Updated: Feb 26, 2020
Disclaimer: This summary is not intended to constitute tax or legal advice.
Publication Date: October 31, 2019
The Tax Cuts and Jobs Act of 2017 (the “TCJA”) modified the prior-law exceptions of the Transfer for Value rules (“TFV Rules”) to include a new reportable policy sale requirement that is applicable to all transfers for valuable consideration. In March, Treasury and the IRS proposed regulations detailing how this new provision interacts with existing TFV Rules. This rulemaking has important implications for the company-owned life insurance (“COLI”) and bank-owned life insurance (“BOLI”) marketplaces and will affect the taxation of death beneits on some contracts.
For readers unfamiliar with the TFV Rules, the tax code generally excludes the value of death benefits from taxable income. However, when insurance contracts are transferred or assigned in exchange for valuable consideration, the TFV Rules apply and limit the portion of the death benefit that is excludable for tax purposes. Unless an exception applies, under the TFV Rules the tax-free death benefit of a transferred life insurance policy may not exceed the sum of the consideration paid in exchange for the transferee to obtain the contract and the unpaid premiums which will now be paid by the transferee.
Prior to the TCJA, two critical exemptions to the TFV Rules excluded certain transactions involving life insurance contracts. Critically, these two exemptions generally shielded COLI/BOLI policies acquired during ordinary-course mergers and acquisitions (“Ordinary Course Transactions”) from the TFV Rules’ tax burden.
The TCJA altered the framework for determining the amount of death benefits generally excluded from gross income, thereby potentially impacting the COLI/BOLI marketplace. The TCJA now requires a determination that the transaction is not a reportable policy sale before deciding whether the transaction falls under existing exemptions to avoid TFV Rules’ tax liability.
On Thursday, October 31, the Treasury Department finalized these rules (the “RPS Final Rule”) and published the regulations in the Federal Register. The RPS Final Rule became effective on October 31, 2019. However, taxpayers may choose to apply all of the rules retroactively to December 31, 2017 when the TCJA changes took effect.
The purpose of this memorandum is to review the outcome of the recently adopted RPS Final Rule with respect to reportable policy sales occurring between companies engaged in Ordinary Course Transactions that include COLI/BOLI assets. In addition, the conclusion will offer a retrospective review of the improvements since the TCJA was enacted.
General Rules – Transfers for Value & Reportable Policy Sales
Before diving into the changes brought about by the TCJA and the RPS Final Rule, it is first important to understand the existing TFV Rules. It is critical to understand that neither the TCJA, nor the RPS Final Rule alter the TFV Regulations described below. Rather, the changes to the tax code introduced by the TCJA add an additional layer of analysis.
As stated above, section 101(a) of the Internal Revenue Code generally excludes life insurance death benefits from income. However, where a life insurance policy is transferred in exchange for valuable consideration, the policy then may be subject to the TFV Rules which limit the excludable portion of the death benefits to the consideration paid for the policy plus any subsequent premiums paid with respect to the policy.
The statutory TFV Rules have two important exceptions known as the “Carryover Basis Exception” and the “Transfer-to-Insured Exception.” Thereby, the TFV Rules apply for any transfer or assignment of a life insurance policy except where: (a) “such contract or interest therein has a basis for determining gain or loss in the hands of a transferee determined in whole or in part by reference to such basis of such contract or interest therein in the hands of the transferor” (the “Carryover Basis Exception”) or (b) “such transfer is to the insured, to a partner of the insured, to a partnership in which the insured is a partner, or to a corporation in which the insured is a shareholder or officer” (“Transfer-to-Insured Exception”).
Neither the statutory reportable policy sale provision nor the RPS Final Rule change the TFV Rule described above. In fact, the RPS Final Rule confirms the statute by specifically providing that in order for the death benefits paid with respect to a transferred life insurance policy to be fully excludable from income (1) the policy must not have been transferred in a reportable policy sale and (2) either the Carryover Basis Exception or the Transfer-to-Insured Exception must apply. Thus, the reportable policy sale exceptions discussed below do not expand the universe of life insurance policy transfers that result in policies whose death benefits are fully excludable.
Under the statutory changes enacted by the TCJA, a life insurance policy has been transferred pursuant to a reportable policy sale if (1) there is a direct or indirect a transfer of life insurance and (2) the acquirer of the life insurance does not have a “substantial family, business, or financial relationship with the insured apart from the acquirer’s interest in such life insurance contract.” If either of these conditions are not met then the transfer is not treated as a reportable policy sale and the Carryover Basis Exception or Transfer-to-Insured Exception to the TFV Rules still apply as before (if assuming such exceptions are otherwise applicable).
As will be demonstrated below, this general rule is essential to understand the effect of the Proposal (defined hereafter) on Ordinary Course Transactions.
