Subject: Larry Brody - The Life Insurance Provisions in the Tax Cuts and Jobs Act and the Indirect Effect of the Act on Life Insurance Planning The Tax Cuts and Jobs Act contains three provisions relating to the taxation of transactions involving life insurance policies. The three provisions are as follows: (1) A reporting requirement for life settlement transactions, creating new Code Section 6050Y; (2) clarification of the income tax basis of life insurance policies sold in the life settlement market, amending Section 1016 of the Code; and (3) an exception to the transfer for valuable consideration rules for sales in the life settlement market, amending Section 101 of the Code. In addition, there are several provisions in the Act which would indirectly affect split-dollar planning, both for existing arrangements and for arrangements entered into after January 1, 2018, the Act s effective date. The House and Senate recently passed the Tax Cuts and Jobs Act, and the bill is headed to the President s desk for signature. While the bill does many things, it impacts life insurance in two important ways, and long-time LISI contributor Larry Body provides members with his commentary on exactly how the bill does that. Lawrence Brody is a Partner of Bryan Cave LLP, an international law firm, resident in the St. Louis office. He is a member of its Private Client Service Group and its Technology, Entrepreneurial & Commercial Practice Client Service Group. He has been an Adjunct Professor at Washington University School of Law since 1968, teaching Estate Planning and Drafting, a visiting Adjunct Professor at the University of Miami Law School, teaching a course on Life Insurance, and is the author or co-author of numerous articles and books on the use of life insurance in estate and employee benefit planning, including two BNA Tax Management Portfolios,
two books for the National Underwriter Company, and a number of volumes in the ABA Insurance Counselor Series. Here is his commentary: EXECUTIVE SUMMARY: The Tax Cuts and Jobs Act contains three provisions relating to the taxation of life insurance policies. The three provisions are as follows: (1) A reporting requirement for life settlement transactions, creating new Code Section 6050Y; (2) clarification of the income tax basis of life insurance policies sold in the life settlement market, amending Section 1016 of the Code; and (3) an exception to the transfer for valuable consideration rules for sales in the life settlement market, amending Section 101 of the Code. FACTS: Any reportable policy sale as defined in amended Code Section 101(a)(3)(B) requires the policy acquirer to report to the IRS and all of the parties to the transaction information about the transaction, including the seller s investment in the contract, and also requires the insurance company which issued the policy to report the seller s basis in the policy sold and the payment of a reportable death benefit, effective for sales after December 31, 2017. A new subsection (3) is added to subsection (a) of Section 101, providing the definition of a reportable policy sale. That definition is the acquisition of an interest in a policy directly or indirectly if the acquirer has no substantial family, business or financial relationship with the insured apart from the acquirer s interest in such insurance contract apparently, a new Federal tax definition of insurable interest. The Act also deletes subparagraph (A) of paragraph (1) of Code Section 1016(a), by adding a new subsection (A), which provides that basis in a life insurance or an annuity contract is not reduced by any mortality, expense or any other reasonable charges incurred under such a contract, effectively overruling that portion of Revenue Ruling 2009-13 which required at least in a life settlement transaction the reduction of the seller s income tax basis in the policy by mortality charges incurred. This provision applies to transactions entered into after August 25, 2009, the effective date of Revenue Ruling 2009-13.
