“People will pay you a lot of money if you pretend to know how the tax code works.”—Adele Valenzuela, CPA, a partner at AVM DeMars CPAs in Williston Park, NY.

It is easy to forget that America was founded, in part, to avoid high taxation.

The CCH Standard Federal Tax Reporter includes the Internal Revenue Code (IRC), IRS regulations, the revenue rulings, and case law covering court proceedings that involve the tax code. Combined, these documents add up to about 70,000 pages. The IRC itself is around 2,600 pages.

From time to time politicians promise to simplify the tax code. They promise to reduce the number of pages. At no point in history has the size of the Tax Reporter shrunk. In fact, the rate of increase actually grew after the 1986 tax and subsequent simplification reforms. This makes sense because the Tax Reporter includes all past tax statutes and all case law. So even if Congress enacts a new one-page statutory tax code, the Tax Reporter would keep growing as more and more cases hit the courts.

A Little History
The United States Constitution gives Congress the power to “Lay and collect taxes, duties, imposts and excises, to pay the debts and provide for the common defense and general welfare of the United States.” (Article I, Section 8)

The Federal Government first levied a federal income tax during the Civil War. Congress rightly deduced that it was going to be a long, costly war, and the government needed revenue. In 1862 the Congress established a Commissioner of Internal Revenue. The first federal income tax was progressive and levied a three percent tax on incomes between $600 and $10,000 and five percent tax on incomes over $10,000.

In 1872 the federal income tax was repealed, but in 1894 the federal income tax made a brief comeback before being ruled unconstitutional in 1896.

On July 2, 1909, Congress passed a proposed Constitutional amendment, and it was ratified on February 3, 1913. The 16th Amendment gave Congress the legal authority to tax income. In 1914 the Bureau of Internal Revenue released the first income tax form, called Form 1040. The initial 1040 form was four pages in length and included only one page of instructions!

The brand new 1913 IRC contained this progressive marginal tax rate schedule:

• One percent on income of $0 to $20,000
• Two percent on income of $20,000 to $50,000
• Three percent on income of $50,000 to $75,000
• Four percent on income of $75,000 to $100,000
• Five percent on income of $100,000 to $250,000
• Six percent on income of $250,000 to $500,000
• And seven percent on income of $500,000 and up

The Revenue Act of 1916 began the recurring Congressional practice of adjusting tax rates and income scales.

It’s Not Just about the Money
Congress asks way more of the U.S. tax code than simply raising money for the government. Through tax policy the federal government tries to nudge us to act in ways they deem preferable.

According to the IRS, “Legislators have three needs in mind as they prepare tax laws: The need to raise revenue, the need to be fair to taxpayers, and the need to influence taxpayers’ behavior.”¹

Social engineering was concomitant with U.S. tax policy from the beginning. Alexander Hamilton proposed the first domestic tax on whisky and cited the health and moral implications of the drink as reasons to support the levy of a tax.

When people think of Congressional attempts to shape society through taxes, they often refer to excise taxes. They point to so-called “sin taxes” used to discourage the use of products and services that could pose a risk to someone’s health, such as alcohol and cigarettes. Or they highlight the gasoline excise tax or the luxury taxes on expensive, nonessential items such as luxury cars.

However, the IRC is replete with attempts by Congress to drive desired behavior through the income tax system. Prime examples of incentives for activities deemed to have social merit include:

• Home ownership
• Adoption
• Child care
• Charitable giving
• Saving for retirement
• And making contingencies for expected health costs

One of my all-time favorite authors is Louis Nizer. His great works include My Life in Court, The Jury Returns, and my personal favorite, Reflections without Mirrors. On June 8, 1985, this inimitable lawyer/author wrote a piece for the Chicago Tribune entitled “Tax Law As Social Engineer.”2 Here are some quotes from that article:

• “The common conception that the sole purpose of taxes is to raise money for the government is a fallacy. Tax deductions are devices for social engineering.”
• “Tax deductions are generally not motivated to escape a just tax. Most of them are deliberate financial inducements for desirable social ends.”
• “Money is a bad master but a good servant. We use the tax code to serve the public good.”