NOTE: Satisfying any of the exceptions described below will generally be sufficient to preserve the prior-law tax treatment of the death benefits. The only exception that is special to C corporations is the first. All the other exceptions apply irrespective of the business form of the entities in question. Practitioners reviewing these exceptions with clients in specific situations should especially consider the application of exceptions 1, 7, 8 and 9(c).
Exceptions from Being Considered a Reportable Policy Sale
1. Certain Ordinary Course Transactions involving C Corporations. This exception provides that there is no “indirect transfer” of life insurance where (a) the acquirer becomes a beneficial owner of a C corporation that owns life insurance contracts and (b) life insurance contracts do not comprise more than 50 percent of the gross value of assets of such C corporation immediately before the acquisition.
As explained above, without a “direct” or “indirect” transfer of a life insurance contract there can be no reportable policy sale—even if an Ordinary Course Transaction is involved.
Thus, for example, where shares in a C corporation that owns life insurance are acquired by another person there is no indirect transfer of life insurance (and thereby no reportable policy sale) so long as the gross value of the life insurance owned by the C corporation does not exceed 50 percent of the C corporation’s gross assets. The RPS Proposal’s use of “gross value” in this test is particularly helpful in the case of Ordinary Course Transactions because it means that otherwise insolvent C corporations (i.e., where the fair market value of the C corporation is below zero) can be sold without automatically giving rise to a reportable policy sale.
Additionally, the RPS Final Rule confirmed that tax-free asset reorganizations and taxable asset transactions do not qualify for the C corporation exemption, thereby creating disparate treatment between life insurance policies transferred through stock transfers and those transferred through asset purchases. Put simply, Treasury acknowledged that the exemption only applies to stock-transfers and confirmed that asset acquisitions will not qualify.
In addition to the carveout for most indirect transactions involving C corporations, the RPS Final Rule contains a number of exceptions that apply regardless of the type of entity that owns the life insurance. They are –
2. De Minimis Acquisition. This exception is for de minimis acquisitions of any entity that owns life insurance. It applies where (a) not more than 50 percent of the gross value of the entity’s assets are life insurance contracts and (b) the acquirer (and any family members, if the acquirer is a natural person) own 5 percent or less of the entity (as measured after the acquisition). In such a case, there is no reportable policy sale.
3. Same Beneficial Owners. Another transactional exception to reportable policy sale status is for transfers of interests in life insurance contracts between entities with the same beneficial owners. This exception applies where the ownership interest of each beneficial owner in the transferor entity does not vary by more 20 percent from that person’s ownership interest in the transferee entity. For these purposes, transitory transfers are ignored—only the interest in the first and last entity that holds the insurance are examined.
4. Consolidated entities. A further exception to reportable policy sale status applies to transfers of life insurance contracts between entities that are consolidated for tax purposes.
5. Indirect Acquisitions. The RPS Final Rule includes an exception for indirect acquisitions of any entity that owns an interest in a life insurance contract and which acquired the interest in the life insurance contract before January 1, 2019. This exemption is critically important for Ordinary Course Transactions involving holding companies that own operating companies which hold COLI/BOLI policies. In instances where an acquiror purchases a holding company owning a subsidiary holding an interest in life insurance, the exemption will apply, so long as the subsidiary acquired its interest in the life insurance policy prior to January 1, 2019. This exemption could prove useful for Ordinary Course Transactions involving banks structured as S corporations which are owned by bank holding companies.
Exceptions based on the Definition of a Substantial Relationship
Other universally applicable carveouts from reportable policy sale status do not depend on the existence of specific transaction types but are related to the determination of whether a substantial “financial” or “business” relationship exists between the acquirer and the insured.
6. Substantial Relationship Rules Generally. The RPS Final Rule includes a helpful rule to establish whether an acquiring entity has a substantial relationship with the insured. The rule specifies that an entity will have a substantial relationship with the insured so long as every “beneficial owner” of the entity has a substantial relationship with the insured; however, these relationships do not need to be all the same type of substantial relationship. Therefore, the entity will be deemed to have a substantial relationship so long as each of the “beneficial owners” have a substantial relationship which they can establish by identifying either some type of substantial familial, business, or financial that the particular owner has with the insured. As an example, a partnership with three partners would itself have a “substantial relationship” with the insured where one partner has a substantial familial relationship with the insured, one partner has a substantial business relationship with the insured, and one partner has a substantial financial relationship with the insured.
7. Special Rule for Indirect Acquisitions of Life Insurance. In applying the substantial relationship tests, an acquirer in an indirect acquisition is deemed to have a substantial business or financial relationship with the insured so long as the acquired entity has a substantial business or financial relationship with the insured both immediately before and immediately after the acquisition. This is a very helpful rule in the case of Ordinary Course Transactions because it “counts” a substantial relationship that exists with respect to either the acquirer or the acquired entity.
8. A Substantial Business Relationship Exists:
a. Where the insured is a “key person” of the acquired business or “materially participates” in the acquired business, and the acquirer/acquiree directly/indirectly owns at least 80 percent of the acquired business.