Understanding The Defective Life Insurance 7702 Policy

Section 7702 of the U.S. Internal Revenue Service (IRS) Tax Code defines what the federal government considers a legitimate life insurance contract. It outlines the criteria that life insurance policies must meet to qualify for tax advantages. If a life insurance policy does not meet the criteria specified in Section 7702, the proceeds may be taxed as ordinary income.

The cash value accumulation test

The CVAT ensures that the cash surrender value of a life insurance policy does not exceed the net single premium required to buy the policy outright, based on its death benefit. In other words, the cash value shouldn't be higher than what you would have paid in a lump sum to purchase the policy, excluding any fees. If a policy passes the CVAT, it qualifies as life insurance for income tax purposes.

For example, if you have a whole life insurance policy, the CVAT ensures that the cash value you could receive if you cancelled the policy is not more than the single payment you would need to buy the policy upfront. Whole life insurance policies accumulate cash value over time, and the CVAT ensures this cash value remains within the limits set by the IRS. By meeting this test, policyholders can benefit from the tax advantages associated with genuine life insurance policies.

The CVAT is chosen by the policyholder when they complete their application. It determines whether the premiums paid into a life insurance policy are reasonable in relation to the benefits provided. In other words, it ensures that the policy is not being used solely as a tax shelter.

The test looks at the amount of premiums paid into the policy and compares it to the policy's cash value. If the cash value exceeds the premiums required at that time to keep the policy funded, the policy fails the test and may lose its tax-deferred status.

In summary, the CVAT ensures that the amount of cash that can be withdrawn from a life insurance policy if it is cancelled is not more than what would be needed to pay for the policy's future benefits upfront. This test helps to ensure that life insurance policies are used appropriately and prevents their misuse as tax shelters.

The guideline premium and corridor test

Guideline Premium Test

This part of the GPT limits the amount of premiums that can be paid into the policy at any given time. The limit can vary based on the insurance company's expenses and claims experience. Essentially, it ensures that the policyholder doesn't pay more into the policy than necessary for it to be considered life insurance.

Corridor Test

This part of the test requires that the policy's death benefit always exceeds a specified multiple of its cash value. This multiple can vary based on the insured individual's age. If the cash value exceeds this corridor, the policy is determined to be overfunded and is classified as a Modified Endowment Contract (MEC), which loses the tax benefits associated with life insurance.

Simplified Explanation:

The GPT makes sure that:

• You don't put too much money into the policy at once. The limit depends on the insurance company's costs and experience.
• The death benefit is always much higher than the cash value of the policy. This multiple varies with age. If the cash value gets too high, the policy is considered overfunded and loses its tax benefits.
• The corridor narrows as you get older, allowing for policies to endow at maturity.

The corridor test

The corridor narrows as the insured person gets older, allowing for the policies to endow at maturity.

The guideline premium test

If a life insurance policy fails to pass the guideline premium test, Section 7702(g) stipulates that the income on the contract will be treated as ordinary income for that year and taxed accordingly. In other words, the owner of the contract will lose the favourable tax treatment of a true life insurance policy.

The GPT is designed to ensure that a life insurance policy is primarily for a death benefit payout and not an investment vehicle.

To summarise, the guideline premium test ensures that the premiums paid into a life insurance policy do not exceed the maximum amount allowed for it to qualify as a life insurance contract and to retain its tax-advantaged status.

The death benefit

However, if a life insurance policy does not meet the requirements of Section 7702, the death benefit may be taxable as ordinary income. This is because the proceeds of policies that do not meet the government's definition of a "legitimate life insurance contract" are taxable as ordinary income.

Section 7702 was created to differentiate between income from a genuine insurance product and income from an investment vehicle. In the early days of life insurance in the U.S., policies were being used as investment vehicles rather than for their intended purpose of providing financial protection. To address this, Congress introduced Section 7702, establishing specific criteria that life insurance policies must meet to maintain their tax-advantaged status.

Therefore, it is important to understand the requirements of Section 7702 to ensure that the death benefit remains tax-free. Life insurance contracts have to pass one of two tests: the cash value accumulation test (CVAT) or the guideline premium and corridor test (GPT). The CVAT ensures that the cash value of a life insurance policy does not exceed the net single premium required to buy the policy outright, while the GPT has two parts: the guideline premium test and the corridor test. The guideline premium test limits the amount of premiums that can be paid into the policy, while the corridor test requires that the death benefit always exceeds a specified multiple of its cash value.

By meeting the requirements of Section 7702, policyholders can benefit from the tax advantages associated with genuine life insurance policies, including a tax-free death benefit.

Frequently asked questions