Taxation of Life Insurance Products: Background and Issues

Taxation of Life Insurance Products: Background and Issues

Order Code RL32000
CRS Report for Congress
Received through the CRS Web
Taxation of Life Insurance Products:
Background and Issues
July 18, 2003
name redacted
Consultant
Government and Finance Division
Congressional Research Service ˜ The Library of Congress

Taxation of Life Insurance Products:
Background and Issues
Summary
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.

Contents
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Description of Life Insurance Products . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Pure Insurance Protection . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Flight Life Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Individual Term Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Employment-Based Group Term Life Insurance . . . . . . . . . . . . . . . . . . 3
Mortgage Life Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Key Person Life Insurance and Business Buy-sell Agreements . . . . . . . 3
Cash Value Life Insurance: Pure Insurance Protection Combined With
Savings Elements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Traditional Level-Premium and Single Premium Policies . . . . . . . . . . 4
Universal Life Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Additional Investment Choices: Variable Life Insurance and
Variable Universal Life . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Overview of Current Tax Treatment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
IRC Section 72: Cash Value Life Insurance and the Taxation of
Investment Income During the Insured’s Life . . . . . . . . . . . . . . . . . . . . 8
IRC Section 101: Exclusion of the Death Benefit . . . . . . . . . . . . . . . . . . . . . 9
IRC Section 79: Provision of Group Term Life Insurance for Employees . 10
IRC Section 7702: Definition of Life Insurance for Tax Purposes . . . . . . . 10
IRC Section 7702A: Modified Endowment Contracts . . . . . . . . . . . . . . . . 11
General Tax Policy Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
Exclusion of the Death Benefit From Income Taxation . . . . . . . . . . . . . . . 12
Taxation of Investment Earnings Credited to Cash Value Life Insurance . 13
Treatment of Life Insurance Compared to Other Tax-Preferred Forms
of Savings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
Taxation of Interest Credited Under a Life Insurance Contract: A Tax
on Unrealized Appreciation? . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
Current Limits on the Use of Life Insurance as an Investment
Vehicle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
Corporate-Owned Life Insurance
(“Janitors Insurance”) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
Split Dollar Life Insurance — Compensatory Arrangements for Corporate
Executives and Other Tax Planning Goals
. . . . . . . . . . . . . . . . . . . . . . . 22
Introduction: The Structure of Split Dollar Arrangements . . . . . . . . . . . . . 22
The Tax Treatment of Split Dollar Arrangements . . . . . . . . . . . . . . . . . . . . 23
Early IRS Analysis of Traditional or Classic Arrangements . . . . . . . . 23
Concerns Leading to Reconsideration . . . . . . . . . . . . . . . . . . . . . . . . . 24
Development of Equity Split Dollar Arrangements . . . . . . . . . . . . . . . 24
Enactment of IRC sections 83 and 7872 and Their Application to
Equity Split Dollar Arrangements . . . . . . . . . . . . . . . . . . . . . . . . 25

Use of Improper Valuation Methods . . . . . . . . . . . . . . . . . . . . . . . . . . 27
Further “Product” Development: “Reverse” Split Dollar
Arrangements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28
Recent IRS Guidance on Taxation of Split Dollar Arrangements . . . 29
Example 1 — Employee Ownership of Life Insurance Contract . . . . . 29
Example 2 — Employer Ownership — Equity Arrangement . . . . . . . 30
Example 3 — Employer Ownership — Non-Equity Arrangement . . . 30
Reverse Split Dollar Arrangements . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
Additional Reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
Related CRS Reports: . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
List of Tables
Table 1. Premium Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Table 2. Estimated Revenue Loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
This report was prepared under the supervision of the Congressional Research
Service. For further information on the subject of this report or its contents, contact
(name redacted), Specialist in Public Finance, Congressional Research Service.

Taxation of Life Insurance Products:
Background and Issues1
Introduction
This report examines the tax treatment of life insurance under the Internal
Revenue Code. Owners and beneficiaries of life insurance contracts receive
preferential treatment under the federal income tax laws. Significantly, an owner of
cash value life insurance generally avoids taxation on the entire amount of interest
(or other returns on the investment) that is credited to the contract’s cash value. If
the life insurance contract remains in effect until the insured’s death, the beneficiaries
generally exclude from income the death benefits paid under the contract, including
the previously untaxed interest.
The second section introduces different types of life insurance, and the financial
and economic framework upon which these products are constructed. This section
begins with a discussion of the concept of “pure life insurance protection” and the
types of life insurance products that provide primarily pure life insurance protection.
The remainder of the section examines life insurance products that combine
investment features with pure life insurance protection, including “whole” life
insurance, “universal” life insurance, and “variable” life insurance.
The third section examines the tax provisions of the Internal Revenue Code that
apply to the owners of life insurance. First, this section discusses the application of
Internal Revenue Code sections 101 and 72, which establish the basic tax treatment.
Second, it provides a brief overview of Internal Revenue Code sections 7702 and
7702A, which contain highly technical limitations on the favorable tax treatment
accorded certain life insurance arrangements. Section IV considers the justifications
for the favorable tax treatment from a tax policy perspective.
Finally, Sections V and VI examine two types of life insurance arrangements
and their tax implications — corporate-owned life insurance and split dollar life
insurance — that have received attention in recent years. In both types of
arrangements, some businesses and corporate executives have utilized life insurance
to obtain significant economic benefits. This section provides an overview of these
arrangements and a brief analysis of the tax issues that they raise.
1 For further information on the subject of this report, or its contents, please contact (name
redacted), Specialist in Public Finance, Government and Finance Division, Congressional
Research Service, [redacted].

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Description of Life Insurance Products
Pure Insurance Protection
All life insurance contracts have two defining characteristics. First, an insurance
company agrees to pay a specified sum following the death of an insured. Second,
premiums are paid to the life insurance company to secure the benefits specified in
the life insurance contract. Although all life insurance contracts incorporate these
elements, the economic terms of life insurance contracts vary widely. In broad terms,
life insurance companies market two broad categories of life insurance: term life
insurance and cash value life insurance.
Individuals often recognize that their deaths may leave their families with
inadequate financial resources. The purchase of a life insurance contract enables an
individual to shift this financial risk to a life insurance company. If the insured dies
while the contract is in effect, the policy’s beneficiaries receive a specified dollar
amount, the “death benefit.” Following the insured’s death, investment of the
insurance proceeds may generate income to replace a portion of the income that the
insured earned prior to death.
The simpler form of life insurance is a “term” arrangement. When a life
insurance company issues a term contract, it commits itself to pay a specified sum if
the insured individual dies during the period of time, or “term,” that the contract
covers. Upon the expiration of the term, neither the owner of the policy nor the life
insurance company has further obligations under the contract. The premium paid
with respect to a term life insurance contract reflects the likelihood that the insured
will die during the year of coverage.
Flight Life Insurance. Perhaps the simplest form of term insurance
protection is “flight” insurance. Under a flight insurance contract, an individual pays
a premium of a few dollars to insure her life for the duration of a flight on an
airplane. The premium does not depend upon the age or health of the insured.
Rather, it depends upon the likelihood of a plane crash. If the insured reaches her
destination alive, then the contract terminates. If, however, the insured does not
survive until the end of the flight, then the insurance company becomes obligated to
pay the death benefit specified in the contract. (These policies are typically limited
to accidental deaths and, accordingly, would not cover health-related deaths during
a flight.) Given the short term of coverage, there is no meaningful investment
incorporated into flight insurance.
Individual Term Insurance . Term life insurance provides current insurance
protection for a limited time. The most common term of coverage is one year,
although term contracts frequently allow the policy owner to renew the policy for
additional years of coverage. As with all forms of life insurance, the insurance
company pays the specified death benefit if the insured dies during the period of
coverage. If the insured remains alive at the end of the policy term, the owner of the
policy (or the designated beneficiaries) has no further economic claims against the
life insurance company.

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The premium that the life insurance company establishes for term life insurance
depends upon the actuarial probability that the insured will die during the period of
coverage. For example, the premium for a one-year term insurance contract with a
death benefit of $100,000 issued to a 35-year-old individual might be $200. Among
the most significant factors used in determining the probability of the insured’s death
are the insured’s age, current health, and the insured’s personal and family history of
life-threatening medical conditions. In addition, the life insurance premium
incorporates amounts reflecting the expenses that the life insurance company expects
to incur (such as commissions payable to the life insurance agent) and anticipated
profit. The linkage between the probability of the insured’s death and the premium
charged causes term insurance premiums to increase as the age of the insured
increases.
Employment-Based Group Term Life Insurance. Many individuals
acquire term life insurance as an employment-based fringe benefit. Most often, a
group-term policy provides term insurance protection for all, or a large portion of, the
employees of an enterprise. The employer may pay the entire premium for the
employees’ coverage. It is a common requirement, however, for the employees to
pay a portion of the premium to obtain life insurance protection.
The premium for life insurance protection provided under a group policy is
likely to differ from that charged for a term life insurance policy issued to an
individual for two reasons. First, the expenses allocable to each insured are likely to
be smaller in a group policy. Second, group premiums generally do not reflect the
insured’s individual medical history. Rather, actuarial expectations of the group’s
mortality are used to establish the premiums for the group.
Mortgage Life Insurance. Mortgage life insurance is a form of term
insurance in which the benefit payable upon the death of the insured decreases over
time. This type of insurance is used primarily to pay off a mortgage loan secured by
the residence of the insured. In a typical self-amortizing mortgage loan, the initial
monthly payments consist primarily of interest, with relatively small amounts
consisting of principal repayments. In later years, the amount of interest decreases
and the principal repayments increase. Therefore, in a mortgage life insurance
policy, the decline in the death benefit matches the decline in the principal balance
payable on the mortgage loan.
Key Person Life Insurance and Business Buy-sell Agreements.
Businesses purchase life insurance contracts for several different purposes. First,
certain small businesses purchase “key person life insurance” to provide a source of
funds to pay for the services of replacement employees following the death of a key
employee. For example, a member of a family may provide important (and perhaps
unpaid) services for the family business. The proceeds of the “key person” life
insurance enable the family business to continue in operation. Second, businesses
may purchase life insurance to provide a source of funds that will be used to purchase
(or buy-out) the ownership interest of a deceased owner. This type of life insurance
is purchased when the owners of a business reach an agreement that the surviving
owners of the business will purchase the interest of any deceased owner at a specified
price.

