Question 72

Tax liability is incurred when the cash value exceeds all premiums paid.

When a policyowner surrenders a policy for its cash value, a tax liability arises if the cash value received is greater than the total premiums paid into the policy. This is because the gain from the surrender is considered taxable income.

A) The cash value exceeds all premiums paid.

This option is correct because, under tax regulations, only the gain from the policy, which is the cash value minus the premiums paid, is subject to taxation. If the cash value is greater than the premiums paid, the difference represents a gain, resulting in a tax liability.

B) The cash value is less than premiums paid.

This option is incorrect. If the cash value is less than the premiums paid, there is no gain realized upon surrendering the policy. Therefore, no tax liability is incurred in this scenario, as the policyowner does not receive more than they have invested.

C) The policy is exchanged for a policy of equal value.

This option is incorrect because an exchange of policies typically falls under a tax-deferred provision, meaning that no immediate tax liability arises. The tax implications would be assessed only when the new policy is surrendered or sold, not at the time of exchange.

D) The policy is transferred to a third party.

This option is also incorrect. Transferring a policy to a third party does not automatically incur a tax liability. Tax implications would depend on the circumstances of the transfer and whether any gain is realized at that time.

Conclusion

In summary, the correct answer is A, as tax liability is specifically triggered when the cash value exceeds the total premiums paid, indicating a realized gain. Options B, C, and D fail to address the conditions under which tax liabilities are incurred, reinforcing the importance of understanding the tax rules related to policy surrenders.