CRS Report Analyzes Taxes and Inside Buildup of Life Insurance

                       CRS REPORT FOR CONGRESS

[2] Subject to certain restrictions, inside build-up is not taxed under current law as it accrues. The ultimate magnitude of the tax benefit depends on the policyholder's disposition of the insurance policy. If a person surrenders a policy in exchange for cash, he or she is taxed on the cash value minus the value of premiums that have been paid. In this case, the inside build-up receives a benefit in the form of a tax deferral or postponement. Tax is ultimately paid on the inside build-up, but not until the policy is cashed in. (Note that the taxpayer receives an added tax benefit from the deduction of the premiums.) If a person keeps a policy until death, the proceeds of the policy are not subject to tax. In this case, the inside build-up is never taxed. ¹

[3] A taxpayer's "basis" in an asset is best defined by reference to its practical function: it is the amount that can be deducted from the asset's sales proceeds when the asset is sold. It is the portion of the sales proceeds that represents the return of capital itself rather than the return TO capital. Frequently, the basis is the asset's acquisition cost. When a person sells an asset -- for example, stock -- he is generally taxed on the sales proceeds minus his basis in the asset, or what he paid for it. Under current law, an heir's basis in an inherited asset is generally the asset's fair market value at the time of death rather than the decedent's basis in the asset. Thus, if the asset appreciated during the decedent's lifetime, the heir receives a "step up" in basis equal to the amount of that appreciation. If the heir subsequently sells the asset, he can therefore deduct the amount of appreciation that occurred during the decedent's lifetime and is effectively not taxed on that appreciation. ²

[4] Bills that propose repeal of the estate tax frequently place restrictions on the step-up in basis; the restrictions reduce the revenue cost of repealing the estate tax. In particular, both the House and Senate bills to repeal the estate tax that were passed in the first part of 200l would limit the step-up in basis to $1.3 million plus $3 million of assets transferred to a surviving spouse. During the early consideration of the estate tax legislation, some suggested that any revenue gain from repealing or restricting the step-up in basis would be limited by the adoption of alternative tax- saving strategies by taxpayers seeking alternative ways to pass appreciated assets on to their heirs, free of tax. In particular, some suggested that taxpayers might divert investments to life insurance policies with a large inside build-up component. As noted above, if kept until death, such policies would not be subject to tax. In effect, they could transmit appreciation to heirs, free of tax, accomplishing a similar tax-saving function as the step-up in basis.

[5] The insurance industry has generally opposed subjecting the inside build-up of policies to tax. Neither the House nor Senate estate tax bills would tax the inside build-up of life insurance policies.

² For a discussion of the step up of basis, see: U.S. Library of Congress, Congressional Research Service, Step-up Carryover Basis for Capital Gains: Implications for Estate Tax Repeal, Report No. RL30875, by Nonna A. Noto (Washington: Apr. 20, 2001), 14 pp.