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Cash Value Life Insurance: Pure Insurance Protection
Combined With Savings Elements
“Cash value life insurance” is a more complicated form of life insurance. As
with term insurance, the life insurance company becomes obligated to pay a specified
sum following the death of the insured. Also referred to as “whole” life insurance,
cash value life insurance remains in effect for many years. The distinguishing feature
of cash value life insurance is the presence of the contract’s cash value, which is the
amount that the policy owner receives if the individual terminates the policy. The
accumulation of cash value reflects the existence of a savings feature in this form of
insurance.
The premium paid with respect to a newly issued cash value life insurance
contract exceeds the term insurance premium for a given insured individual. In
effect, the premium consists of the following two components: (1) a charge equal to
the cost of the insured’s term insurance protection; and (2) an amount that is added
to the contract’s cash value, that can be analogized to a deposit into an individual’s
savings account or mutual fund account. As shown in table 1, the life insurance
company credits interest (or other forms of investment income) to the cash value in
subsequent years. Although the amount credited to the cash value represents an
economic form of income, it is taxed in a favorable manner.
As discussed below, variations in the basic cash value life insurance design
include “universal” life insurance, “variable” life insurance, single premium life
insurance and “second-to-die” life insurance. In addition, “key person” life
insurance, corporate-owned life insurance (COLI) and split dollar life insurance
incorporate cash value life insurance into other financial arrangements.
Traditional Level-Premium and Single Premium Policies. Level-
premium “whole” life insurance is the most traditional form of cash value life
insurance. In a whole life insurance contract, the life insurance company establishes
a fixed premium that remains in effect for the remainder of the insured’s life. The
premium remains constant notwithstanding the increasing actuarial likelihood of the
insured’s death. Consequently, the annual premium exceeds the cost of current
insurance protection during the early years of the contract. This excess serves as the
basis for computing the policy’s cash value.
To illustrate the generation of cash value under a level-premium contract,
consider a simplified hypothetical contract with a death benefit of $100,000 issued
to a 35-year-old individual. The annual premium for this contract is $1,300. During
the first year, the premium of $1,300 is applied to pay the cost of the current year’s
insurance protection, which is $200. The remaining $1,100 might earn interest at
a 4% rate, or $44, during the first year, thereby building the cash value to $1,144.
The $44 of interest credited is commonly called “the inside interest build-up” of a life
insurance policy.
This one-year illustration sets out the basic components of all cash value life
insurance policies: the premium, the charges imposed for current insurance

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protection, the interest credited, and the cash value.2 The precise relationship among
these components depends, however, on the level of current insurance charges, the
rate at which interest is credited, and the pattern and magnitude of the premium
payments. For example, decreases in the charges for current insurance protection
cause the cash value (and the interest credited thereon) to increase. Similarly, an
increase in the rate of interest credited causes the cash value to increase at a faster
rate, thereby decreasing the amount of, and charges for, current insurance protection
at a more rapid rate. However, the interaction of these factors, particularly when
more than one of them change, makes it quite difficult to predict the net effect of the
changes.
The investment orientation of a life insurance contract depends on the amount
of investment income credited to a policy’s cash value relative to the cost of
insurance protection during the years that the policy remains in effect. The level-
premium policy represents one of the least investment-oriented cash value life
insurance designs. Single premium life insurance represents the most investment-
oriented design. In a single premium contract, the contract owner pays one premium
when the life insurance company issues the contract. Because no further premiums
are paid with respect to this contract, the single premium is much larger than the level
premiums discussed above. To illustrate, consider a $100,000 single-premium life
insurance contract issued to the same 35-year-old individual discussed above. The
single premium for this contract might be $25,000. The death benefit is $100,000.
In comparison to the level-premium contract discussed previously, in every year the
single-premium contract generates higher levels of cash value and credits more
interest. The larger cash values reduce the amount and the cost of current insurance
protection.
The differences between the level-premium contract and the single-premium
contract (both having a $100,000 death benefit) during the first year are illustrated
as follows:
Table 1. Premium Contracts
Level
Single
Premium
Premium
Contract
Contract
Yr 1: Premium
$1,300
$25,000
- Cost of Insurance Protectiona
- $200
- $150
+ Interest Earned
+ $44
+ $994
= Closing Cash Value
$1,144
$25,834
Yr 2: Current Insurance Protection
$98,856
$74,166
a As illustrated, the cost of insurance protection under the single premium contract is less that than
under the level premium contract since the current insurance protection of roughly $75,000 is
proportionately less than that under the level premium contract.
2 Life insurance companies also impose “loading” charges in connection with most cash
value life insurance policies. These charges are designed to allow the life insurance
company to recover its expenses incurred in connection with the contract (including the
selling agent’s commissions) and to build in a profit factor. The loading charges reduce the
contract’s cash value.

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Universal Life Insurance. “Universal” life insurance is a modern variant of
the traditional cash value life insurance contract. From a marketing perspective,
universal life insurance incorporates two significant innovations: greater flexibility,
and transparency.
In a traditional cash value contract, the financial terms are extraordinarily
inflexible. Specifically:
! the size and the timing of the premium payments are fixed and
specified in the contract;
! for many contracts (traditional “nonparticipating” contracts) the
implicit rate of return on the cash value and the charges for current
insurance protection are also fixed; and
! the policy owner cannot change the contract’s death benefit after the
contract is issued.
The economic relationships implicit in traditional cash value life insurance are
also incomprehensible to most consumers. Typically, these contracts do not disclose,
in an understandable manner, the amount of interest that the insurance company
credits to the cash value and the level of charges for current insurance protection.
Moreover, the rate of interest implicitly credited in traditional cash value contracts
credited was low in comparison to the rates available from competing investments
during the late 1970s and 1980s.
Universal life insurance was designed to overcome these shortcomings. First,
it allows a far greater degree of flexibility than is permitted under traditional cash
value contracts. Initially, the owner of a universal life policy sets the size of the
initial premium and the initial death benefit. Subsequently, the policy owner has
complete discretion to determine the timing and size of subsequent premium
payments. The policy owner also has the discretion to increase or decrease the death
benefit as the need for insurance changes.
Second, universal life insurance provides a much greater degree of transparency
and disclosure. The interrelationships existing between the financial components that
were always inherent in a traditional cash value life insurance contract are made
explicit in a universal life insurance contract. Specifically, premium payments are
added to the contract’s cash value which, in turn, is reduced by charges for current
insurance protection. The remaining cash value earns interest. Unless additional
premium payments are made, insurance protection continues until the cash value is
depleted. A universal life policy owner receives periodic statements summarizing
these developments. Moreover, the rate of interest credited is clearly stated and the
charges for current insurance protection are made explicit.
Additional Investment Choices: Variable Life Insurance and
Variable Universal Life. Variable life insurance was developed to expand the
range of investment options for investments made in cash value life insurance. In the
traditional design, the investment component of the cash value contract is analogous
to a certificate of deposit that a bank issues: the life insurance company credits
interest to the cash value either at a fixed rate (in nonparticipating contracts) or at

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rates that vary based upon the discretion of the life insurance company (in
participating contracts).
Alternatively, in a variable life insurance contract, the investment component
is analogous to an investment in one or more mutual funds. When the owner of a
variable life insurance contract pays a premium, the life insurance company imposes
charges for the current insurance protection and expenses. The remaining amount is
invested in a pool of assets that are separate from the insurer’s general investment
assets. As with shares of a mutual fund, the cash value will increase or decrease in
proportion to changes in the value of the assets in the separate account.
Consequently, the cash value of a variable life insurance contract can decrease if the
value of the underlying pool of assets declines. Most life insurance companies offer
investment options relating to a range of funds, including money market funds,
common stock funds, and bond funds.
Variable universal life insurance combines the investment flexibility of variable
life insurance with the premium payment flexibility of universal life insurance.
Overview of Current Tax Treatment
Introduction
The owners and beneficiaries of life insurance contracts are accorded favorable
treatment under the Internal Revenue Code. Specifically, during the life of the
insured, the tax treatment of the interest (or other investment income) credited to the
cash value of life insurance contracts differs from the tax treatment of many other
forms of interest in the following significant respects:
! the income measurement rules cause a portion of the interest
credited to avoid taxation;
! the interest is not taxed currently; at a minimum, taxation is
deferred;
! IRC section 101 generally excludes the remaining interest from
gross income if the policy remains in force until the death of the
insured; and
! unlike other tax-preferred forms of investment (such as pension
plans and IRAs), no dollar limits are imposed with respect to
investments made in cash value life insurance.
Each of these benefits is discussed below.
Congress has enacted restrictions on the arrangements that receive this
preferential tax treatment. First, contracts must satisfy the definition of “life
insurance” contained in IRC section 7702. Second, contracts that are classified under
IRC section 7702A as modified endowment contracts are taxed in a less preferential
fashion. These limitations are also discussed below.