Life Insurance Serves the Public Good
In the mid-to-late 1980’s the life insurance industry had a hot product—single premium life. This product maximized the tax-deferred build-up of cash in the policy by minimizing the death benefit. It was the product that drove changes to the IRC in regard to life insurance taxation and created MECs.

During that debate, the U.S. Government Accountability Office (GAO) was asked to weigh in. The GAO “provides Congress, the heads of executive agencies, and the public with timely, fact-based, non-partisan information that can be used to improve government and save taxpayers billions of dollars.”³

In January 1990, the GAO produced a memorandum entitled “GGD-90-31 Tax Policy: Tax Treatment of Life Insurance and Annuity Accrued Interest.” It was addressed to both The Honorable Lloyd Bentsen, Chairman, Committee on Finance for the United States Senate, and The Honorable Dan Rostenkowski, Chairman, Committee on Ways and Means for the House of Representatives.

• The memorandum was submitted in response to Section 5014 of the Technical and Miscellaneous Revenue Act of 1988. Section 5014 called for the GAO to report on:
• “The effectiveness of the revised tax treatment of life insurance products in preventing the sale of life insurance primarily for investment purposes; and
• The policy justification for, and the practical implications of, the present treatment of earnings on the cash surrender value of life insurance and annuity contracts in light of the Tax Reform Act of 1986.”⁴

The GAO saw clearly that the life insurance industry had pushed the letter of the law, and perhaps violated the spirit of the law, with these products. The report was sometimes written in twisted logic and strained syntax. This couplet is exemplary:

“It may be preferable to give the tax advantage to those who would substantially reduce their coverage in the absence of the tax advantage, and not give the advantage to those who would purchase sufficient insurance even without the incentive. Unfortunately, it is very difficult to provide a targeted incentive for something that would not have occurred without the incentive, and not to provide incentives for activities that would have occurred anyway.”⁴

Whew. After much internal debate, the report concluded as follows:

“The only reason for not taxing inside buildup that we found to have merit is that doing so would reduce the amount of life insurance coverage that some people buy. Protecting survivors against income loss is a goal that society has traditionally supported.”⁵

Life insurance is desirable and deserves tax benefits because protecting survivors against income loss is something society supports!

Remember what the IRS stated as the three-prong purposes of tax policy:

• Raise revenue
• Be fair to taxpayers
• Influence taxpayers’ behavior

However, the reason for maintaining a tax code provision designed to guide behavior is proof that it is working.

A Word of Caution
Changes in the IRC often have unintended consequences, and sometimes bring to light aspects of the system that no longer function as intended.

Consider IRC Section 163 allowing as a deduction all interest paid or accrued within the taxable year on indebtedness. This section applies to mortgage interest.

President Trump signed the Tax Cuts and Jobs Act (TCJA) into law on Dec. 22, 2017, and it brought sweeping changes to the tax code. The standard deduction nearly doubled from $6,500 to $12,000 for individual filers, and from $13,000 to $24,000 for joint filers.
Mortgage interest deductions already favored the richer citizens because low-income filers almost always used the standard deduction anyway.

It is estimated that nearly 90 percent of taxpayers simply took the standard deduction for tax years 2019 and 2020. This was a dramatic increase. Previous to the Trump tax reform law, about two-thirds of all taxpayers used the standard deduction.

Question: Who still itemizes deductions? Generally, the wealthiest taxpayers. For tax filings in 2017, 93 percent of taxpayers earning adjusted gross incomes of $500,000 or more itemized deductions. Those itemized deductions averaged $247,000.6 Are these same people waiting to own homes until Congress encourages them through tax deductions? No.

With roughly 90 percent of taxpayers taking the standard deduction, is the mortgage interest deduction working to guide behavior as Congress initially intended?

Lawmakers may wake up one day and eliminate the mortgage interest deduction if it only favors the rich.

Life Insurance as a Public Good
According to the IRS: “Generally, life insurance proceeds you receive as a beneficiary due to the death of the insured person, aren’t includable in gross income and you don’t have to report them.”⁷

Since 1913 the IRC has recognized the social usefulness of life insurance, which helps protect widowed spouses and children and keeps them off of public assistance. Accordingly, Congress created liberal tax benefits as an incentive to those who put their hard-earned dollars into life insurance policies.

