Proposed life insurance policy transfer rules would rationalize and relax existing tax rules

Congress enacted rules imposing tax and adding reporting requirements for certain life insurance policy transfers in 2017. Those rules require buyers of life insurance contracts in many situations to pay tax on the death benefits paid out under the contracts. They also require Form 1099 filings with regard to insurance policy transfers classified as “reportable policy sales.” The IRS has now proposed new regulations that would rationalize and relax those rules. 

Key takeaways

• The proposed regulations address tax-free life insurance policy exchanges: 
  If death benefits on the exchanged policy would qualify for tax exemption, a tax-free exchange for a new policy would ordinarily not be reportable.
  However, where a life insurance contract acquired in a reportable policy sale is exchanged for a new policy in a tax-free transaction, the exchange would be classified as a reportable policy sale.
• Rules for tax-free acquisitions of corporations having corporate-owned life insurance would be relaxed if the value of the insurance policy represents a small enough portion of the transaction value.
• The proposed regulations generally would be effective when finalized. Taxpayers have multiple options to start applying the proposal at an earlier date. In some cases, taxpayers may apply the proposed regulations to all tax years beginning after Dec. 31, 2017.

Background

Death benefits under a life insurance policy generally are exempt from federal income tax. On the other hand, if the life insurance policy was acquired by a person without a substantial family, business or financial relationship with the insured (apart from the interest in the life insurance contract), that person will be taxed on the receipt of death benefits after the insured dies.

This sort of policy acquisition is called a “reportable policy sale” under rules Congress enacted in 2017. Acquirers and issuers of life insurance contracts are required to send reportable policy sale information to the IRS (generally on Form 1099-LS (for policy acquirers) or Form 1099-SB (for policy issuers)).

Tax-free life insurance policy exchanges

The rules requiring these tax and reporting results have not always fit smoothly with some long-standing sets of rules providing certain transactions with tax-free treatment. One of these sets of rules provides tax-free treatment to certain exchanges of life insurance policies (Section 1035 Exchanges), allowing taxpayers to exchange their old insurance policies for new ones better suited to their needs without triggering income tax.

Final regulations issued in 2019, while not intended to classify Section 1035 Exchanges as reportable policy sales, did have that result in some circumstances. The new proposed regulations are designed to correct this unintended result. The proposal would exclude issuances of new life insurance policies from the category of reportable policy sales.

For situations where a taxpayer acquires a policy in a reportable policy sale and then exchanges it for a new policy in a Section 1035 Exchange, the proposed regulations set out a method for calculating the portion of the new policy’s death benefits that are taxable to the policy owner. The proposal includes corresponding amendments to the Form 1099 reporting requirements.

Corporate acquisitions  

Under another set of long-standing rules, one corporation can acquire another in a merger (or other transaction) qualifying as a tax-free reorganization. A concern arising under the reportable policy sale rules is that an acquisition of a target corporation having corporate-owned life insurance policies would have the undesirable result that the acquirer would be taxed on receipt of death benefits. The banking industry has been particularly concerned on this point due to the prevalence of bank-owned life insurance (BOLI).

The 2019 final regulations prevented this undesirable result for acquisitions of corporations having life insurance contracts with value of 50% or less of their total gross asset value. However, they did not provide protection to acquisitions made via a tax-free asset acquisition.

Tax-free asset acquisitions are commonly used in connection with bank acquisitions, typically by merging the target bank into the acquiring bank (often following an initial stock acquisition step). One reason is that merging the two banks generally permits avoiding the costs associated with maintaining two bank charters (licenses) in the U.S.

The new proposed regulations would exclude these bank mergers (and other tax-free corporate asset acquisitions) from reportable policy sale classification if certain requirements are met. Among these requirements, the target corporation and the acquirer each: (1) must not have more than 5% of their gross asset value consisting of life insurance contracts, and (2) must not operate a trade or business of investing in life insurance contracts. Under these proposed rules, banks (or other corporations) owning life insurance policies having a value greater than 5% of their gross asset value that are participating in acquisitions would remain concerned with loss of the tax exemption for life insurance proceeds.

Questions?

Please reach out to your Baker Tilly advisor if you have questions or would like to discuss how these proposed regulations may affect you.

The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.