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The Joint Committee on Taxation treats the exclusion of investment income on
life insurance and annuity contracts as a tax expenditure. In April 2001, the
committee estimated that these exclusions from income will reduce tax revenues in
the following amounts:
Table 2. Estimated Revenue Loss
(In billions of dollars)
Fiscal Year
Individuals
Corporations
Total
2003
24.0
1.4
25.4
2004
24.6
1.4
26.0
2005
25.2
1.4
26.6
2006
25.8
1.5
27.3
2007
26.5
1.5
28.0
Source: U.S. Congress, Joint Committee on Taxation, Estimates of Federal Tax Expenditures for
Fiscal Year 2003-2007, 107th Cong., 2nd sess. (Washington: April 6, 2001). Posted on the Joint
Committee on Taxation’s Web site: [http://frwebgate.access.gpo.gov/cgi-bin/getdoc.cgi?dbname=
2002_joint_committee_on_taxation&docid=f:83132.pdf].

Compared to the impact of other tax expenditures, the exclusion of investment
income on life insurance and annuity contracts is the 11th largest in terms of forgone
revenue over the estimating period, as reported by the Joint Committee on Taxation.
Furthermore, according to the American Council of Life Insurers (ACLI), the number
of permanent, individual “whole life” policies has increased by 20% over the past
four years, from 109 million in 1998 to 131 million in 2001.3
IRC Section 72: Cash Value Life Insurance and the Taxation
of Investment Income During the Insured’s Life
One of the most significant benefits arising from the ownership of cash value
life insurance relates to the timing of taxation: if the policy owner allows the cash
value to accumulate, no portion of the investment income credited to the cash value
is included in gross income. At a minimum, taxation is deferred unless (and until)
the owner of the contract withdraws the cash value. By comparison, interest credited
to a bank certificate of deposit (or dividends reinvested with respect to either stock
or mutual fund shares) is taxed at the time it is credited. On the other hand, certain
investments instruments such as pensions, 401(k)s, and savings bonds do have
investment build-up free of tax. As discussed in Section IV, some question whether
this favorable tax treatment of life insurance is justified.
3 American Council of Life Insurers, 1999 Life Insurers Fact Book, 1999, and ACLI Product
Line Report: Life Insurance, March 2003, available at [http://www.acli.com/NR/rdonlyres/
eqcnzwvo5rgnkqqaefmqplcobx5dc5wx6fxbhszmdc55vhsxjycpkzgqodubmgbnucocu2hxr
zqsvvxil3rriit3eed/LifeInsuranceTables.pdf].

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IRC section 72 governs the tax treatment of distributions made with respect to
life insurance contracts. Under this provision, further deferral results from the
operation of a “stacking rule.” When a policy owner receives cash from a life
insurance contract (other than a modified endowment contract discussed below), this
stacking rule characterizes the distribution as a nontaxable return of the policy
owner’s capital until the aggregate amount received exceeds the policy owner’s
investment in the contract. As a result, taxation of the interest credited under a cash
value life insurance contract is deferred until the policy owner converts their
investment portion of the cash value into cash.
A policy owner can extend the period of deferral and receive cash in excess of
her investment without realizing any income by borrowing the cash value of the
policy from the life insurance company. All cash value policies include a provision
that gives the policy owner the right to borrow most of the policy’s cash value.
Loans secured by life insurance contracts (other than modified endowment contracts)
are not treated as taxable distributions for purposes of IRC section 72. Although the
policy owner pays interest on policy loans, the after-tax costs incurred are minimal
in connection with this type of indebtedness for two reasons. First, the policy
owner’s pretax “cost” of borrowing equals the difference between the interest payable
on the loan and the interest credited to the allocable amount of cash value. This
difference, typically, is small. Second, interest paid on the policy loan may be
deductible.4 However, it should be noted that the proceeds of many other types of
loans are generally not taxable. One example to the contrary is a loan taken from a
qualified retirement plan. With certain exemptions relating to timing and use of the
proceeds, the proceeds from these loans may be considered a distribution and
included in an individual’s taxable gross income.
The combined effect of the income deferral allowed under IRC section 72 and
the availability of nontaxable policy loans can often result in the interest credited
under cash value life insurance (other than modified endowment contracts) not being
taxed until the policy terminates.
IRC Section 101: Exclusion of the Death Benefit
Under IRC section 101, a life insurance contract’s beneficiary may exclude from
income amounts received under a life insurance contract that are paid by reason of
death of the insured. This exclusion is extremely broad in scope. It applies to:

! amounts paid with respect to term life insurance;
! amounts paid with respect to cash value life insurance, including the
accumulated (and untaxed) investment income credited to the
contract’s cash value; and
4 IRC section 163 authorizes a deduction for certain interest expenses. Taxpayers are
allowed to deduct interest allocable to a trade or business. In addition, interest paid in
connection with the taxpayer’s investments or the taxpayer’s home mortgage are also
deductible, although subject to statutory limitations. Other anti-abuse provisions may limit
these deductions.

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! beneficiaries that are corporations, partnerships, trusts and the estate
of the insured in addition to members of the insured’s family.
From a tax policy perspective, the most significant consequence of this
exclusion relates to the investment income previously credited to the cash value
during the insured’s life. Absent section 101, taxation of the investment income is
deferred. If the contract remains in force until the insured’s death, it becomes evident
that taxation of the investment income is forgiven.
In response to the AIDS crisis, Congress expanded the scope of IRC section 101
so that certain “accelerated death benefits” paid during the life of the insured are also
excluded from income. To qualify for this treatment, the insured must be either
terminally ill or chronically ill. Moreover, the payments must be used to pay for
long-term care of the insured that otherwise would not be covered by insurance.
IRC Section 79: Provision of Group Term Life Insurance for
Employees
Many employees acquire life insurance protection as a fringe benefit provided
by their employers. Until 1964, the value of this employer-provided benefit was
treated as a tax-free fringe benefit. IRC section 79 now limits the extent to which
employer-provided group term life is a tax-free fringe benefit for an employee.
First, the value of the first $50,000 of employer-provided group term life
insurance coverage is excluded from an employee’s income. The value of this
exclusion is quite modest for most employees: the value of $50,000 of term life
insurance protection for most employees younger than age 50 is less than $100 per
year. The entire value of the life insurance protection provided to a disabled retired
employee is excluded from the ex-employee’s income.
Second, the value of any additional employer-provided group-term life
insurance protection is included in the employee’s income. In general, the amount
included in income does not depend upon the actual value (or cost) of the insurance
protection. Rather, the taxable benefit is computed using the rates specified in Table
I contained in section 1.79-3(d)(2) of the Income Tax Regulations. Because these
rates do not reflect the medical condition or gender of the employee, the amount
included in income may differ from the actual value of the insurance protection.
IRC Section 7702: Definition of Life Insurance for Tax
Purposes
The owner of a life insurance contract is taxed in accordance with the provisions
discussed above only if the contract complies with the statutory definition of life
insurance contained in IRC section 7702. This provision denies the preferential tax
treatment to arrangements that are overly investment oriented. Specifically, the
owner of a contract that does not satisfy the requirements of IRC section 7702 must
include in gross income the sum of: (1) the increase in the net surrender value during
the year and (2) the cost of insurance protection provided during the year, reduced by
(3) the premiums paid during the year. This approximates the amount of investment

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income credited under the policy. The amount paid on account of the insured’s
death in excess of the cash value is treated as proceeds of a term life insurance policy
and is therefore excluded from income.
IRC section 7702 adopts two alternative actuarial tests to identify overly
investment-oriented contracts: (1) the cash value accumulation test and (2) the
guideline premium/cash value corridor test. These tests were designed to
accommodate the principal models of life insurance sold in the market. The cash
value accumulation test reflects the structure of the traditional cash value life
insurance contract, which specifies a fixed pattern of premium payments and a fixed
death benefit (or a death benefit determinable based on the accumulated cash value).
The guideline premium test reflects the distinguishing characteristics of the universal
life insurance policy design.
A life insurance contract satisfies the cash value accumulation test if, under the
terms of the contract, the contract’s cash value can never exceed the current “net
single premium.” For any specified age of the insured, the net single premium is
defined as the amount needed, in present value terms, to generate the cash values and
pay the mortality charges for the death benefit specified in the contract. The cash
value accumulation test denies life insurance status to a contract that, by its terms,
permits accumulation of any additional cash value.
The alternative test that a contract may satisfy to qualify as life insurance for tax
purposes is the guideline premium/cash value corridor test. This alternative test
incorporates two requirements. First, the cumulative dollar amount of premiums
actually paid under the contract can never exceed the guideline premium limitation.5
Second, the ratio of the death benefit to the cash value of the policy cannot, at any
time, fall below specified percentages. The minimum amount of current insurance
protection for a given death benefit constitutes the cash value corridor.
IRC Section 7702A: Modified Endowment Contracts
Congress enacted IRC section 7702A out of concern that investors were
purchasing single premium life insurance as a tax-sheltered investment rather than
for life insurance protection. Under this provision, adverse tax consequences apply
to life insurance contracts characterized as “modified endowment contracts.” This
characterization applies if the contract fails to satisfy the “seven-pay-test.” Under this
test, the premiums paid during the first seven years that the contract is in effect are
compared to the premiums that would be required under a hypothetical contract with
the same death benefit. In the hypothetical contract, premiums would be payable on
a level basis for only seven years. The contract is a modified endowment contract if
the premiums actually paid exceed the premiums that would be paid with respect to
the hypothetical contract.
5 The guideline premium limitation is generally determined at the time the contract is issued
and is computed under the provisions of IRC section 7702(c), including the specified IRS
regulations of reasonable mortality charges.