This is not an article about the tax advantages enjoyed by life insurance, especially cash value life insurance. Rather, it is a call to all independent financial professionals to proudly trumpet the public good that life insurance serves.

Question: Who is buying individual life insurance, and are the tax advantages Congress created for life insurance products leading to the intended results?

According to LIMRA’s 2020 Insurance Barometer Study, 54 percent of all people in the United States were covered by some type of life insurance in 2019. That year, 71 percent of consumers who owned life insurance had a term life policy, and 44 percent of policyholders owned a permanent life insurance policy.⁸ (Some people obviously owned both term and permanent.)

According to the ACLI 2019 Life Insurance Fact Book,⁹ a total of 10,289,000 individual life policies were purchased in 2018. This compares with 10,478,000 in 2017, and 10,207,000 in 2008. The average annual percent change from 2008 to 2018 was 0.1 percent and from 2017 to 2018 -1.8 percent.

Further, the ACLI states that 90 million American families rely on life insurers’ products for financial and retirement security. Americans purchased $3.1 trillion of new life insurance coverage in 2019. By the end of 2019, total life insurance coverage in the United States was $19.8 trillion. To put this staggering amount in perspective, the U.S. GDP in 2019 was $21.73 trillion.¹⁰

Although the life insurance death benefit is normally paid out in a lump sum whereas the Social Security’s Survivor benefit is paid over a number of years, beneficiary payments from life insurance annually equate to about 58 percent of the aggregate survivors’ benefits from the government.¹¹

So how is the Life Insurance Industry doing?

• Nearly six out of 10 Americans have life insurance. “Even for low-income households, 34 percent of households in the lowest income quintile and 55 percent of those in the second lowest quintile own life insurance.”¹²
• Approximately 10 million new policies are sold annually.
• Total life insurance in force nearly equals the nation’s annual GDP.
• The life insurance industry pays out nearly 60 percent to survivors as does the government through Social Security.

It would appear that far more American taxpayers are benefiting from the tax advantages granted life insurance than those benefiting from mortgage interest deductions. In other words, if Congress intended to motivate people to provide protection for their families by offering tax advantages, it should feel justified to keep those advantages in place.

Summary
The Internal Revenue Code has three goals:

• Raise revenue
• Be fair to taxpayers
• And influence taxpayers’ behavior

By offering tax deferred build-up, and tax-free treatment of benefits, the IRS for the last 108 years has recognized the social usefulness of life insurance. Indeed, the life insurance industry continues to effectively provide families with income replacement for survivors.

More Yet to Be Done
Still, 40 percent of Americans do not own life insurance. Even those that own individual life insurance, they own too little and a significant coverage gap exists.

One major obstacle remains sticky—earning the trust and respect of the average citizen.

In Sylvia Plath’s novel, The Bell Jar, the protagonist, Esther Greenwood, laments, “My mother had taught shorthand and typing to support us since my father died, and secretly she hated it and hated him for dying and leaving no money because he didn’t trust life insurance salesmen.”¹³

Perhaps no one had told Mr. Greenwood about the public good that life insurance performs and how Congress has recognized that social benefit for over 108 years!
Who are you telling?

References:

1. https://apps.irs.gov/app/understandingTaxes/student/whys_thm05_les01.jsp.
2. https://www.chicagotribune.com/news/ct-xpm-1985-06-08-8502060183-story.html.
3. https://www.gao.gov/about/what-gao-does.
4. https://www.gao.gov/assets/ggd-90-31.pdf.
5. Ibid.
6. https://www.taxpolicycenter.org/briefing-book/what-are-itemized-deductions-and-who-claims-them.
7. https://www.irs.gov/faqs/interest-dividends-other-types-of-income/life-insurance-disability-insurance-proceeds.
8. https://www.limra.com/en/research/research-abstracts-public/2020/2020-insurance-barometer-study/.
9. https://www.acli.com/Posting/RP20-010.
10. https://www.bea.gov/news/2020/gross-domestic-product-fourth-quarter-and-year-2019-advance-estimate.
11. http://files.brattle.com/files/7063_the_social_and_economic_contributions_of_the_life_insurance_industry.pdf.
12. Ibid.
13. The Bell Jar, Chapter 4, by Sylvia Plath.