Life Insurance Underwriting, Uses, and Federal Tax Treatment
Underwriting sources and decisions
Field underwriting begins with the agent's report and the application. The home office may use the MIB (coding, not detailed records), paramedical exams, attending physician statements, inspection reports, and financial underwriting for large faces. Ratings: preferred, standard, substandard (table rating or flat extra per $1,000), and rated/declined. A conditional receipt provides coverage as of the application date if the applicant proves insurable under the insurer's rules; a temporary insurance agreement has limits.
Uses
Personal: income replacement, estate liquidity, mortgage protection. Business: key person, buy-sell funding, split dollar, executive bonus (Section 162 - premiums are deductible to the employer but taxable income to the executive), deferred compensation, and group carve-outs.
Federal income tax
Death proceeds are generally income-tax-free to the beneficiary (estate tax may apply if the insured held incidents of ownership). Cash value grows tax-deferred; loans are generally not taxable unless the policy lapses or is a MEC (fails the 7-pay test - then distributions are taxed LIFO with a 10% penalty before 59½). Transfer-for-value makes proceeds taxable to the buyer, with exceptions for the insured, partners, and corporations. Employer-paid group term above $50,000 creates imputed income; employer-paid premiums are deductible to the business.
Rule of thumb
Tax the owner's pocket, not the beneficiary's: proceeds income-tax-free, but cash value, MEC distributions, dividends beyond basis, and interest are taxable events.