TAX RESEARCH MEMORANDUM
Category : Taxation Law
Tax Research Memorandum
A corporation obtained life insurance over the life of a company officer. The corporation paid the premiums and designated the shareholders as beneficiaries of the policy. After the death of the officer, the insurance company awarded death benefits to the shareholders. However, upon company audit by the Internal Revenue Service, the agent contended that the amount received by shareholders should be included as taxable income since they do not have insurable interest in the officer, making the insurance policy a speculative contract.
Is the payment made to the shareholders excludable as a death benefit payment from a life insurance policy for tax purposes?
The benefit derivable by shareholders to establish the existence of insurable interest determine the exclusion of payments from tax so that payment under a valid life insurance policy makes the amount received tax exempt while payment received under a speculative contract is included under taxable gross income.
Arguments and Authorities
Insurable interest exist when loss of the life of the person covered by the insurance policy results to financial and other types of losses. Insurable interest is a basic requirement for every kind of insurance so that the person or entity purchasing a life insurance policy should hold an insurable interest over the subject of the policy. In life insurance, every person has an insurable interest over one’s life together with spouses and dependents. The insurable interest is required to exist during the time of purchase of the policy.
In insurance regulation, federal law governs concerning matters related to the insurance industry peripherals such as labor, securities and tax through the Sherman Act, Clayton Act 15 U.S.C. § 12 and the Federal Trade Commission Act. State laws regulate the insurance business as provided by the McCarran-Ferguson Act 15 U.S.C § 1011. Thus insurable interest is defined by state laws with 47 states providing explicit requirements to establish insurable interest. In the state of New York § 3205(a)(1)(b) defines insurable interest
“in the case of other persons, a lawful and substantial economic interest in the continued life, health or bodily safety of the person insured, as distinguished from an interest which would arise only by, or would be enhanced in value by, the death, disablement or injury of the insured”.
Based on this definition, it is important to distinguish the benefit derivable by the policy beneficiaries, in that the interest in the continued life and health of the person should outweigh the benefits derived from the death of the person. In the given case, if the interest of the shareholders in the continued life of the company officer is greater than the benefits derivable from his death, the payment made to the shareholders upon the death of the company officer holds. Otherwise, the policy may be deemed as a speculative contract.
A secondary issue is whether companies can have an insurable interest in the lives of their employees for purposes of claiming tax exemptions. (2005) provides that the company have an insurable interest over its employees although the determination of the economic substance of a corporate-owned life insurance is a question of fact.
Title 26, Subtitle A, Chapter 1, Subchapter B, Part III § 101 of the Internal Revenue Code provides that life insurance proceeds received due to death are not included in gross income. In application, the validity of the payment received by the shareholders from a valid life insurance policy due to the existence of an insurable interest would make the payment exempt from tax while the lack of insurable interest making the policy a speculative contract would make the payment subject to tax.