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If a contract is characterized as a modified endowment contract, withdrawals of
cash from the contract are not taxed in the manner discussed above. Rather, the
distributions are taxed under IRC section 72(e) in the same manner as distributions
from a deferred annuity contract. Consequently:
! The “stacking rule” applicable to distributions is reversed: amounts
withdrawn from a modified endowment contract are first
characterized as income, rather than as a nontaxable return of the
taxpayer’s investment in the contract.
! A policy loan is treated as a taxable distribution rather than as a
nontaxable loan.
! The portion of any distribution included in income is subject to an
additional 10% tax.
General Tax Policy Issues
Exclusion of the Death Benefit From Income Taxation
The death benefits paid following the death of an insured have been excluded
from taxation since the enactment of the income tax in 1913. Economically, the
death benefit is attributable to the following three sources:
! the portion of the premiums paid that exceeds charges for current
insurance protection (and other expenses) and was added to the cash
value during the insured’s life;
! the investment income credited to the cash value during the
insured’s life; and
! the term insurance protection provided under the contract at the time
of the insured’s death.
Following is an evaluation of the income tax exclusion of the death benefit,
considering each of these three sources of the death benefit.
To the extent that the death benefit is attributable to the premiums paid during
the insured’s life, the death benefit represents a transfer of property that takes effect
upon the insured’s death. Consequently, this portion of the death benefit is quite
similar to property passing to the beneficiaries of a deceased individual’s will. Under
the Internal Revenue Code, property received as bequests is not subject to the income
tax.
In terms of the investment income credited to the cash value during the insured’s
life, the tax-free treatment to beneficiaries has some similarities with the transfer of
other assets. If the life insurance contract is surrendered prior to death, amounts in
excess of the premiums paid for the insurance are included in gross income. If the
contract is held until the death of the insured, the investment build-up is not included
in gross income for the beneficiary. Consistent with this treatment, under current law
through 2009, the basis for an asset’s value transferred to a beneficiary is the asset’s

CRS-13
fair market value at the time of death, not the value at the time the asset was
acquired.6
The portion of the death benefit attributable to the term insurance protection
provided at the time of the insured’s death represents an accretion to wealth. The
Internal Revenue Code treats similar types of income in a somewhat inconsistent
manner. For instance, amounts that an individual receives under an accident or
health insurance policy purchased by the insured is excluded from income. One
rationale for this result is that, in aggregate, no income is generated with respect to
term insurance. The economic gain that the beneficiaries of life or health insurance
realize is offset by the economic loss incurred by policy owners who purchase
insurance and receive nothing. As an example to the contrary, gambling winnings
are treated as income for purposes of the income tax despite that fact that, in
aggregate, gambling winnings are offset by gambling losses. On the individual level,
however, a taxpayer is allowed to subtract any wagering losses from any gains to
determine her tax liability.
Two additional universal justifications for excluding the death benefit may be
historic. One plausible rationale might have been that it was undesirable to impose
a tax on widows and orphans who received life insurance proceeds, which were often
modest in magnitude and represented the principal financial asset available to the
insured’s survivors. Another possible rationale might originate from the view that
the accumulation of wealth and its passage to heirs is viewed by some as a benefit to
society.
Taxation of Investment Earnings Credited to Cash Value Life
Insurance
The tax treatment of investments made in the form of cash value life insurance
stands in contrast to the treatment of some other financial investments. The interest
(or other investment income) credited to life insurance contracts is not taxed until
(and unless) cash or other property is distributed to the policy owner prior to the
death of the insured. Current interest income, however, generally is included in
income for taxation purposes presently. Although Congress has enacted tax-
preferred savings vehicles, such as qualified pension plans, 401 (k) plans, IRAs, and
section 529 plans to encourage savings to pay for retirement and college tuition, as
discussed below these arrangements are subject to numerous requirements and
limitations. Consequently, some question the justification for treating interest
credited under a life insurance contract differently from both taxable and tax-
preferred forms of income from savings.
Alternatively, investment gains from other forms of appreciating assets are not
taxed until those gains are realized. Examples of this tax treatment include capital
6 This “step-up” basis for inherited assets will be replaced with a modified carryover basis
in 2010 as a result of the repeal of the estate tax included in P.L. 107-16, EGTRRA. For
more information on the taxation of estates, see CRS Report RL31061, Estate and Gift Tax
Law: Changes Under the Economic Growth and Tax Relief Reconciliation Act of 2001, by
(name redacted).

CRS-14
gains from the investment in equities or real property. Further, even at the time these
investment gains are realized, they are subject to lower tax rates than other forms of
income.
The nontaxable status of the investment earnings, or “inside build-up” dates
back to 1913. Although this provision was not explicitly included in law, floor
discussions of the bill made it clear that the investment earnings were not taxable.7
Supporters of the current income tax treatment of investment income credited
to life insurance contracts have advanced several rationales. The first two focus on
the fundamental tax policy issue: whether the current exclusion of this investment
income is justified. The third considers a subsidiary tax policy issue: the limits on
investment oriented uses of life insurance contained in IRC sections 7702 and
7702A.
Treatment of Life Insurance Compared to Other Tax-Preferred
Forms of Savings. The broadest exceptions to the general tax treatment of
interest income involve interest income credited to qualified pension plans (including
401k plans), individual retirement accounts (IRAs), deferred annuities and section
529 educational savings plans.8 Some who endorse the preferential tax treatment of
investment income generated in cash value life insurance assert that this income
should be taxed in the same manner as these other tax-preferred savings vehicles.
There are significant differences, however, between investments made using
cash value life insurance and the other tax-preferred forms of investment. First, the
favorable tax rules applicable to other savings vehicles were enacted to encourage
individuals to save to meet specific financial goals. For example, the tax rules
governing qualified pension plans and IRAs are designed to encourage savings to
meet the needs of individuals during their retirement years. Similarly, the section
529 plans encourage individuals to save in order to pay for their children’s higher
education expenses. In both of these arrangements, laws limit the dollar amounts that
can be invested to meet these needs.
Unlike these identified investment vehicles, individuals invest in cash value life
insurance for many different purposes. For example, many individuals purchase cash
value life insurance to provide a replacement for the insured’s wage income to
support the insured’s spouse and young children in the event of the insured’s death.
Others purchase cash value life insurance as a means of transferring assets out of
their estates to reduce estate tax liability. Similarly, corporations purchase cash value
life insurance to generate funds to protect against the financial loss associated with
7 U.S. Senate, Committee on the Budget, United States Senate, Tax Expenditures:
Compendium of Background Material on Individual Provisions, 107th Cong., 2nd Sess.
(Washington: Dec. 2002).
8 Interest income paid with respect to state and local bonds is exempt from federal income
taxation. This exemption is designed to reduce the borrowing cost of the bond issuers rather
than benefit the investors who purchase the bonds. For this reason, it may not be
comparable to the tax provisions that primarily benefit investors.

CRS-15
the loss of key workers, to pay for business expenses, or to provide compensation
packages for executives.
Term insurance, on the other hand, offers no tax benefits. Although providing
tax preferences to life insurance products may encourage parents to purchase life
insurance protection for their dependents or companies to effectively plan for future
liabilities, the existing tax incentives may not always achieve these results. If this
individual replaces a term life insurance contract with cash value life insurance, the
individual may obtain less insurance protection. The premium charged for a level-
premium cash value life insurance contract is generally much larger than the initial
premium for a term contract with an identical death benefit. Unless the individual
increases the amount spent for life insurance, the amount of insurance protection will
decline. Thus, in terms of tax incentives, current law may encourage some families
to reduce, rather than increase, the financial protection of their dependent children.
Further, the largest tax benefits are available to taxpayers who can afford to purchase
the more investment-oriented cash value life insurance contracts, although they
arguably may have less need for life insurance protection. This, of course, is true for
many other tax-preferred forms of investment.
Some argue that cash value life insurance is used to generate funds that serve
as a source of retirement income for the policy owner. The perceived need to
encourage savings for retirement also underlies the preferential tax treatment of
qualified pension plans. However, if an individual covered by a qualified pension
plan seeks to save additional amounts for retirement, these benefits are subject to
very strict limitations.9 To the extent that the current tax treatment of cash value life
insurance is viewed as a source for, and is integrated with, post-retirement savings,
critics might argue the premiums payable should be subject to limitations comparable
to, and integrated with, those imposed on individual retirement accounts.10

Taxation of Interest Credited Under a Life Insurance Contract: A
Tax on Unrealized Appreciation? Supporters of the current tax treatment of
cash value life insurance argue that the increase in the cash value represents
unrealized appreciation and the interest credited should not be subject to tax until the
gain is realized. Unrealized appreciation generally represents changes in the value
of an asset caused by market forces. In an economic sense, appreciation in an asset’s
value constitutes income whether or not the asset is sold. Under the current income
tax, however, changes in the market value of assets are not taxed until “realized”
through a sale or other taxable disposition. For example, an investor owning real
estate or stock is not taxed on any appreciation in value of these assets until the gain
is “realized.”
9 Beginning in 2002, the maximum annual benefit under a qualified pension plan was
$160,000, indexed to inflation, and the annual compensation that can be considered under
such a plan was $200,000, also indexed to inflation.
10 Notwithstanding certain catch-up provisions, the maximum annual contribution to an
individual retirement account (IRA) for 2003 is $3,000. For more information on the
monetary limits associated with retirement plans, including both defined contribution and
defined benefit plans, see CRS Report RS20629, Pension Reform: The Economic Growth
and Tax Relief Reonciliation Act of 2001, by (name redacted).

