Journal of Financial Planning: October 2016
David M. Cordell, Ph.D., CFA, CFP®, CLU®, is director of finance programs at the University of Texas at Dallas.
Thomas P. Langdon, J.D., LL.M., CFA, CFP®, is a professor of business law at Roger Williams University in Bristol, Rhode Island.
Earlier this year, President Obama presented his 2017 budget proposal to Congress. Commonly known as the “Green Book,” the budget proposal includes a number of measures that appear to be loophole closers designed to raise revenue for the federal government. As in prior years, the Green Book includes several provisions that affect insurance companies and consumers.
These proposals have received little attention in the popular press, probably due to the likelihood that Congress will not take them up this year, when the presidency, the entire House of Representatives, and a third of the Senate are up for grabs. They do, however, give insight into what may be on the horizon once the new Congress is seated in January 2017. Planners should be aware of these proposals and the potential impact they may have on clients.
Small Business Owners and the Transfer-for-Value Rule
One proposal that could affect consumers of life insurance involves a change to the transfer-for-value rule. One of the benefits purchasers of life insurance receive is the ability to transfer the death benefit on the policy to the named beneficiary free of federal income tax. The income-tax-free nature of the death benefit was designed to encourage life insurance ownership so that the insured’s survivors would be financially provided for, reducing their need to apply for public assistance. A major exception to this tax treatment occurs when a policy is sold for valuable consideration. Upon the sale of a policy, the transfer-for-value rule is invoked, and the death benefit received by the beneficiary is subject to income tax to the extent it exceeds the owner’s basis in the policy.
The transfer-for-value rule itself has exceptions, which, if met, restore the income-tax-free nature of the death benefit. Some of these exceptions have specific application to business owners who may want to sell a life insurance policy that is no longer needed for personal purposes (such as paying off a mortgage, sending children to college, or providing an income stream for the insured’s spouse and family in the event of an early death) to their business to fund an entity buy-sell agreement taking effect at their death. Under current law, insurance policies that are sold to a corporation in which the insured is a shareholder, or to a partnership in which the insured is a partner, are exempt from the transfer-for-value rule; consequently, the full tax-free death benefit can be used to fund an entity-redemption buy-sell agreement at the owner’s death.
To close this so-called loophole and to prevent some life insurance death benefit from escaping income taxation when sold to a business entity, the Green Book proposal would eliminate these exceptions to the transfer-for-value rule, unless the insured is at least a 20 percent owner of the business. This proposal denies an income-tax-free life insurance death benefit to small business owners attempting to engage in succession planning for the business, unless the owner/insured has a substantial ownership interest in the entity. Estate planning for small business owners with less than a 20 percent ownership in the entity will become much more difficult, and costly, as a result of this proposal.
The reputed purpose of imposing this new requirement for application of the transfer-for-value rule is to crack down on life settlements, where insurance policies are sold to third parties (viatical settlement providers), who, prior to the sale of the policy, create a partnership in which the insured has a very small ownership percentage (such as 0.1 percent). Because the viatical settlement provider and the insured are partners, the sale of the policy would not trigger the imposition of the transfer-for-value rule, and the government would not be able to impose a tax on the death benefit in excess of basis. While this application of the rule change would discourage a perceived abuse, it may be overbroad in its application, thus imposing obstacles on legitimate business succession planning for business owners.
New reporting requirements would be imposed to alert the government of a sale of a life insurance policy so it could impose an income tax on the death benefit, which would require the disclosure of policy information upon the sale of a life insurance policy with a death benefit exceeding $500,000 to the insurance company that issued the policy, the seller of the policy, and the IRS. The disclosure would need to include: the buyer’s and seller’s tax identification numbers, the purchase price of the policy, the company issuing the policy, and the policy number. After the insured dies, the insurance company that issued the policy would be required to report to the IRS an estimate of the cost basis for the policy, the policy death benefit, and the buyer’s tax identification number.
Private Placement Insurance and Separate Accounts
Over the past decade or so, life insurance companies have been expanding their product offerings to make them more attractive to taxpayers, particularly high net worth individuals with unique needs. The income-tax-free accumulation of funds inside a life insurance policy is particularly attractive to the wealthy, but if the policy owner has little control over how the funds in the policy are invested, some of the allure of life insurance vanishes. Some insurance companies now negotiate custom-tailored life insurance contracts with wealthy individuals that give the insured an ability to control policy costs and have more discretion on how premium dollars are invested. This design approach is accomplished by using private separate accounts.
Private separate accounts afford the policy owner much more discretion over the investments that can be purchased inside the policy, which may include private equity and derivative investments in addition to the more traditional public equities, mutual funds, and bonds typically associated with traditional cash-value life insurance policies. By itself, the use of separate accounts does not eliminate the tax-free accumulation of funds inside the policy, provided that the owner of the policy does not retain sufficient control over investments to be treated as the owner of those investments. However, if the policy owner is deemed to own the assets in the separate account, what should have been tax-free growth inside the policy will become taxable.
The popularity of private placement life insurance policies among the wealthy has caught the attention of the IRS and the president. To ensure that owners of private placement policies do not have sufficient control over the underlying assets to be deemed the owner of those assets, the budget proposal suggests new reporting requirements that would permit the IRS to increase enforcement of these provisions. Life insurance companies would be required to report to the IRS information on each contract they have issued with a 10 percent or greater investment in a private separate account for any portion of the taxable year. Private separate accounts covered by the reporting requirement would include any account in which a related group of persons owns policies where the aggregate cash value represents 10 percent of the value of the separate account.
The Green Book proposal would require reporting of: the policy number, the portion of the value that was invested in private separate accounts, the policyholder’s name and tax identification number, the amount of accumulated untaxed income, and the total contract account value. If adopted, the proposal would be effective for private separate accounts maintained on or after December 31, 2016.
Ostensibly, this provision would merely provide information to the IRS to help it enforce compliance with what then would be existing law. To the extent that the IRS begins to examine these arrangements aggressively, it is likely that minimal additional tax revenue would be raised, because insurance companies and taxpayers would most likely comply with the law. However, this provision could increase the insurance company’s and taxpayer’s cost (in time and dollars) of using private placement insurance arrangements, possibly discouraging the use of an effective life insurance technique.
Other Proposals Affecting Insurance Companies
The budget proposals also specify several provisions affecting insurance companies, including: a modification of the proration rules for life insurance company general and separate accounts; disallowing deductions for “excess non-taxed reinsurance premiums paid to affiliates;” the imposition of a “financial fee” that is designed to “reduce the incentive for large financial institutions to leverage, reducing the cost of externalities arising from financial firm default as a result of high leverage;” and the imposition of “reverse FACTA” (Foreign Account Tax Compliance Act) reporting obligations on companies that issue insurance policies to foreign persons. All of these proposals would increase either tax or regulatory burdens for insurance companies, which could be passed on to consumers in the form of increased insurance premiums in the future.
Time Will Tell
These proposals could have a significant impact on clients engaging in legitimate business and estate planning.
Practitioners with knowledge of the proposed changes and practical planning experience with clients may be able to offer insight to policymakers so that government objectives can be achieved with minimal impact on client planning options. This may be particularly important during a period of administrative change, where new priorities will be set by newly elected government officials.