Taxes and Life Insurance Contracts

The American Revolution and the birth of the United States was largely a tax issue. As colonist James Otis famously stated, “taxation without representation is tyranny.”

Frequently a topic of discussion, taxes were something the Founding Fathers had strong feelings about:

The democracy will cease to exist when you take away from those who are willing to work and give to those who would not. To compel a man to furnish funds for the propagation of ideas he disbelieves and abhors is sinful and tyrannical.
— Thomas Jefferson
No taxes can be devised which are not more or less inconvenient and unpleasant.
— George Washington

They also recognized the role of taxes played in establishing a new government:

The power of taxing people and their property is essential to the very existence of government.
— James Madison

And although we may recognize the necessity of taxes, no one likes paying them, and no one voluntarily pays more than they are asked to pay, no matter what your political affiliation. And the government does not expect them to. The United States Supreme Court in 1873 illustrated this point well. It had to determine whether a mining and drilling company that was using creative means to lower its tax burden was guilty of the crime of tax evasion.

In finding nothing wrong with the way the company had structured their taxes, the Supreme Court used an example of the Stamp Act of 1862, which imposed a tax of two cents for every bank check written out for at least $20. The Supreme Court explained that if a man chose to write two checks for $10 each, instead of writing one check for $20, he still pays his creditor, but he owes no stamp tax. The court concluded, “While his operations deprive the government of the duties it might reasonably expect to receive, it is not perceived that the practice is open to the charge of fraud. He resorts to devices to avoid the payment of duties, but they are not illegal. He has the legal right to split up his evidences of payment, and thus to avoid the tax.” United States v. Isham, 84 U.S. 496, 506, 21 L. Ed. 728 (1873).

Another court considering a similar issue reached the same conclusion: "We do not speak of evasion, because, when the law draws a line, a case is on one side of it or the other, and if on the safe side is none the worse legally that a party has availed himself to the full of what the law permits.” Bullen v. State of Wisconsin, 240 U.S. 625, 630, 36 S. Ct. 473, 474, 60 L. Ed. 830 (1916)

Over and over again courts have said that there is nothing sinister in so arranging one’s affairs as to keep taxes as low as possible. Everybody does so, rich or poor; and all do right, for nobody owes any public duty to pay more than the law demands: taxes are enforced exactions, not voluntary contributions. To demand more in the name of morals is mere cant.
— Judge Learned Hand, Commissioner v. Newman, 159 F.2d 848, 851 (2d Cir. 1947) - dissenting opinion
Anyone may arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which best pays the treasury. There is not even a patriotic duty to increase one’s taxes.
— Judge Learned Hand, Gregory v. Helvering, 69 F.2d 809, 810 (2d Cir. 1934)

Unfortunately, navigating the tax code is no easy feat. To try to figure out what one can do or not do within the bounds of the law is something that stumped even one of the greatest minds who ever lived. Indeed, when asked for his reaction to a labyrinth of income tax questions, this genius was perplexed:

This is a question too difficult for a mathematician. It should be asked of a philosopher.
— Albert Einstein

True to form, the internal revenue code relating to insurance contracts might as well have been written in Greek. It can be found at IRC 7702. Here is a sampling:

(D) Recapture ceiling where change occurs after 5th year and before 16th year

If the change referred to in subparagraph (B) occurs after the 5-year period referred to under subparagraph (C), the recapture ceiling is the excess of the cash surrender value of the contract, immediately before the reduction, over the cash value corridor of subsection (d) (determined immediately after the reduction and whether or not subsection (d) applies to the contract).

(E) Treatment of certain distributions made in anticipation of benefit reductions

Under regulations prescribed by the Secretary, subparagraph (B) shall apply also to any distribution made in anticipation of a reduction in benefits under the contract. For purposes of the preceding sentence, appropriate adjustments shall be made in the provisions of subparagraphs (C) and (D); and any distribution which reduces the cash surrender value of a contract and which is made within 2 years before a reduction in benefits under the contract shall be treated as made in anticipation of such reduction.


Here’s the good news—you don’t have to understand this code. The entire section is basically a mathematical algorithm written out in words, rather than symbols. That algorithm is designed to differentiate a true life insurance contract from a modified endowment contract.

The rule is basically designed to measure the ratio between cash value and death benefit in whole life insurance policies to prevent people from stuffing so much money into a policy that it looks more like a high-yield savings account than an insurance contract.

As long as your policy is written in a way that it is a true insurance contract rather than a modified endowment contract, your policy will be able to take advantage of the favorable tax treatment that insurance contracts enjoy.

Some of the benefits of having a life insurance contract (they must be written a certain way to get all these benefits) include the following:

  • Practically no annual contribution limits

  • Protected from creditors

  • Guaranteed returns

  • Never lose your principal

  • No penalties for accessing your money

  • Liquid

  • You can carve out your employees

  • Tax free transfer to heirs

  • No RMDs

  • Disability benefits

If you have questions about how a life insurance contract can be a vehicle for you to save in taxes and invest in anything tax-free, contact us for more information.

Zachariah Parry