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Amounts that represent compensation paid for the use of an asset (such as
interest) are generally taxed when credited to the taxpayer’s account. An individual
who invests in a certificate of deposit is taxed when interest is credited
notwithstanding the fact that the interest may remain on deposit with the bank. In
other situations, property owners are taxed on investment income that is not received.
Partners in a partnership and shareholders of S corporations are taxed currently on
their shares of income earned and retained by the business entity. Similarly, interest
accruing on debt instruments having original issue discount is included in income
despite the absence of a sale of the instrument.
The cash value of a life insurance contract is a financial asset. The owner of the
contract receives compensation for the life insurance company’s use of the policy’s
cash value when the company credits interest to the cash value. As presented above,
the lack of actual receipt of the interest may or may not justify postponement of the
interest credited to cash value of life insurance contracts. Congress has deemed that
the interest income should not be considered the policyholder’s income since the
owner would have to forgo insurance protection to obtain the interest.
Current Limits on the Use of Life Insurance as an Investment
Vehicle. Supporters of the status quo with regard to the taxation of cash value life
insurance state that Congress dealt with inappropriate uses of life insurance when it
enacted IRC sections 7702 and 7702A. As discussed below, these two statutory
provisions create actuarial limitations on the use of cash value life insurance. In
general, these provisions compare the amount of term life insurance protection to the
investment components of a life insurance contract. If, in relative terms, the term life
insurance protection is too small, these provisions limit, or eliminate, the tax
preference. Critics argue that unlike the limitations applicable to IRAs and pension
plans, however, IRC sections 7702 and 7702A do not limit the amounts that can be
invested in cash value life insurance. Nor, say opponents, do these provisions limit
the uses to which the investment returns can be expended, unlike the limitations
applicable to section 529 plans.
The following discussion of IRC sections 7702 and 7702A evaluates the
limitations currently imposed by Congress.
The Section 7702 Limitations. Congress enacted IRC sections 7702 and
7702A in response to the marketing of life insurance contracts that provided minimal
amounts of current insurance protection. IRC section 7702's definition of life
insurance was designed to deny life insurance status to overly investment-oriented
products without altering the preferential tax treatment for traditional uses of cash
value life insurance. To achieve this result, IRC section 7702 uses the single
premium contract design as the maximum limit of investment orientation.
Life insurance performs a unique risk shifting function: most directly, it can
provide resources to replace the insured’s income following the death of the insured.
Parents of dependent children are often concerned that the death of one or both
parents would leave their children without adequate means of support. Many argue
that society should encourage parents to provide the resources to take care of their
dependent children in the event of their death.

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Given this specific rationale for favorable tax treatment, these limitations seem
appropriate if the tax revenue forgone generates an adequate amount of pure
insurance protection. From this perspective, the tax revenue that the Treasury
forgoes (as a result of not taxing the interest income credited) should not exceed the
cost of current insurance protection provided. Otherwise, it arguably would be
cheaper for the government to provide the insurance without charge to families with
young dependent children.
Consider the $100,000 single-premium life insurance contract discussed above.
The single premium for this contract is $25,000. As explained previously, during the
first year that the contract is in effect, the life insurance company credits interest of
$994 and the charge for pure insurance protection totals $150. For many subsequent
years, the interest credited will greatly exceed the charges imposed for current
insurance protection. For a number of years, the tax revenue forgone due not taxing
the interest credited under a single premium policy exceeds the cost that the
government would incur if it purchased the insurance protection and provided it to
the policy owner without charge.
This suggests that IRC section 7702 treats arrangements that generate a
substantial amount of investment income relative to the insurance protection obtained
as life insurance. This illustration may raise questions about limitations contained
in IRC section 7702 and suggest a broader analysis of the benefits and costs of
providing life insurance protection would be useful.
The IRC section 7702A Limitations — Modified Endowment
Contracts. As discussed previously, IRC section 7702A characterizes life
insurance contracts as modified endowment contracts if the premiums paid exceed
the premiums that would have been paid under a hypothetical “seven premium”
contract. The tax treatment of distributions from modified endowment contracts
differs from the treatment of distributions from other life insurance contracts.
Specifically, (1) amounts withdrawn from a modified endowment contract are first
characterized as income rather than as a nontaxable return of the taxpayer’s
investment, (2) policy loans are treated as taxable distributions rather than as
nontaxable loans, and (3) the amount included in income is subject to an additional
10% tax.
In effect, distributions from modified endowment contracts are treated
identically to distributions from other tax-preferred savings vehicles, such as IRAs
and annuities. The distribution rules are also similar to the rules applicable to pre-
retirement distributions from qualified pension plans.11 When a taxpayer withdraws
money from these tax-preferred savings vehicles prior to retirement, some argue it
demonstrates that the policy justification for the preferential tax treatment no longer
exists. To the extent that the distributions represent previously untaxed income,
Congress has decided to require immediate taxation. In addition, it imposed the 10%
11 A portion of a pre-retirement distribution from a qualified pension plan is included in
income and is subject to the 10% additional tax. In general, loans from qualified pension
plans are also included in income when received. IRC section 72(p)(2), however, treats
certain loans totaling not more than $50,000 as nontaxable loans.

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additional tax to eliminate the unjustified deferral benefit that the taxpayer obtained
from not paying tax on the investment income during the years in which income was
earned. Similar rules apply to distributions from Section 529 plans to the extent that
the distributions are not used to pay for “qualified higher education expenses.”
In conclusion, under IRC section 7702A distributions from contracts that are
classified as modified endowment contracts are taxed in the same manner as
distributions from other tax-preferred forms of savings, such as pension plans, IRAs,
annuities, and Section 529 plans. Distributions from life insurance contracts that are
not characterized as modified endowment contracts are taxed more favorably.
Corporate-Owned Life Insurance12
(“Janitors Insurance”)
Corporate-owned life insurance (COLI) is an arrangement in which a business
purchases life insurance contracts on the life of one or more of its employees.
Traditionally, life insurance utilized as part of a COLI arrangement was purchased
on the life of the business’ top executives and owners. Also known as “key person”
insurance, these life insurance arrangements generally insured the life of a small
number of employees.
In recent years, however, large corporations have purchased life insurance
contracts that insure the lives of large numbers of their employees. Reports in the
Wall Street Journal and other newspapers referred to these arrangements as “janitors
insurance.” According to these reports, some employees were not notified that their
employer had purchased life insurance on their lives.13 When the insured employees
died, the employers did not pay the proceeds from the life insurance to the
employees’ surviving family members or other designated beneficiaries. Rather,
consistent with the typical COLI arrangement, the employer is the beneficiary of the
contract. Consequently, the employers receive the proceeds of the policies for their
use. It is frequently claimed that the employers use the life insurance proceeds to pay
for employee benefits, including health insurance for retired employees of the
company.14
12 For additional background information on COLI policies and a broader discussion of
related state and federal legislative activity, see CRS Report RS21304, COLI: Corporate
Owned Life Insurance, by S. Roy Woodall, Jr. For further discussion of the taxation of
COLI, see CRS Report RS21498, Corporate-Owned Life Insurance: Tax Issues, by Don C.
Richards.
13 Two examples of such articles include: Ellen E. Schultz and Theo Francis, “Valued
Employees: Worker Dies, Firm Profits — Why? — Many Companies Insure Staff, Yeilding
Benefits on Taxes, Bottom Line — Where to Put Dead Peasants,” The Wall Street Journal,
April 19, 2002, Sec. A, p.1 and Kim Clark, “Better off Dead?,” U.S. News & World Report,
May 6, 2002, p. 32.
14 See C. David Buckalew and Don R. Teasley, “Financing Employee Coverages Can Spur
Big Dividends,” Risk Management, December 1990, pp. 36-40, and Bryn Mawr, John T.
Adney, Kirk Van Brunt, and Bryan W. Keene, “COLI Reconsidered,” Journal of Financial
Service Professionals, vol. 56, Nov. 2002, p. 41-58.

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Two distinct tax policy issues arise in connection with COLI arrangements.
Under current law, the investment income that a corporation earns in connection with
a COLI arrangement is not taxed if it is paid to the employer on account of the death
of the insured. The first tax policy question is whether it is appropriate that a
corporation can benefit from these arrangements. One of the main justifications for
the exclusion of investment income from taxation is to provide the insured’s family
with life insurance proceeds to replace the income that the insured would have earned
if she had survived. Some would argue, therefore, that the life insurance proceeds
that a corporation receives should be free of tax only if the employer distributes the
proceeds to the employee’s family or other designated beneficiary. Others would
point out that corporations have been allowed to shelter income in insurance policies
for years.
In many circumstances, however, corporations purchase life insurance to obtain
a tax-free investment return. Rather than making the proceeds available to the
employee’s family to replace the employee’s income, the corporations use the
proceeds to meet their general business needs (including the payment of benefits to
other employees).15 In these circumstances, the policy justification for exempting the
life insurance proceeds from taxation is unclear.
The second, and distinct, tax policy issue arises in connection with what has
been termed “leveraged” COLI arrangements. In a leveraged COLI arrangement, the
corporate owner of the life insurance contract borrows to pay a substantial portion of
the insurance premiums. This is a form of “tax arbitrage” in which a taxpayer incurs
tax deductible interest while earning tax-free investment returns. The combined
effect of this arrangement is similar to many other corporate tax shelters: the tax
savings may exceed the costs incurred in paying for the life insurance.
The economics of a “leveraged” COLI arrangement can be illustrated by
examining the facts of Winn-Dixie Stores, Inc. v. Commissioner, 113 T.C. 254 (1999)
aff’d 254 F.3d 1313 (11th Cir. 2001). In this case, it was projected that the taxpayer
would purchase life insurance on the lives of 38,000 of its employees. In the first
year of this arrangement, it was projected that the taxpayer would pay aggregate
premiums of $114 million. The cash values for the life insurance policies would total
approximately $120 million at the end of the first year. The taxpayer would take out
loans from the policies in the aggregate amount of almost $108 million, and the
taxpayer would pay interest of approximately $12 million on these loans. After
taking into account the projected net $2 million payable to the company as a result
of deaths of its employees, the taxpayer was projected to incur a pretax loss of more
than $4 million.
After taking into account the purported tax benefits arising from these
transactions, however, the taxpayer was projected to realize a slight after-tax profit.
15 Recently, The Wall Street Journal reported that large corporations are purchasing cash
value life insurance contracts with the intent of donating the proceeds of the contracts to
charity. It is claimed that the tax benefits are sufficient to generate the contributions to
charity at no net cost to the corporations. T. Francis and E. Schultz, “Dying to Donate:
Charities Invest in Death Benefits,” The Wall Street Journal, Feb. 6, 2003.

