The congressional intent on tax exemption on the insurance benefits of terminally ill individuals is to alleviate the financial burden for long-term expenses on healthcare. The inclusion of accelerated death benefits in life insurance allows terminally ill individuals to receive part or all of the death benefits presupposed by the insurance policy and use the money to support their health (Burke & Friel, 2008). Death benefits and other proceeds relating to the purchase of policies for individuals with terminal illness are non-taxable death earnings. A terminally ill person can obtain the cash suggested by a policy with the associated gains being separated from the gross income, which means that s/he does not have to pay tax on the gains. Gains due the cancellation or sale of a life insurance policy before the death of the insured are subject to taxation because the tax exemption on proceeds from life insurance applies upon the death of the policy owner. The taxpayer treats the proceeds from a canceled or sold life insurance as an investment taxable on the principle of gains over the premium (Miller & Maine, 2010).
Bob’s decision was inconsistent with the congressional intent to provide the tax exemption on his insurance because he exploited the policy to enjoy the benefits of tax-deferred growth on a pool of capital. Bob’s actions highlight a loophole in the federal laws on taxation, which individuals can exploit as a source of tax-free proceeds to offset the expenses incurred due to the taxation of other pools of capital such as fixed income, equities and mutual funds. He used tax exemptions to gain income, which he used for purposes unrelated to the expense on healthcare. The Income Tax Act allows the owner of a tax-exempted insurance policy to transfer and distribute the proceeds from the policy on a tax-free basis. The lack of specific policies in the use of proceeds from a tax-exempted policy has created a tax shelter under which individuals can accumulate money for use in diverse projects (Stephens, 2005). The insured has a chance to increase his wealth using the current federal taxation laws by investing in a tax-exempted policy before transferring the proceeds to mainstream investment, such as real estate. The exploitation of the policies on tax exemption for terminally ill individuals has minimal effects on tax collection because only individuals certified as terminally ill can exploit accelerated death benefits.
There is no need to close the loophole because people who purchase insurance policies from the terminally ill cannot inherit the benefits of tax-exemption. Although Bob used the benefits on his insurance for the unintended purpose, the impact of his actions on tax collection is insignificant. Considering that the criteria for certifying a terminally ill person entails the expectation of death of the insured within 24 months, the impacts of the tax-free gains on life insurance are mainly short-term (Tiller & Fagerberg, 2005). The transfer of property acquired from the proceeds of the cash surrendered on an insurance policy is subjected to federal laws on taxation of inheritance, which limits the scope of exploiting tax-exempted insurance as an investment vehicle or means of transferring wealth without paying taxes. The framework for the exploitation of tax exemption on accelerated death benefits and sale of an insurance policy for a terminally ill person cannot serve the long-term purpose of an asset class in an investment portfolio.
References
Burke, J. M., & Friel, M. K. (2008). Understanding federal income taxation (3rd ed.). Newark, NJ: LexisNexis.
Miller, J. A., & Maine, J. A. (2010). The fundamentals of federal taxation: problems and materials (2nd ed.). Durham, NC: Carolina Academic Press.
Stephens, G. R. (2005). Estate planning with life insurance (3rd ed.). Toronto: CCH Canadian.
Tiller, J., & Fagerberg, D. (2005). Life, Health & Annuity Reinsurance. Minnesota: ACTEX Publications.