a $100,000 life insurance policy sells the policy to a licensed viatical settlement provider for $70,000, a death benefit of $30,000 will be paid to his or her named beneficiary at the death of the insured. a. True b. False

b. False Explanation: When a policy is sold to a viatical settlement company, the viatical company becomes the policy owner and the beneficary of the full death benefit amount.

Which of the following statements regarding the taxation of life insurance is correct? a. Death benefits receive favorable capital-gains tax treatment. b. If a policy owner surrenders a policy and elects to receive installment payments, a portion of those payments is received as a tax-free return of basis. c. Life insurance policies lose much of their favorable tax treatment if they are no longer considered modified endowment contracts (MECs). d. Dividends from a life insurance policy receive favorable capital-gains tax treatment so long as they are considered qualified dividends.

b. If a policy owner surrenders a policy and elects to receive installment payments, a portion of those payments is received as a tax-free return of basis. Explanation: A portion of installment payments are received as a tax-free return of basis. Neither death benefits nor dividend payments receive favorable capital-gains tax treatment. Death benefits are generally received tax-free, whereas dividends are received either as a tax-free return of basis or as ordinary income. Life insurance policies lose much of their favorable tax treatment if they are classified as MECs. Once a policy is classified as a MEC, it cannot lose this classification.

Members of a three-person partnership want to enter into a buy-sell arrangement. How many life insurance policies would need to be purchased to properly fund coverage of the partnership using an entity-purchase agreement? a. one policy b. three policies c. six policies d. nine policies

b. three policies Explanation: With an entity-purchase buy-sell arrangement, the business would purchase life insurance policies on each owner. Therefore, a total of 3 policies, one for each owner, would need to be purchased.

Bentley has paid $40,000 in premiums on a whole life policy with a $250,000 death benefit. The policy has paid a dividend of $1,000 per year for the past 10 years. If Bentley surrenders the policy today for its cash value of $55,000, what will be the amount of gain subject to taxation? a. $0 b. $15,000 c. $25,000 d. $55,000

c. $25,000 Explanation: The cost basis is equal to the total premiums paid less the dividends received. $40,000 − $10,000 = $30,000 The gain upon surrender is $55,000 − $30,000 = $25,000.

A 7-person partnership is considering entering into a buy-sell agreement. While most members prefer an entity arrangement, one prefers everyone own policies on the others as part of a cross-purchase agreement. If this partner gets his way, how many policies would need to be purchased to fully implement a cross-purchase agreement? a. one policy b. seven policies c. 42 policies d. 49 policies

c. 42 policies Explanation: Each owner would need to purchase a life insurance policy on each of the other owners. Therefore, a total of 42 policies would need to be purchased. 7 × (7 − 1) = 7 × 6 = 42

Which of the following is a taxable event? a. A beneficiary receives the death benefit from a modified endowment contract (MEC). b. An insured takes a policy loan from the cash value of a universal life insurance policy. c. An insured receives an interest payment after electing the interest-only surrender option. d. A beneficiary receives a $100,000 death benefit from a group term life insurance policy.

c. An insured receives an interest payment after electing the interest-only surrender option. Explanation: When the interest-only surrender option is selected, the death benefit is left with the insurance company. Gains on that balance are received as taxable interest income. Answer (A) is incorrect because death benefits from a MEC are received tax-free by the beneficiary. Answer (B) is incorrect because policy loans, like all loans, are not considered taxable income. Answer (D) is incorrect because death benefits from group term life insurance policies are received tax-free by the beneficiary.

Which of the following statements concerning a properly designed buy-sell agreement is (are) correct? I. It ensures that a business owner's estate can sell the business for a reasonable price. II. It should specify how the purchase price will be established. a. I only b. II only c. Both I & II d. Neither I nor II

c. Both I & II Explanation: Both I & II are correct

Which of the following test(s) can be used to determine whether or not a life insurance contract meets the definition of a modified endowment contract (MEC)? I. The corridor test II. The seven-pay test a. I only b. II only c. Both I & II d. Neither I nor II

c. Both I & II Explanation: Both the corridor test and the seven-pay test are used to determine whether or not a life insurance contract is a MEC.