CRS-20
The difference between the pretax loss and the after tax profit was attributable to the
following two factors: (1) the tax savings arising from the deduction of the interest
and fees; and (2) the nontaxable nature of the loan proceeds and the death benefits.
In subsequent years, the taxpayer was projected to realize much larger pretax losses
and after-tax profits. During the period from 1993-2052, it was projected that the
taxpayer would realize after-tax earnings in excess of $2.2 billion, while incurring
pretax losses aggregating more than $750 million.
The Tax Court concluded that this arrangement was a sham transaction. Under
the sham transaction doctrine, tax benefits are disallowed if the transaction lacks
economic effects or substance other than the generation of tax benefits. As a
consequence, the court determined that the taxpayer was not entitled to the claimed
tax benefits.
The life insurance industry asserts that any unjustified tax benefits arising from
the use of corporate-owned life insurance were fully addressed in legislative changes
enacted in 1996 and 1997. These changes limited the interest deduction allowed in
connection with certain COLI arrangements.
First, IRC section 264(e) establishes limits on the amount of deductible interest
paid “with respect to” life insurance contracts insuring the lives of corporate
employees. This provision limits the deductible interest in an indirect manner-it
specifies that deductions are allowed only on interest paid on a limited amount of
indebtedness incurred “with respect to” life insurance contracts. Specifically:
! the maximum amount of indebtedness that may give rise to
deductible interest is limited to $50,000 per insured “key person”
and
! at most, 20 insured individuals are characterized as key persons.
Under this provision, at most $1,000,000 of indebtedness could give rise to
deductible interest payments. This limitation would eliminate most of the tax
benefits claimed in connection with transactions structured in the same manner as the
transaction in the Winn-Dixie Stores case discussed above. Specifically, this
provision limits tax benefits arising under those COLI arrangements in which the
corporate owner of the life insurance contracts uses the contracts as security for the
loans. This limitation, however, appears limited to interest arising under life
insurance policy loans. If a taxpayer borrows from other unrelated sources, it is
possible that this limitation would not apply.
In 1997, Congress expanded the limitations contained in IRC section 264(e).
The popular press reported that the Federal National Mortgage Association (“Fannie
Mae”) planned to enter into a COLI arrangement covering the lives of the individuals
who had borrowed money to purchase homes. To address this situation, Congress
enacted IRC section 264(f). This provision disallows a portion of a corporation’s
interest deduction. The magnitude of the disallowance depends upon the aggregate
cash value of the corporation’s life insurance contracts and the aggregate adjusted
basis of its other assets. For example, consider a bank that owns life insurance
contracts with an aggregate cash value of $1 billion and assets with an aggregate

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basis of $10 billion. The unborrowed cash value represents 10% of the bank’s assets.
Consequently, IRC section 264(f) disallows 10% of the bank’s interest expense.
It is likely that this provision achieves its goal — to eliminate the tax benefits
of bank-owned life insurance (BOLI) arrangements in which financial institutions
purchase life insurance contracts on the lives of individuals who borrow from the
bank. By its terms, however, this interest disallowance provision does not apply to
COLI arrangements that involve individual life insurance contracts on the lives of a
corporation’s officers, directors, employees and certain shareholders. Consequently,
unless the interest is treated as incurred with respect to life insurance contracts, a
corporation would not lose its interest deduction when it continues to borrow funds
(other than policy loans) at the same time that it pays the life insurance premiums on
the lives of its employees.
In the 108th Congress, there have been a number of attempts to impose
restrictions on corporate-owned life insurance or remove tax advantages.
Representative Gene Green introduced H.R. 414, Life Insurance Employee
Notification Act, which would require that employers who purchase corporate-owned
life insurance notify the covered employee of the policy. Representative Rahm
Emanuel introduced H.R. 2127, which would repeal the tax-free treatment of death
benefits for certain COLI policies as well as require disclosure to and provide
objection rights for employees upon whom insurance contracts are purchased. In the
Senate, Senator John Edwards offered an amendment to the Jobs and Growth Tax
Relief Reconciliation Act of 2003 (JGTRRA; P.L. 108-27) that would have similarly
eliminated the exclusions of death benefits from income tax for many COLI policies.
The amendment was ruled not germane pursuant to the Congressional Budget Act of
1974.16
16 Rollcall Vote No. 175 Leg. to amendment numbered 662, Congressional Record, May 15,
2003, p. S6441.

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Split Dollar Life Insurance — Compensatory
Arrangements for Corporate Executives
and Other Tax Planning Goals
Introduction: The Structure of Split Dollar Arrangements
Recently, “split dollar life insurance” has received a great deal of attention.
Corporations and highly compensated executives have utilized this arrangement as
a form of non-qualified deferred compensation.17 According to the press, the cash
value on a split dollar life insurance arrangement for one corporate executive will
total $18 million, while another corporation reportedly paid $3 million per year on
premiums under a split dollar arrangement.18 Parents (or grandparents) have used
split dollar life insurance to transfer wealth to their children (or grandchilren). The
press has reported arrangements in which wealthy individuals have utilized split
dollar life insurance to transfer wealth to their children and grandchildren while
purporting to avoid both the gift tax and the estate tax.19
“Split dollar life insurance” is not a special type of life insurance contract.
Rather, it describes an arrangement in which several parties “split” the beneficial
interest in the economic rights arising under a cash value life insurance contract.
When an employer uses split dollar life insurance as a form of compensation, it will
pay most or all of the premiums. In addition, the employer is entitled to receive a
portion of the death benefit paid following the death of the insured.
In a “traditional” split dollar arrangement, the employer is not obligated to pay
the entire premium. Rather, its obligation is limited to the anticipated increase in the
life insurance contract’s cash value. The employee is obligated to pay the remaining
portion of the premium. Under the economics of a typical cash value life insurance
contract used in split dollar arrangements, the employee’s share of the premiums
declines rapidly and frequently disappears within a few years. In this traditional
arrangement, the employer is entitled to receive the greater of: (1) the cash value of
the contract; or (2) the aggregate amount of premiums that it paid. The remainder of
the death benefit is paid to the beneficiary that the executive designates. In effect the
employee enjoys the benefit of term insurance protection for the remainder of his life.
17 The term “nonqualified deferred compensation” refers to a wide variety of compensation
arrangements between employers and employees. Typically, an employer transfers money
(or other property) to a third party, and the employee will become entitled to receive the
money (or property) years later. Most often, these arrangements benefit senior executives
and other highly compensated employees. There are two essential characteristics of
nonqualified deferred compensation. First, these arrangements do not satisfy the
requirements of “qualified” retirement plans (such as pension plans, 401(k) salary reduction
plans, 403(b) plans for employees of nonprofit organizations or Individual Retirement
Accounts). Second, taxation of the employees is deferred until some future year.
18 Tracie Rozhon and Joseph B. Treaster, “Insurance Plans of Top Executives May Violate
Law,” New York Times, Aug. 29, 2002, p. A-1.
19 David Cay Johnson, “I.R.S. Loophole Allows Wealthy to Avoid Taxes,” New York Times,
July 28, 2002.

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For example, the annual premium on a policy with a death benefit of $1 million
may be $20,000 per year. If the executive dies during the 10th year in which the
policy is in effect, the employer would receive $200,000 and the executive’s
beneficiary would receive the remaining portion of the death benefit — $800,000.
The employer receives no payment (such as interest) to compensate it for the
premium payments.
The economic rights and obligations in a split dollar arrangement are
incorporated into an agreement between the parties. The agreement will specify
which party is designated as the legal owner of the life insurance contract. If the
agreement designates the employer as the owner of the life insurance contract, the life
insurance contract will contain a provision called an “endorsement” which specifies
the rights of the employee to proceeds from the contract. This type of split dollar
arrangement is called an “endorsement method” arrangement.
Alternatively, the parties may agree that the employee will own the life
insurance contract. In this case, the life insurance contract is used as collateral for
the employer’s right to receive an amount equal to the aggregate amount of premiums
paid. This type of split dollar arrangement is called a “collateral assignment”
arrangement.
Under many of the contemporary (or “equity”) split dollar arrangements,
employers (or wealthy older relatives) pay all of the premiums and the executives (or
younger relatives) become entitled to a substantial portion of the contracts’ cash
values. In cases reported in the press, certain executives become entitled to millions
of dollars of cash value. Because the executives’ rights with respect to the cash
values are attributable exclusively to premium payments made by their employers,
the arrangements have the same effect as other deferred compensation arrangements.
Similarly, under split dollar arrangements utilized by families, younger relatives
become entitled to millions of dollars of cash value that is attributable to premiums
that their wealthier relatives paid. Consequently, these arrangements produce the
same economic results as inter-vivos gifts.
The remainder of this report discusses the tax treatment of split dollar
arrangements. First, the tax treatment of the “classic” or “traditional” split dollar
arrangement is summarized. Second, the developments that led the Internal Revenue
Service (and the Department of the Treasury) to reconsider the early analysis is
reviewed. Third, recent Internal Revenue Service (IRS) guidance on the taxation of
these arrangements is discussed.
The Tax Treatment of Split Dollar Arrangements
Early IRS Analysis of Traditional or Classic Arrangements. The
Internal Revenue Service published revenue rulings that, for many years, governed
the tax treatment of split dollar arrangements. Initially, the IRS characterized the
employer’s premium payments as interest free loans from the employer to the
employee. At that time, an interest-free loan from an employer to an employee did
not create any taxable compensation.

