The guideline premium and corridor test (GPT) plays a pivotal role in determining whether an insurance product can benefit from favorable tax treatment as insurance rather than an investment. GPT imposes restrictions on the amount of premiums that can be paid into an insurance policy relative to the policy’s death benefit.
Key Takeaways
- The Guideline Premium and Corridor Test (GPT) assesses whether an insurance product qualifies for taxation as insurance or as an investment.
- GPT restricts the premium amounts in proportion to the insurance policy’s death benefit.
- GPT is especially relevant for policies focused on cash accumulation rather than solely the death benefit.
- To meet the IRS requirements, a life insurance policy must offer a sufficient death benefit to qualify as insurance.
- GPT was formalized through the Deficit Reduction Act (DEFRA) to prevent misuse of life insurance as an investment tool.
Understanding the Guideline Premium and Corridor Test (GPT)
To determine whether a life insurance policy qualifies for advantageous tax treatment, the IRS uses the GPT method. Life insurance policies, particularly universal life insurance, split premiums between basic policy costs and a cash accumulation account. This cash reserve can be accessed through loans or partial withdrawals, subject to certain conditions.
Insurance Policy Structures
Life insurance policies can be structured for either maximum death benefit or significant cash accumulation. Death benefit-focused policies entail higher premiums initially, leveling off in later years. Conversely, cash accumulation-focused policies have lower early premiums, which increase over time.
Regardless of the chosen structure, each policy must pass a test to determine its tax status. Taxation as an insurance product—a preferable lower tax rate—is contingent on passing either the GPT or the alternative Cash Value Accumulation Test (CVAT).
GPT Implementation
The GPT method benefits policyholders seeking to maximize premium payments while maintaining variable death benefits or preferring substantial cash accumulation within the policy. By emphasizing the cash accumulation portion for benefits at a later age rather than the death benefit at life expectancy, GPT provides flexibility.
Insurance policies appreciating in value defer taxes, and death benefits are exempt from income and capital gains taxes. Successfully passing the GPT ensures the policy’s continued favorable tax status. Failure means higher tax rates as the policy would be treated as an investment.
Choosing Between GPT and CVAT
Insurers might also consider using the Cash Value Accumulation Test (CVAT), which limits the cash value relative to the death benefit, differing from GPT’s premium limit criteria. The choice, declared at the policy’s inception, impacts premiums, cash value, and benefits.
Connection to the Deficit Reduction Act (DEFRA)
Universal life insurance policies, seen partially as investment vehicles due to their cash reserves, led to the establishment of the guideline premium and corridor test under DEFRA in 1984. This law ensures policies providing an adequate “amount at risk”—the pure death benefit—maintain their advantaged tax status as insurance products under the Internal Revenue Code (IRC) Section 7702.
Related Terms: life insurance, universal life insurance, cash value accumulation test, death benefit, Deficit Reduction Act of 1984.
References
- Cornell Law School, Legal Information Institute. “26 U.S. Code Sec. 7702 - Life Insurance Contract Defined”.
- U.S Congress, the Joint Committee on Taxation. “Tax Treatment of Single Premium and Other Investment-Oriented Life Insurance”, Pages 6-7.
