What Is the Guideline Premium and Corridor Test (GPT)

The guideline premium and corridor test (GPT) is used to determine whether an insurance product can be taxed as insurance rather than as an investment. GPT limits 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) is a test used to determine whether an insurance product is taxable as insurance or as an investment.
  • The amount of premiums that can be paid into an insurance policy relative to the policy's death benefit is limited by the guideline premium and corridor test (GPT).
  • The GPT is used when an insurance policy is focused on the cash accumulation portion as opposed to the death benefit portion.
  • To meet the Internal Revenue Service (IRS) definition of insurance, a life insurance policy must provide for a sufficient "amount at risk," which is the death benefit protection that a beneficiary receives upon the death of the insured.
  • The guideline premium and corridor test (GPT) was established through the Deficit Reduction Act (DEFRA).

Understanding the Guideline Premium and Corridor Test (GPT)

The GPT is an Internal Revenue Service (IRS) approved method that determines whether or not a life insurance policy is allowed advantaged tax treatment.

Life insurance policies come in many different shapes and sizes. A special component of a universal life insurance policy is that the premium is split into two portions. The first portion is allocated towards the cost of the policy, whereas the second portion goes towards a cash accumulation account; a sort of savings account for the insured. This cash reserve can be borrowed against or allowed withdrawals, both with certain stipulations.

Life insurance policies can be structured to either take full advantage of the death benefit when a person passes away or full advantage of the cash accumulation reserve. Those that are death benefit focused start with higher premiums in the early years and lower premiums in the later years. Life insurance policies focused on cash accumulation are the opposite, with lower premiums in the early years and higher premiums in the later years.

Regardless of the life insurance policy selected, each policy must pass a specific test to determine whether it qualifies to be taxed as an insurance product or taxed as an investment. Being taxed as an insurance product is better as the tax rate is lower.

There are two tests to determine this factor: the guideline premium and corridor test (GPT) and the cash value accumulation test (CVAT).

Guideline Premium and Corridor Test (GPT) Implementation

The GPT method is used when the policyholder wants to pay the maximum amount of premiums while maintaining a variable death benefit or wants to maximize the amount of cash that they can accumulate in the policy more so than maximizing the death benefit. Rather than focusing on the death benefit available at life expectancy, the GPT is used when the policyholder wants to maximize the cash accumulation portion with benefits at a later age.

Insurance policies can grow in value on a tax-deferred basis, with death benefits being exempt from income tax or capital gains tax. Being able to pass the GPT is incredibly important to a policyholder as well as the insurer. If an insurance product fails to pass the test, it is no longer considered an insurance product and is thus taxed like an investment, meaning that failing to pass the test will lead to a higher tax rate.

In addition to the guided premium and corridor test, an insurer has the option of designing a policy so that it passes the cash value accumulation test (CVAT). The CVAT limits the cash value relative to the death benefit, unlike the GPT, which limits the premiums relative to the death benefit. Determining which test to use is based on which insurance product is chosen.

The insurer must indicate which test is going to be used on the issue date, and once the policy is issued, the insurer cannot decide to use the other test option instead. The choice of test can determine what the policy premiums, cash value, and benefits will be.

Guideline Premium and Corridor Test (GPT) and the Deficit Reduction Act (DEFRA).

As universal life insurance policies have an investment aspect through cash accumulation with interest earned on the cash reserves, they started being regarded as investment vehicles with cash surrender values. The IRS believed it was important to differentiate between life insurance policies that were being used as traditional insurance or as investment vehicles, so they established the Deficit Reduction Act of 1984 (DEFRA).

DEFRA established the qualifications that universal life insurance policies must meet to maintain advantaged tax status under the Internal Revenue Code (IRC) Section 7702. To fulfill the IRC definition of life insurance, life insurance contracts must provide for a sufficient “amount at risk”, meaning that the pure death benefit protection that a beneficiary would receive upon the death of the insured is adequate.