May 11, 2009

Obama Administration Calls For More Tax on Life Insurance

The White House Monday afternoon announced another $59 billion in tax increases to help pay for its health insurance proposals. Three proposed changes affecting life insurance policies popped out at us.

Treasury’s Office of Tax Policy summarizes the tax increases in the “2009 Green Book”, its General Explanations of the Administration’s Fiscal Year 2010 Revenue Proposals. As we find other interesting tidbits, we’ll let you know.

Taxing Sales of Life Insurance Policies

This would, the administration says, raise $812 million in the next decade, two-thirds of that in the second half .

Current Law

The seller of a life insurance policy generally is taxed on the amount received minus the policy’s adjusted basis. Exceptions exist if the buyer is a viatical settlement provider and the insured is terminally or chronically ill.

Under the transfer-for-value rule, the buyer of an existing policy pays tax on the death benefit received (reduced by what he paid for the policy and premiums paid after buying it). There are several exceptions to that rule.

Businesses must report payments over $600 of premiums, compensations, remunerations, other fixed or determinable gains, profits and income, or certain other types of payments. There are some exceptions involving the purchase of a life insurance contract.

Reasons for the Change

Recent years have seen a significant increase in the number and size of life settlement transactions where individuals sell policies to investors. A lack of information reporting makes compliance difficult. Investors use the exceptions to the transfer-for-value rule to structure a sale to avoid paying tax on the profit when the insured dies.

Proposal

This change affects only policies with a death benefit of $1 or more. The buyer of such a policy must report certain information to the IRS, the insurance company and the seller. That information includes the purchase price, the buyer’s and seller’s taxpayer identification numbers, the name of the company that issued the policy and policy number.

The transfer-for-value rule exceptions will longer apply to buyers of policies. Insurance companies must report the gross death benefit payment, the buyer’s TIN, and the insurance company’s estimate of the buyer’s basis to the IRS and to the payee.

This change would apply to sales or assignment of interests in life insurance policies and payments of death benefits for taxable years beginning after December 31, 2010.

Expand Pro Rata Interest Expense Disallowance For Corporate-Owned Life Insurance (COLI)

Treasury thinks this would raise $8.5 billion in the next decade, 60% in the last half.

Current Law

In general, there is no tax on the inside buildup of life insurance policies and of gains in annuity contracts owned by natural persons. There is also no income tax on life insurance death benefits.

Unless you are a business and a life policy insured a key person, you generally can’t deduct interest on policy loans. Even then, you may deduct interest only to the extent you can trace the debt to a life insurance, endowment or annuity contract. A key person includes a 20-percent owner of the business, as well as a limited number of the business’ officers or employees.

Businesses (other an insurance company) must reduce interest deductions to the extent the interest is allocable to unborrowed policy cash values. That is based on a statutory formula. There is an exception for policies on officers, directors, employees, or 20-percent owners of the taxpayer. Special proration rules require adjustments to prevent or limit funding tax-deductible reserve increases with tax preferred income. This includes earnings credited under life insurance, endowment and annuity contracts that would be subject to the pro rata interest disallowance rule if owned by a non-insurance company.

Reasons for the Change

Leveraged business can fund deductible interest expenses with tax-exempt or tax-deferred income credited under life insurance, endowment or annuity contracts insuring certain types of individuals. For example, these businesses often invest in investment-oriented insurance policies covering the lives of their employees, officers, directors or owners. These entities generally do not take out secured policy loans or loans that are otherwise traceable to the insurance contracts. Instead, they borrow from depositors or other lenders, or issue bonds. Similar tax arbitrage benefits result when insurance companies invest in certain insurance contracts that cover the lives of their employees, officers, directors or 20-percent shareholders and fund deductible reserves with tax-exempt or tax-deferred income.

Proposal

The proposal would repeal the exception from the pro rata interest expense disallowance rule for contracts covering employees, officers or directors, other than 20-percent owners of a business that is the owner or beneficiary of the contracts.

It would apply to contracts entered into after the date of enactment.

Require Information Reporting For Private Separate Accounts Of Life Insurance Companies

There is no projection of income from this change.

Current Law

Earnings from direct investment in securities generally are taxable income to the holder. However, those same investments held in a separate account of a life insurance company are tax-free or tax-deferred. This favorable tax treatment is not available if the policyholder, rather than the insurance company, is treated as the owner of those investments.

Reasons for the Change

Sometimes, taxpayers use private separate accounts to avoid tax that would be due if they held the assets directly. Better reporting will help the IRS to ensure that income is properly reported. It will also help the IRS more easily identify variable insurance contracts it should ignore under the investor control doctrine.

Proposal

Life insurance companies would have to provide information to the IRS about contracts invested in a private separate account any time during a taxable year. Information reported would include the policyholder’s taxpayer identification number, the policy number, the accumulated untaxed income, the total contract account value, and the portion of that value invested in one or more private separate accounts. A private separate account would be defined as any account with respect to which a related group of persons owned policies whose cash values, in the aggregate, represented at least 10 percent of the value of the separate account.

The proposal would be effective for taxable years beginning after December 31, 2010.

Walt