All of the following are reasons that an employer might favor a non-qualified plan over a qualified retirement plan except: a. There is more design flexibility with a non-qualified plan b. A non-qualified plan typically has lower administrative costs c. Non-qualified plans typically allow the employer an immediate income tax deduction d. Employers can generally exclude rank-and-file employees from a non-qualified plan

c. Non-qualified plans typically allow the employer an immediate income tax deduction Explanation: Nonqualified plans do not allow the employer to take an income tax deduction until the employee recognizes the income. All of the other statements are correct.

Which of the following statements regarding entity-purchase buy-sell agreements is correct? a. If the business has five owners, 20 life insurance policies must be purchased. b. When one of the owners dies, the surviving owners will have an increased cost basis in their share of the business. c. When an owner dies, the business may need to pay income tax on the death benefit. d. The business entity will purchase a life insurance policy on each owner and will pay the premiums, which are tax deductible as a business expense.

c. When an owner dies, the business may need to pay income tax on the death benefit. Explanation: Death benefits may be subject to income tax by the business if the rules of IRC Sec. 101(j) Employee Notice and Consent have not been followed. Statement (A) is incorrect because, with an entity-purchase agreement, the business will purchase one policy on each owner; therefore, a business with five owners will require five policies. Statement (B) is incorrect because it is the business, not the surviving owners, that will receive the death benefits and purchase the deceased owner's interest; therefore, the surviving owners' cost basis does not increase with an entity-purchase agreement. Statement (D) is incorrect because while the business will pay the premiums, the premiums are not tax deductible.

A Section 1035 exchange would allow which of the following tax-free exchanges? a. a modified endowment contract (MEC) to typical life insurance policy b. a deferred annuity to a life insurance policy c. a modified endowment contract (MEC) to an annuity d. all of the above

c. a modified endowment contract (MEC) to an annuity Explanation: A life insurance policy, whether a typical policy or a MEC, may be exchanged tax-free for an annuity. Answer (A) is incorrect because a MEC cannot be converted to a typical policy; "once a MEC, always a MEC". Answer (B) is incorrect because annuities may not be exchanged for life insurance policies tax-free under Section 1035.

An owner-insured of a viatical settlement is not subject to income tax on the capital gains of the policy if a. the death benefit is less than $1 million. b. the individual is less than 65 years of age. c. the individual is terminally ill. d. the owner-insured's basis in the policy is greater than $1 million dollars.

c. the individual is terminally ill Explanation: If the owner-insured of a life insurance policy is terminally ill at the time the policy is sold, the gain in the policy is not subject to income tax. Terminal illness is defined as having a life expectancy of less than 24 months.

Watson, Inc. has four equal partners. All four partners are interested in entering into a buy-sell arrangment .How many life insurance policies would be purchased to properly fund using a cross-purchase agreement? a. 4 policies b. 6 policies c. 8 policies d. 12 policies

d. 12 policies Explanation: Each owner would need to purchase a life insurance policy on the other owners. Therefore, 12 policies would be purchased in total or 4(4-1) = 12.

A rabbi trust can provide the employee with protection against employer insolvency. a. True b. False

b. False Explanation: A rabbi trust can protect the employee in the event of a change in ownership or management of the business, but assets must remain available to the employer's creditors.

Members of a four-person partnership want to enter into a buy-sell arrangement. How many life insurance policies would need to be purchased to properly fund coverage of the partnership using a cross-purchase agreement? a. one policy b. four policies c. eight policies d. twelve policies

d. twelve policies Explanation: Each owner would need to purchase a life insurance policy on each of the other owners. Therefore a total of 12 policies would need to be purchased. 4 × (4 − 1) = 4 × 3 = 12

Members of a five-person partnership want to enter into a buy-sell arrangement. How many life insurance policies would need to be purchased to properly fund coverage of the partnership using a cross-purchase agreement? a. one policy b. five policies c. ten policies d. twenty policies

d. twenty policies Explanation: Each owner would need to purchase a life insurance policy on each of the other owners. Therefore, a total of 20 policies would need to be purchased. 5 × (5 − 1) = 5 × 4 = 20