CRS-24
In 1964, the Service revoked this interpretation and issued Revenue Ruling 64-
328, which governed the treatment of split dollar arrangements for the next three
decades. In this ruling, the Service reasoned that:
! the employer provided the funds needed to generate the cash value
of the life insurance contract;
! in an arm’s length arrangement, the employer would enjoy the
benefit of the earnings on the cash value;
! the investment earnings that the cash value generates are applied to
provide current life insurance protection without cost to the
employee.
The net effect of this arrangement was that the investment earnings (or a portion
of the employer’s premium payment) was used to provide term life insurance
protection for the employee. The IRS concluded that the use of the employer’s
investment income (or premium payments) to provide the insurance protection
created additional compensation each year. The amount of income equals the value
of the current life insurance protection provided under the split dollar arrangement
during the year (reduced by any amount that the employee paid for this insurance).
In addition, the Service stated that taxpayers could use the insurance rates set out in
a published table of term insurance rates (the “P.S. 58" rate table) to determine the
value of the life insurance protection. In a later ruling, the Service determined that
taxpayers could value the cost of current life insurance protection using the actual
cost of 1-year term life insurance charged by the issuer of the split dollar life
insurance contract if these rates were available to all “standard risks.”
Under Revenue Ruling 64 — 328, the employees received only one economic
benefit: the executives enjoyed term life insurance protection without paying the full
cost of this protection. Also under the same ruling, the executives had to treat the
value of this benefit as additional taxable compensation. Moreover, the methods
used to value this benefit incorporated an objective methodology that, in most
instances, reached reasonable results.
Concerns Leading to Reconsideration. In 2001 and 2002, the
Department of the Treasury and the IRS reconsidered the tax treatment of split dollar
life insurance arrangements to reflect at least four significant developments that
either occurred or became more significant in the years subsequent to the issuance
of the original revenue rulings.
Development of Equity Split Dollar Arrangements. The first, and most
significant, development was that split dollar arrangements were marketed
incorporating significantly different economic terms. Unlike the traditional split
dollar arrangement, in which an employee enjoys only the benefit of current term life
insurance protection, an “equity” split dollar arrangement generates additional
economic benefits for the employee. Specifically, under an “equity” split dollar
arrangement, the cash value of the life insurance contract is also split between the
employer and the employee. When the arrangement terminates (either on account of
the death of the employee or by agreement), the employer receives an amount equal
to the aggregate amount of premiums that it has paid. When the life insurance
contract’s cash value exceeds the aggregate premiums paid, this “equity” in the

CRS-25
contract belongs to the employee. This equity represents a vested economic benefit
accruing to the employee which was generated by the employer’s premium payments.

The following example illustrates the economic benefits arising from an equity
split dollar arrangement. Corporation A and its chief executive officer, P, enter into
the following agreement:
! P will own the life insurance contract with a death benefit of $1
million.
! Each year, Corporation A will pay a premium of $20,000; Executive
P does not make any premium payment.
! Upon the death of Executive P, Corporation A is entitled to receive
the cumulative amount of premiums that it paid with respect to this
contract.
! Executive P (or the beneficiary that Executive P designates) receives
the remainder of the $1 million death benefit.
! If the life insurance contract terminates or is transferred to Executive
P, Corporation A is also entitled to receive the aggregate amount of
premiums that it paid with respect to this contract. Executive P
keeps the remaining cash value if the contract is terminated.

As with the other types of split dollar life insurance arrangements, Executive P
receives the benefit of the current life insurance protection, and the value of this
protection is included in P’s income for tax purposes. In addition, to the extent that
the life insurance contract’s cash value exceeds the cumulative premiums paid,
Executive P enjoys an additional economic benefit. To illustrate, assume that the
cash value of the contract at the end of the first year equals $21,000. Because
Corporation A is entitled to receive the $20,000 that it paid as the premium,
Executive P has vested ownership rights with respect to the remaining $1,000 of cash
value. Assume further that the cash value equals $45,000 at the end of the second
year. Again Corporation A is entitled to receive the $40,000 that it paid as premiums
during the two years that the contract is in effect. Consequently, Executive P’s has
vested ownership rights with respect to $5,000 of the cash value.
Enactment of IRC sections 83 and 7872 and Their Application to
Equity Split Dollar Arrangements. Subsequent to the issuance of Revenue
Ruling 64-328, Congress enacted IRC sections 83 and 7872. These provisions
establish statutory rules that apply to deferred compensation arrangements and
interest-free loans. As discussed below, application of these statutory provisions
result in an employee having more income arising from her interest in an equity split
dollar arrangement than under a traditional split dollar arrangement.
IRC Section 83 applies when cash or property is transferred by an employer in
connection with the performance of services by an employee. The property need not
be transferred to the employee; if it is transferred to a third party, the employee has
income in an amount equal to:
! the fair market value of the such property; minus
! the amount (if any) that the employee pays for such property.

CRS-26
Under IRC section 83, the employee has income when, and only to the extent, that
the employee acquires nonforfeitable rights to the property.
IRC Section 83 applies in a different manner to traditional and equity split dollar
arrangements. The only nonforfeitable right that an employee acquires in a
traditional split dollar arrangement is the right to term insurance protection.
Consequently, under IRC section 83 an employee would be required to include in
income the fair market value of this protection. This is also the tax treatment that
Revenue Ruling 64-328 mandates. In an equity split dollar arrangement, however,
the employee also acquires a nonforfeitable right to an increased portion of the life
insurance contract’s cash value. Under section 83, the employee could be required
to include both the value of the term insurance protection and the increase in the
employee’s share of the cash value.
Congress enacted comprehensive statutory rules governing the federal income
tax consequences resulting from the creation of interest-free loans when it enacted
IRC section 7872 in 1984. Prior to the enactment of IRC section 7872, taxpayers
utilized interest-free loans to transfer economic benefits to employees or family
members while avoiding income and transfer taxes. Under IRC section 7872, a
taxpayer who lends money on an interest-free basis may be treated as having paid
compensation or having made a gift. The following two examples illustrate how IRC
section 7872 operates:
! Example 1: Corporation lends $1 million to an executive which is
repayable in 10 years. Assume further that the present value of the
amount that the executive must repay equals $600,000 if no interest
is payable on this loan. Under IRC section 7872, the executive is
treated as having $400,000 of compensation when this interest free
loan is created.
! Example 2: Corporation lends $2 million to an executive that is
repayable whenever Corporation requests repayment (i.e., the loan
is repayable “on demand”). Assume further that no interest is
payable on this loan. Under IRC section 7872, the executive is
treated as having income from compensation each year. The amount
of income equals the amount of forgone interest on this loan, which
in this case would equal the outstanding balance on the loan ($2
million) multiplied by the “applicable federal rate.”
For IRC section 7872 to apply to split dollar arrangements, there has to be a loan
and forgone interest. In certain split dollar arrangements, (1) the employee is treated
as the owner of the life insurance contract, (2) the employer pays the premiums, and
(3) under the terms of the arrangement, the total amount of premiums paid must be
repaid to the employer. One characterization of the arrangement that comports with
the economic terms is that the employer’s payment of each premium constitutes a
loan to the employee. Under IRC section 7872, the “forgone interest” would be
taxed as compensation paid to the employee. In the traditional split dollar
arrangement, the employer is entitled to all increases in the life insurance contract’s
cash value. A portion of the interest that the cash value generates is credited to, and

CRS-27
increases, the life insurance contract’s cash value. The remainder of the interest
earned is used to pay for the cost of term insurance protection.
The portion of the interest that increases the cash value accrues to the benefit of
the employer/lender. Consequently, IRC section 7872 would not treat this portion
as forgone interest. The remaining interest (i.e., that portion that is used to pay for
the cost of current insurance protection) would be characterized as forgone interest
for purposes of IRC section 7872, and therefore treated as taxable compensation. As
is evident, the amount of income generated under Revenue Ruling 64-328 and IRC
section 7872 is approximately equal: in both cases, the amount of compensation
approximates the cost of the annual term life insurance protection.
Once again, different tax consequences result when equity split dollar
arrangements are analyzed. In an equity split dollar arrangement, the employer is not
entitled to receive the entire cash value; rather it has the right to receive a lesser
amount — the aggregate amount of premiums that it paid with respect to the contract.
In this case, all of the interest credited to the cash value accrues to the benefit of the
employee. Under IRC section 7872 this larger amount of interest is characterized as
forgone interest. As a result, the employee realizes more income than is generated
under Revenue Ruling 64-328.
In sum, in equity split dollar arrangements under Revenue Ruling 64-328,
employees have economic income arising from their employment relationship that
avoids tax. If section 83 and section 7872 properly apply to these newer
arrangements, then the employee would have additional taxable income.
Use of Improper Valuation Methods. Two concerns with the methodology
used to value current insurance protection also led the IRS to reconsider the tax
treatment of split dollar arrangements. First, taxpayers could value life insurance
protection using the actual cost of one-year term life insurance charged by the issuer
of the life insurance contract if these rates were available to all applicants for life
insurance who qualified as “standard risks.” In recent years, the IRS learned that
some life insurance companies claimed that low term insurance rates were available
when, in fact, these rates were not available to all standard risks.20 Consequently,
some taxpayers may have understated the value of the current insurance protection
provided to employees under split dollar arrangements.
Second, the mortality tables, upon which the term insurance charges within P.S.
58 are based, no longer relate to the present market for term insurance.21 As a result,
the term insurance charges set forth in the P.S. 58 rate table overstate the actual value
of term insurance protection for most taxpayers. Consequently, taxpayers who used
this table to value the current life insurance protection provided under a split dollar
arrangement generally included an excessive amount in income.
20 U.S. Department of the Treasury, Internal Revenue Service, Internal Revenue Bulletin,
Bulletin No. 2001-5, Jan. 29, 2001, p. 461.
21 U.S. Department of the Treasury, Internal Revenue Service, Internal Revenue Bulletin,
Bulletin No. 2001-5, Jan. 29, 2001, p. 460.