Finally, the Act further amends Code Section 101(a), by providing that paragraph (2) of that Section will not apply in the case of a transfer of a life insurance contract or any interest in a contract which is a reportable policy sale (as defined in subparagraph (B)), effective for transfers after December 31, 2017. The effect of deleting the second sentence of Section 101(a)(2), with respect to the transfer of a policy in a reportable policy sale, would mean that none of the exceptions to the transfer for value rule would be applicable to such a sale. COMMENT: Revenue Ruling 2009-13 and the companion Ruling 2009-14, spelled out, for the first time, the IRS s view how to calculate the amount realized and the character of that amount on the sale of a life insurance policy in the life settlement market. With regard to the character of gain on a sale of a policy in the life settlement market, the Ruling held that, while a life insurance policy was a capital asset and the sale in the life settlement market provided the required sale or exchange, not all of the gain on the sale of a policy with cash value, would be treated as a capital gain. Instead, the Ruling held that gain above basis, up to cash surrender value, would be treated as ordinary income on the sale, under the so-called substitution of income theory, which generally holds that gain on the sale of a capital asset is nonetheless treated as ordinary income to the extent it represents substitution for an ordinary income asset, in this case, policy cash values. Any gain above cash surrender value would be capital. In addition, the Ruling held that a policy owner s basis on the sale of a policy in the life settlement market had to be reduced by the cost of current life insurance protection the policy owner enjoyed while he or she owned the policy, without defining how to determine that cost of insurance. Finally, the Ruling held that the purchaser of a life insurance policy in the life settlement market could not rely on any exceptions provided in Section 101(a)(2) of the Code to avoid the application the transfer for value rule on collection of the policy death proceeds. This provision of the Act directly reverses that portion of the holding in Revenue Ruling 2009-13 which, as noted above, required a reduction in the basis in the policy sold by the cost of insurance, but codified that portion of the Ruling that held that the purchaser in a life settlement sale
could not rely on any exceptions to the transfer for value rule when the policy proceeds were collected. Provisions of the Tax Act Indirectly Affecting Life Insurance Planning In addition to the effects the increased transfer tax exemptions in the Act will have on the need for both some existing and new policies, there are several provisions in the Act which would indirectly affect split-dollar planning, both for existing arrangements and for arrangements entered into after the Act s effective date. In the first place, the bill doubles the Federal transfer tax exemptions (gift, estate, and generation-skipping) as indexed, beginning in 2018 through 2024. While there are many possible uses clients and their advisors will consider for those increased exemptions, one that shouldn t be overlooked is the possibility of using the increased gift and generation-skipping tax exemptions to either wholly or partially terminate existing split-dollar arrangements (whether economic benefit or loan regime) by repaying the premium provider. The overriding concern split-dollar arrangements address in a transfer tax planning scenario (where the policy is owned by a third-party such as an irrevocable life insurance trust) is to reduce (or in some cases even eliminate) the tax consequences of funding substantial premiums on policies owned by such trusts. The use of an economic benefit regime splitdollar arrangement reduces the gift and generation-skipping transfer tax cost of funding policy premiums from the whole premium to the economic benefit conferred on the trust each year. In a loan regime split-dollar arrangement, the transfer tax consequences of funding the trust are either reduced from the full premium to the interest that would have to be contributed to the trust to allow it to pay interest to the lender or to eliminate the transfer tax consequences of funding the trust where interest is accrued at the Applicable Federal Rate. Both arrangements get increasingly expensive over time and accordingly, the best planning for such arrangements involves finding ways to terminate them as early as possible. The use of the increased gift and generationskipping exemptions provided by the Act in 2018 would allow many such arrangements to be terminated during the insured s lifetime. The insured could transfer cash or other property to the trust which owns the policy to totally or partially repay the amounts due the premium provider, or even
more simply, have the premium provider forgive all or some part of the split-dollar receivable or note, in either case using the increased exemptions to avoid current gift or generation-skipping implications. Secondly, the Act dramatically reduces the Federal income tax rate on C Corporations and pass-through entities. That reduction will indirectly make it less expensive for corporate or pass-through entities to utilize employment-related split-dollar arrangements (again, either economic benefit or loan regime) to fund life insurance premiums for policies owned by employees or trusts created by them. That is because the economic benefit premium advance or the loan regime loan is not deductible (so lowering the entity s income tax rate makes them or any other nondeductible item less expensive) and any reimbursement of the economic benefit cost or payment or accrual of interest on the note will be taxed at a lower rate. HOPE THIS HELPS YOU HELP OTHERS MAKE A POSITIVE DIFFERENCE! Larry Brody CITE AS: LISI Income Tax Planning Newsletter #122 (December 21, 2017) at http://www.leimbergservices.com Copyright 2017 Leimberg Information Services, Inc. (LISI). Reproduction in Any Form or Forwarding to Any Person Prohibited Without Express Permission.