26 U.S.C. § 101 — Certain death benefits

(a) Proceeds of life insurance contracts payable by reason of death. If a life insurance company pays you money because the insured person died, you normally don't pay tax on it. This is true whether you get it all at once or in installments. Paragraph (2), transfer for valuable consideration: Suppose someone sold or assigned the policy to you for money before the insured died. Then your tax-free amount is capped. You can only exclude an amount equal to what you paid for the policy, plus any premiums or other costs you paid afterward. "Other amounts" includes interest you paid on a loan to cover premiums, as long as you couldn't already deduct that interest under section 264(a)(4). This cap doesn't apply in two situations: if your basis in the policy came from the previous owner's basis (like a gift), or if you bought the policy from the insured, the insured's business partner, a partnership where the insured is a partner, or a corporation where the insured is a shareholder or officer. Paragraph (3), exception for commercial transfers: The cap in paragraph (2) doesn't apply to a "reportable policy sale." That's when someone buys an interest in a life insurance policy but has no real family, business, or financial connection to the insured, other than owning that policy interest. This includes buying indirectly, such as buying into a partnership or trust that holds the policy. (b) Repealed. This subsection no longer has any effect. (c) Interest. If your tax-free insurance money is held back and paid out later with interest added, that interest is taxable income, even though the underlying insurance money is not. (d) Payments made later than the date of death. Sometimes an insurer holds the death benefit and pays it out over time instead of in one lump sum. Paragraph (1): The tax-free amount is spread evenly across the payment period. Each year, you exclude your prorated share from income; anything you receive beyond that prorated share is taxable. Paragraph (2): The "amount held by the insurer" is the value of the future-payment agreement as of the date of death, figured as if any payment option had been exercised right then, discounted using the insurer's own interest rate and government mortality tables. Paragraph (3): This subsection does not apply to money already covered by subsection (c). (e) Repealed. This subsection no longer has any effect. (f) Proceeds of flexible premium contracts issued before January 1, 1985. A "flexible premium" policy lets you vary how much and when you pay premiums. Paragraph (1): For a death benefit under one of these contracts to stay tax-free, the contract must pass one of two tests. Test (A): the total premiums paid must never exceed a limit called the "guideline premium limitation," and the death benefit must always be at least a set percentage of the policy's cash value. Test (B): the policy's cash value must never exceed the "net single premium" needed to fund the death benefit. Paragraph (2) defines the guideline premium limitation. It's the larger of the "guideline single premium" (a lump-sum premium calculated using the contract's guaranteed charges and 6% interest) or the sum of "guideline level premiums" to date (the same calculation, but as a level yearly amount paid over a set period, using 4% interest instead of 6%). Special computation rules apply: the gap between the death benefit and cash value is locked in at the level it was when the policy was issued; the payout date used is the contract's latest allowed maturity date, but not less than 20 years out or before age 95; and any built-in "endowment" payout is capped at the smallest death benefit the contract ever promises. These numbers must be recalculated if the contract's future benefits change. Paragraph (3) adds definitions and rules: A "flexible premium life insurance contract" is one where premium timing and amount aren't fixed by the insurer; it doesn't include any part treated as an annuity under state law. "Premiums paid" means premiums minus amounts covered by section 72(e); if the insurer refunds excess premium (with interest) within 60 days after the contract year ends, the refunded premium (not the interest) reduces that year's premiums paid, and the refunded interest is still taxable. The "applicable percentage" used in the death-benefit test is 140% for an insured 40 or younger, dropping by 1 percentage point per year over 40, but never below 105%. Cash value is figured without subtracting surrender charges or loans. "Qualified additional benefits" means guaranteed insurability, accidental death benefit, family term coverage, or waiver of premium. A premium payment that would push total premiums over the limit is ignored for the limitation test if it's only large enough to keep the policy from lapsing. The "net single premium" is computed using the contract's guaranteed mortality table, interest at the higher of 4% (3% for contracts before July 1, 1983) or the contract's guaranteed minimum rate, and the same computation rules as paragraph (2) except the maturity date can't be before age 95. If a taxpayer shows a failure was a reasonable error and is being fixed, the Secretary may waive it. The Secretary must issue regulations to carry out this subsection. (g) Treatment