Fourth Edition William Kratzke

II. Social Benefits

•“If any amount excluded from gross income ... is held under an agreement to pay interest thereon, the interest payments shall be included in gross income.” § 101(c).

•In the event that life insurance proceeds are paid otherwise than as a lump sum, a portion of each payment is allocated pro rata to the amount excluded and the remaining return on investment is subject to income tax. § 101(d)(1).

Consider: H purchased a life insurance policy on his life with a face amount of $200,000 and named W as the beneficiary. H died. W and the insurance company entered an agreement whereby the insurance company would hold $200,000 and pay her $250,000 in five years; W would have no claim of right to the funds during that time. At that time, instead of paying W $250,000, the insurance company will pay W $28,000 per year at a time when her life expectancy will be ten years.

•How would the payments to W be taxed during the first five years after H’s death, assuming W had no claim of right during that time?

•How would the payments to W during the succeeding ten years be taxed?

•See §§ 101(c and d); Reg. § 1.101-3(a); Reg. § 1.101-4(a)(1)(i); Reg. § 1.101-4(g) (Examples 1 and 3 (first two sentences only)).

•The last provision might not be in your edition of the Regulations. Go to Westlaw or Lexis to find it.

•An exception to this exception is made when the transferee takes for her basis the basis of the transferor. § 101(a)(2)(A).

•When might a transferee take for her basis the basis of the transferee?

•Another exception to the exception is made when the transfer is to the insured, a partner of the insured, a partnership in which the insured is a partner, or a corporation in which the insured is a shareholder or officer. § 101(a)(2)(B).

•How would you compute H’s gross income from this sale?

•How would you compute H’s gross income if instead H surrendered the policy to the insurance company for its cash value of $100,000?

•Are there additional facts that you would need to know?

•Thus, annuity treatment can only apply to payments made under the named type of contracts.

•A taxpayer may invest after-tax dollars in an annuity contract. As with life insurance contracts, the inside buildup of an annuity contract is not subject to income tax. At a certain point in time, the taxpayer begins to receive a stream of payments from the investment and the income that the annuity has accumulated. [You should see immediately that taxpayer will be receiving some of her own after-tax money and some not-yet-taxed investment income.] There may be a fixed number of payments or the stream of payments may terminate only on the death of the taxpayer. Section 72 allocates a portion of each payment to taxpayer’s recovery of basis and a portion to not-yet-taxed inside buildup.

•Section 72(c)(1) defines taxpayer’s “investment in the contract.”

•Section 72(c)(4) defines “annuity starting date” as “the first day of the first period for which an amount is received as an annuity under the contract[.]”

•Section 72(a)(1) provides that taxpayer must include in gross income “any amount received as an annuity[.]”

•Section 72(b)(1) excepts from “amounts received as an annuity” a pro-rated amount of taxpayer’s basis in the contract. This requires a determination of taxpayer’s “expected return under the contract.”

•If the “expected return” depends on the life expectancy of one or more individuals, taxpayer determines the “expected return” in accordance with actuarial tables that the Secretary of the Treasury has prescribed. These tables are in the regulations, see Reg. § 1.72-9.

•Simply multiply the number of payments taxpayer can expect based on these actuarial tables by the amount of each payment. This product is the “expected return.”

•Divide the taxpayer’s investment in the contract by the “expected return.” Taxpayer multiplies this product by “any amount received as an annuity” to determine the amount that she excludes from gross income.

•If taxpayer outlives what the actuaries predicted ...: Once taxpayer has excluded her investment in the annuity contract from her gross income, taxpayer may no longer exclude any “amount received as an annuity” from her gross income. § 72(b)(2).

•If taxpayer dies before the actuaries predicted she would ...: On the other hand, should payments cease because taxpayer died prior to recovery of

taxpayer’s investment in the contract, taxpayer may deduct the amount of the unrecovered investment for her last taxable year. § 72(b)(3)(A).
4. Section 72(e) states rules applicable to amounts received under an annuity, endowment, or life insurance contract that are not received as an annuity – if no other provision of this subtitle is applicable. § 72(e)(1).

•Section 1001 is a provision of “this subtitle.”

•In Situation 2, no payments were made under the contract. Instead, a third party bought the contract. For that reason, § 72(e)(1) did not apply. The ruling requires treatment of the sale as any other sale of property with adjustments to basis for prior expenditures on life insurance.