CRS-28
Further “Product” Development: “Reverse” Split Dollar
Arrangements. The fourth development results from the use of the P.S. 58 term
insurance rate table to create a problematic tax-avoidance vehicle: the so-called
“reverse” split dollar arrangement. In a reverse split dollar arrangement, the parties
reverse the traditional allocation of interests in a cash value life insurance contract.
As with a conventional split dollar arrangement, the employer pays the premium.
Unlike the conventional arrangements, the employee becomes entitled to the cash
value of the life insurance contract; the employer receives the remainder of the death
benefit. Employers computed the employee’s compensatory economic benefit in an
indirect manner: the employer compared the employer’s premium payment to the
value of current life insurance protection that it retained. In making this comparison,
taxpayers utilized the P.S. 58 rate table, thereby overstating the value of the benefits
allocable to the employer. As a result, taxpayers have claimed that the premium
payment produces little or no benefit to the employee.
The following example illustrates the claimed benefits arising from a reverse
equity split dollar arrangement. Corporation C and its chief executive officer, E,
enter into the following agreement:
! Executive E will own the life insurance contract with a death benefit
of $10 million.
! Each year, Corporation C will pay a premium of $200,000;
Executive E does not make any premium payment.
! If the life insurance contract terminates or is transferred to Executive
E (or his designate), Executive E is entitled to receive the aggregate
amount of premiums that Corporation C paid with respect to this
contract.
! Upon the death of Executive E, Executive E (or the beneficiary that
Executive E designates) is entitled to receive the cumulative amount
of premiums that the employer paid with respect to this contract.
! Corporation C receives the remainder of the $10 million death
benefit.
The actual cost of term insurance protection charged by the life insurance company
in connection with this arrangement might be $60,000. Using the rates specified in
the P.S. 58 rate table, however, the value of the term insurance protection may
exceed the $200,000 annual premium. Taxpayers claimed that Corporation C
received an economic benefit at least equal to the premium that it paid. Based on this
conclusion, taxpayers claimed that Executive E did not have any income despite the
fact that Executive E had vested rights to the cash value (plus all interest credited to
the cash value).
Taxpayers also utilized reverse split dollar arrangements as a device to transfer
wealth from parents (or grandparents) to children (or grandchildren) while purporting
to avoid estate and gift tax. The parent pays the entire premium. The child becomes
entitled to the life insurance contract’s cash value. The parent is entitled to the
remainder of the death benefit. In this transaction, the parent makes a gift to the
child. For gift tax purposes, there is no gift to the extent that the parent receives
value as a result of making the premium payment. Again, some taxpayers computed
the value of the current life insurance protection utilizing the P.S. 58 rates. Because

CRS-29
these rates overstate the fair market value of the current life insurance protection,
taxpayers have understated the magnitude of the gift.
Recent IRS Guidance on Taxation of Split Dollar Arrangements. In
2001 and 2002, the IRS issued proposed regulations and several notices that address
the tax treatment of split dollar life insurance. In these proposed regulations and
notices, the IRS addressed the developments discussed above. Under the proposed
regulations,22 the tax treatment of split dollar arrangements will depend on the
identity of the owner of the life insurance contract. If the employer is the owner of
a split dollar life insurance contract, then the employee is taxed on all of the
economic benefits provided to her under the arrangement. If, however, the employee
is the owner of the contract, the employer’s premium payments are characterized
under IRC section 7872, which governs the tax treatment of interest-free loans.23
The following examples illustrate how the proposed regulations would apply in
several basic types of split dollar arrangements. Each example discusses a split
dollar arrangement that incorporates the follow common terms:
! Corporation C and Executive E enter into an agreement that
specifies their rights with respect to a life insurance contract.
! The death benefit of the life insurance contract is $3,000,000.
! Corporation C pays the entire annual premium of $100,000;
Executive E does not make any premium payment.
! Corporation C will receive an amount equal to the total amount of
premiums paid. Thus, if Executive E dies at the end of his life
expectancy of 15 years, Corporation A will receive $1,500,000.
! If the life insurance contract terminates or is transferred to Executive
E (or his designate), Corporation C is also entitled to receive the
aggregate amount of premiums that it paid with respect to this
contract.
! The remainder of the death benefit will be paid to the beneficiaries
that Executive E designates.
Example 1 — Employee Ownership of Life Insurance Contract. In
addition to the common terms discussed above, Executive E is designated as the
owner of the life insurance contract. The proposed regulations characterize each
premium payment as an interest-free loan made from Corporation C to Executive E.
In effect, IRC section 7872 would bifurcate this $100,000 loan into two components.
First, the present value of Executive E’s obligation to repay $100,000 at the end of
the 15-year period is treated as a bona fide loan. Second, the remainder of the
$100,000 payment is treated as compensation paid by Corporation C to Executive E.
22 U.S. Department of the Treasury, Internal Revenue Service, “Split-Dollar Life Insurance
Arrangements,” Federal Register, vol. 67, no. 131, July 9, 2002, p. 45414.
23 These proposed regulations would also govern the tax consequences arising from split
dollar arrangements involving corporations (and their shareholders) and wealthy individuals
(and their relations). In these arrangements, the ownership of the life insurance contract
determines which approach to taxation will apply.

CRS-30
Assuming that the computation of present value utilizes a 6% interest rate, the
present value of Executive E’s obligation to repay the first $100,000 payment equals
$41,726. Under IRC section 7872 and the proposed regulations, Executive E is
treated as having received compensation for the remainder of the $100,000, or
$58,274.
Example 2 — Employer Ownership — Equity Arrangement. In
contrast to Example 1, Corporation C, rather than Executive E, is designated as the
owner of the life insurance contract. In formal terms, no loan has been made from
the Corporation to the Executive so that IRC section 7872 does not apply to this
arrangement. Consequently, the proposed regulations specify that Executive E has
income to the extent of the fair market value of all economic benefits provided under
the arrangement.
Under the proposed regulations, the acquisition of this equity interest arising
from Corporation C’s premium payments is characterized as a taxable economic
benefit. Consequently, the increase in Executive E’s vested right with respect to the
cash value is included in Executive E’s income for federal income tax purposes. The
proposed regulations do not specify how this vested interest should be valued. The
IRS has requested comments from the public concerning the proper valuation of this
equity interest.
Under the proposed regulations, Executive E enjoys an additional economic
benefit: the value of the current life insurance protection. In determining the value
of the current life insurance protection, Executive E may use the rates contained in
Table 2001. This table of term life insurance rates reflects the decline in term life
insurance rates that has occurred in recent decades. Alternatively, Executive E may
determine the value of the current life insurance protection using the insurer’s lower
published premium rates. To use these lower rates, however, the insurer must make
these rates known to individuals who apply for term insurance and the insurer must
sell term insurance at those rates
Example 3 — Employer Ownership — Non-Equity Arrangement. As
in Example 2, Corporation C is designated as the owner of the life insurance contract.
In addition, Corporation C’s entitlement to receive cash is not limited to the
aggregate amount of premiums paid. Rather, it is entitled to receive the entire cash
value of the contract upon the death of Executive E or upon the surrender of the life
insurance contract.
In formal terms, no loan has been made from the Corporation C to Executive E
in this arrangement, so that IRC section 7872 does not apply. Consequently,
Executive E has income to the extent of the fair market value of the economic benefit
provided to him. In this transaction, the only economic benefit provided to Executive
E is the value of the current life insurance protection. Thus, the proposed regulations
prescribe the same tax treatment as existed under the earlier IRS revenue rulings.
In determining the value of the current life insurance protection, Executive E
may use the rates contained in Table 2001. This table of term life insurance rates
reflects the decline in term life insurance rates that has occurred in recent decades.
Alternatively, Executive E may determine the value of the current life insurance

CRS-31
protection using the insurer’s lower published premium rates. To use these lower
rates, however, the insurer must make these rates known to individuals who apply for
term insurance and the insurer must sell term insurance at those rates.
Reverse Split Dollar Arrangements. The IRS has announced special
limitations to restrict the abusive use of reverse split dollar arrangement. As
discussed above, in a reverse split dollar arrangement, the employer (or a donor)
utilized P.S. 58 rates to determine the value of current life insurance protection that
it retained. Because these taxpayers overstated the value of the benefits allocable to
the employer (or a donor), they claimed that the premium payment produces little or
no benefit to the employee (or a donee). In Notice 2002-59 and in the proposed
regulations, the IRS announced that taxpayers may not use either the P.S. 58 rates or
the Table 2001 rates in a reverse split dollar arrangement to calculate the value of the
interest of an employee or a donee.

CRS-32
Additional Reading
K. Black and H. Skipper, Life and Health Insurance, 13th ed. (Prentice Hall, 2000).
L. Brody, L. Richey, W. Thater and R. Baier, “Insurance-related Compensation” Tax
Management Portfolio #386, 2nd.
G. Gallagher and C. Ratner, Federal Income Taxation of Life Insurance, 2d ed.
(American Bar Association, Real Property, Probate and Trust Law Section,
1999).
A. Pike, “Reflections on the Meaning of Life: An Analysis of Section 7702 and the
Taxation of Cash Value Life Insurance” 43 Tax Law Review 491 (1989).
S. Simmons, “Practical Guide to the Use of Split Dollar Life Insurance Plans” 47
U.S.C. Annual Institute on Federal Taxation (1995).
“Split Dollar Life Insurance Arrangements — Notice of Proposed Rulemaking” 67
Federal Register 45414 (July 9, 2002).
Related CRS Reports:
CRS Report RS21304. COLI: Corporate Owned Life Insurance, by S. Roy Woodall,
Jr.
CRS Report RS21498. Corporate-Owned Life Insurance: Tax Issues, by Don C.
Richards.
CRS Report RS20923. Taxes and the ‘Inside Build-Up’ of Life Insurance: Recent
Issues, by David L. Brumbaugh.

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