of certain accelerated death benefits. Paragraph (1): Money paid under a life insurance contract to a terminally ill or chronically ill insured counts as if it were paid because the insured died. Paragraph (2): If part of the death benefit is sold or assigned to a "viatical settlement provider," the sale price is treated the same way, as paid by reason of death. A viatical settlement provider is someone regularly in the business of buying these policies from terminally or chronically ill insureds, who is either licensed for that purpose in the insured's state or, if the state doesn't require a license, meets specific standards set by the National Association of Insurance Commissioners for terminally ill insureds (or similar standards for chronically ill insureds). Paragraph (3): For chronically ill insureds specifically, this tax break only applies to payments that cover actual, unreimbursed long-term care costs for that period, and only if the contract meets the requirements of section 7702B(b)(1)(B) plus any further requirements listed in subparagraph (B) below. A payment still qualifies even if it's paid per day rather than tied to actual expenses. Section 7702B(d) separately caps how much of a periodic payment can qualify. Subparagraph (B) lists which added standards apply: rules the Secretary specifies under sections 7702B(g) and 4980C, or, if adopted, standards from the National Association of Insurance Commissioners or from the policyholder's state, which then replace the Secretary's rules. Paragraph (4) defines terms: A "terminally ill individual" is someone a doctor certifies is reasonably expected to die within 24 months. A "chronically ill individual" has the meaning in section 7702B(c)(2) but excludes terminally ill people. "Qualified long-term care services" has the meaning in section 7702B(c). "Physician" has the meaning used in the Social Security Act. Paragraph (5): This accelerated-benefits exclusion does not apply when the payment goes to someone other than the insured who has an insurable interest only because the insured is a director, officer, or employee of that taxpayer, or is financially connected to that taxpayer's business. In other words, business-owned policies on key people don't get this break. (h) Survivor benefits for public safety officers killed in the line of duty. Paragraph (1): A survivor annuity paid because a public safety officer was killed in the line of duty is tax-free if it comes from a qualifying government retirement plan and goes to the officer's spouse, former spouse, or child, to the extent it's based on the officer's public-safety service. Paragraph (2): This tax break does not apply if: the officer caused their own death on purpose or intended to die; the officer was voluntarily intoxicated at the time of death; the officer was grossly negligent while on duty; or the payment would go to someone whose actions substantially contributed to the officer's death. (i) Death benefits for terrorism victims and astronauts. Paragraph (1): Money an employer pays because an employee died as a "specified terrorist victim" is tax-free. Paragraph (2): This exclusion does not cover amounts that would have been paid anyway if the person had died some other way, except that incidental death benefits from a tax-qualified retirement plan still stay tax-free. Paragraph (3): "Employee" here includes a self-employed person. Paragraph (4): The same rules apply to an astronaut who dies in the line of duty. (j) Employer-owned life insurance contracts. Paragraph (1): For a life insurance policy a business owns on an employee's life, the tax-free amount is normally capped at what the business paid in premiums and other costs. Any profit above that is taxable. Paragraph (2): That cap doesn't apply, so the full death benefit stays tax-free, if the business gave proper notice and got the employee's consent (see paragraph 4), and either: (A) the insured worked for the business sometime in the 12 months before death, or was a director, a highly compensated employee, or a highly compensated individual (using a 35% threshold instead of the usual 25%) when the policy was issued; or (B) the money goes to the insured's family member, named beneficiary, a trust for them, the estate, or is used to buy an ownership stake back from any of those people. Paragraph (3) defines terms: An "employer-owned life insurance contract" is a policy owned by a business where the business (or a related party) is a beneficiary, covering an employee of that business at issuance. Each person covered under one master policy can count as a separate contract. The "applicable policyholder" is the business that owns the policy, plus any related businesses under common ownership or control. Paragraph (4): Before the policy is issued, the employee must: (A) get written notice that they'll be insured and the maximum coverage amount; (B) give written consent, including that coverage can continue after they leave the job; and (C) be told in writing that the business will be a beneficiary of the death payout. Paragraph (5) defines terms: "Employee" includes officers, directors, and highly compensated employees. "Insured" means a covered person who is a U.S. citizen or resident; if a policy covers two people jointly, both count as insureds.