•Section 72(e)(5)(C) provides that § 72(e)(1) applies to amounts not received as an annuity under a life insurance or endowment contract.

•This describes the payment from the insurance company to the taxpayer in Situation 1.

•Section 72(e)(1) provides that the amount taxpayer must include in her gross income is the amount of the payment “to the extent it exceeds the investment in the contract.” Section 72(e)(6) defines “investment in the contract” to include the aggregate of premiums or other consideration paid for the contract minus any amounts previously received that taxpayer excluded from her gross income.

•It is because of § 72(e)(5) that Situations 1 and 2 are resolved differently.
5. Section 101(g): Amounts that a “terminally ill” or “chronically ill” person receives under a life insurance contract may qualify for exclusion under § 101(a)(1). The same is true of the “amount realized” on the sale of a life insurance policy to a “viatical settlement provider.” § 101(g)(2).

•A “terminally ill” taxpayer is one who is certified by a physician as having “an illness or physical condition which can reasonably be expected to result in death in 24 months or less after the date of the certification.” § 101(g)(4)(A).

•A “chronically ill” taxpayer is one who is not “terminally ill” and is unable to perform at least two activities of daily living (i.e., eating, toileting, transferring, bathing, dressing, and continence) or requires substantial supervision to protect herself “from threats to health and safety due to severe cognitive impairment.” § 101(g)(4)(B), referencing § 7702B(c)(2).

•A “chronically ill” taxpayer must use the payment for unreimbursed costs of long-term care. § 101(g)(3)(A).

•In 2006 – before release of the movie – Congress enacted § 101(j) which limited the exclusion in the case of employer-owned contracts to the amounts paid for the policy. § 101(j)(1).

•There is an exception to the exception if the employee is a key employee and is notified that the employer intends to procure such insurance and the employee gives her consent. § 101(g)(2 and 4).

Do the CALI Lesson, Basic Federal Income Taxation: Gross Income: Annuities and Life Insurance Proceeds. You may have to read some portions of the Code to answer all of the questions. That would be a good thing. In a tax-deferred corporate reorganization, the basis of the transferee is determined by reference to the basis of the contract in the hands of the transferor.

•”Health and accident” insurance includes wage continuation policies. This would be important for employees whose employers provide health insurance but not disability insurance.

•The exclusion applies to multiple payments from more than one self-purchased policy, even though the amount received exceeds the expense against which taxpayer procured the insurance.
•Read § 105. What rule emerges from §§ 105(a and b)?
•The following two problems are derived from and answered by Rev. Rul. 69-154. What is your intuition about how they should be solved? Feel free to examine the revenue ruling.

•C is covered by his employer’s health insurance policy. C’s employer pays the annual premium of $10,000. This amount is excluded from C’s gross income. In addition, C paid the entire premium of $5000 for a personal health insurance policy.

•During the year, C had only one illness and incurred and paid total medical expenses, as defined in § 213 of the Code, of $2700. In the same year as a result of this illness, C was indemnified $2100 under his employer’s insurance policy and $1500 under his personal insurance policy.
•What is C’s gross income from the insurance companies’ reimbursements?
•D is covered by his employer’s health insurance policy. The annual premium is $10,000, of which the employer pays $4000 and $6000 is deducted from D’s wages. In addition, D paid the entire premium of $5000 for a personal health insurance policy.

•During the year, D had only one illness and paid total medical expenses, as defined in § 213 of the Code, of $2700. In the same year as a result of this illness, D was indemnified $2100 under his employer’s insurance policy and $1500 under his personal insurance policy.

•What is D’s gross income from these reimbursements?
•Read § 106(a).

Do: CALI Lesson, Basic Federal Income Taxation: Gross Income: Damages and Related Receipts

•Section 86 establishes three levels of so-called “(b)(1)(A) amounts” of income – which we define momentarily.

•This amount will fall into one of three ranges that the Code defines in terms of the taxpayer’s filing status. Each income range is subject to a different set of rules governing inclusion of social security benefits in taxpayer’s gross income. The three income ranges are the following:

•“(b)(1)(A) amount” of income that is below the statutory “base amount.”

•“(b)(1)(A) amount” of income that is above the statutory “base amount” but below the statutory “adjusted base amount.”

•“(b)(1)(A) amount” of income that is above the statutory “adjusted base amount.”

Section 86(a) with deceptive simplicity sets forth rules governing taxpayer inclusion in gross income of social security benefits. Section 86(a) requires computations of various amounts and then comparing them. Hopefully, we can reduce this to a few straight-forward “if ... then” rules. It is best⁵² to begin with § 86(b) – the provision that actually defines the “Taxpayers to Whom Subsection (a) applies.”

•Section 86(b)(1)(A)(i) requires that we determine what Joe’s “modified agi” is. That phrase is defined in § 86(b)(2). Joe’s AGI at the moment, not counting his social security benefits or tax exempt interest, is $6000. To obtain Joe’s “modified agi,” we do not add his benefits (§ 86(b)(2)(A) (“determined without regard to this section”)) but we do add certain items, including his tax exempt interest income, § 86(b)(2)(B), i.e., $1000. Joe’s modified adjusted gross income is $7000.

•Section 86(b)(1)(A) requires us to add Joe’s modified adjusted gross income plus one-half of his social security benefits. $7000 + $10,000 = $17,000. We will refer to this as the “(b)(1)(A) amount.”

•Subtract the “base amount” from $17,000.

•“Base amount” is defined for Joe in § 86(c)(1)(A) as $25,000.

•According to § 86(a)(1), Joe must include in his gross income the lesser of one-half of the social security benefits that he received or one-half of the amount by which his “(b)(1)(A) amount” exceeds his “base amount.”

•Joe’s “modified agi” does not exceed his “base amount,” so one-half of the excess described in § 86(b)(1) in our case will of course be $0.

•§ 86(a)(1) requires a comparison: $0 < $10,000.

•Joe must include the lesser of these figures, i.e., $0, of his Social Security benefits in his gross income.

•Joe’s “modified agi” plus one-half of his social security benefits plus tax exempt interest (i.e., “(b)(1)(A)” amount) equals $29,000. This is more than the statutory “base amount,” i.e., $25,000, § 86(c)(1)(A).

•Section 86(b)(1) describes a taxpayer whose “(b)(1)(A) amount” is more than an “adjusted base amount.” For Joe, that amount is $34,000. § 86(c)(2)(A). Joe’s “(b)(1)(A) amount” does not exceed his “adjusted base amount,” so § 86(a)(1) applies to him.

•According to § 86(a)(1), Joe must include in his gross income the lesser of one-half of the social security benefits that he received or one-half of the amount by which his “(b)(1)(A)” amount exceeds his “base amount.”

•The first amount is $10,000. The second amount is $2000.

•Joe must include $2000 of social security benefits in his gross income.

•Joe’s “(b)(1)(A) amount” is now $41,000. This is $7000 more than his “adjusted base amount,” i.e., $34,000, § 86(c)(2)(A). This means that § 86(a)(2) applies rather than § 86(a)(1).

•Section 86(a)(2) requires us to determine two different amounts and to include the lesser in Joe’s gross income.

•The first amount (§ 86(a)(2)(A)) is –

•85% of the “excess,” i.e., 85% of $7000, i.e., $5950, PLUS

•the lesser of

•the amount that would be included in Joe’s gross income if our second rule (i.e., § 86(a)(1)) did apply. The lesser of one-half of Joe’s social security benefits (i.e., $10,000) or one-half of the excess of Joe’s “(b)(1)(A) amount” over his “base amount” (i.e., ½ of ($41,000 − $25,000) = $8000) is $8000.

•or

•one-half of the difference between Joe’s “base amount” and “adjusted base amount.” The difference between Joe’s “base amount” and his “modified base amount” is $34,000 − $25,000. One-half of that amount is $4500.

•$4500 < $8000.

•$5940 + $4500 EQUALS $10,440.
•The second amount (§ 86(a)(2)(B)) is –

•85% of Joe’s social security benefit, i.e., 85% of $20,000 = $17,000.

•$10,440 < $17,000. Joe must include $10,440 in his gross income.
We state the third of our straight-forward rules.

3. If taxpayer’s “modified agi” plus one-half of her social security benefits is more than the statutory “adjusted base amount,” taxpayer must include in her gross income the lesser of two amounts computed according to two more rules.
D. Unemployment Benefits: § 85
A taxpayer must include in her gross income unemployment compensation. § 85.

Do: CALI Lesson, Basic Federal Income Taxation: Gross Income: The Taxability of Employment Connected Payments: Fringe Benefits, Meals and Lodging, Unemployment Compensation, and Social Security Benefits. Several of the questions are derived from the next section of the text. You should do the Lesson twice: now and when you finish reading the next section.