Life Insurance: The Reportable Policy Sale Tax Trap

Take-Away: The 2017 Tax Act provided new rules on who, when and how to report a sale of a life insurance policy. Less obvious is that these new rules can make part of the death benefit paid under a life insurance policy taxable when under the prior tax laws the death benefit paid would have been income tax-free.

Background: What follows is a short summary of what was covered in a missive a couple of weeks ago with regard to the transfer-for-value rules associated with life insurance. Those rules, or more accurately the exceptions to those rules, is what is changed by the 2017 Tax Act’s reportable policy sale rules. The basic rules of taxation of life insurance death benefits, previously summarized, follow:

Life insurance death benefits received by the policy’s beneficiaries are normally income tax-free. [IRC 101)(a).]

If an individual transfers an interest in the policy of life insurance for valuable consideration, a transfer-for-value, or now as part of, or following, a reportable policy sale, the owner of the policy will be subject to income tax on some, or all, of the death benefit, unless a statutory exception applies. [IRC 101(a)(2).]

The amount of the death benefit that is subject to income taxation is the excess of the death benefit paid over the amount actually paid for the interest in the life insurance policy, plus any premiums and other amounts paid by the policy transferee following the policy’s transfer. An example of ‘other amounts’ would be interest paid or accrued by the transferee on indebtedness with respect to the acquired policy.

Example: Allen pays a premium of $500 for a life insurance policy with a face death benefit of $1,000 on the life of Beth. Allen subsequently transfers the policy on Beth’s life to Charlie for $600. Charlie receives the death benefit of $1,000 on Beth’s death. The amount that Charlie can exclude from his gross income upon receipt of the death benefit is limited to $600 plus any premiums that Charlie paid on the policy after he acquired the policy.

The transfer-for-value rule applies to both whole-life and term life insurance policies.

There are several statutory exceptions to the transfer-for-value rule that we covered a couple of weeks ago. The death benefit paid will not be subject to income taxation, even in the case of a transfer of the policy for value, if the transfer of the policy is to: (i) the insured under the life insurance policy; (ii) a partner of the insured; (iii) a partnership in which the insured is a partner; or (iv) a corporation in which the insured is a shareholder or officer. [IRC 101(a)(2)(A) and (B).]

The death benefit paid under a transferred life insurance policy is also not subject to income taxation if the transferee’s basis in the transferred policy is determined, in whole or in part, by the transferor’s basis in the policy, often called the carryover basis exception. Thus, the gift of a life insurance policy would result in a carryover basis of the owner’s tax basis in the policy to the new owner, resulting in no income taxation of the policy’s death benefit. When a life insurance policy is transferred by gift, the amount of proceeds excluded from income is equal to the amount that would have been excluded by the transferor had the transferred not occurred.

Example: Alex is employed by BigCo, Inc. BigCo acquires a life insurance policy on Alex’s life and pays a $500 premium. The life insurance policy has a face death benefit of $1,000. BigCo transfers the policy to CapCom, Inc. in a tax-free corporate reorganization. The policy will have a tax basis to determine gain or loss in the hands of CapCom the same as it had when the policy was owned by BigCo. CapCom receives the $1,000 death benefit on Alex’s death. The entire $1,000 is excluded from CapCom’s gross income in the year of its receipt. [Treasury Regulation 1.101-1(b)(1)(ii)(A).]
Example: Alex is employed by BigCo, Inc. BigCo acquires a life insurance policy on Alex’s life and pays a $500 premium. The life insurance policy has a face death benefit of $1,000. Prior to Alex’s death, BigCo transfers the life insurance policy to CapCom, Inc. in which Alex is a shareholder. Alex dies and CapCom receives the entire $1,000 death benefit. The entire $1,000 is excluded from CapCom’s gross income. [Treasury Regulation 1.101-1(b)(1)(ii)(B)(1).]

Change in Taxation: These general rules of taxation, or exclusion from taxation, of a life insurance policy’s death benefit, were changed with the 2017 Tax Act. Neither of the exceptions described in the two prior Examples apply if the transfer is considered a reportable policy sale. Even if a current transfer of the policy does qualify for one of the transfer-for-value exceptions, if the policy was transferred in a reportable policy sale at any time prior to the current transfer, some portion of the death benefit may still be subject to taxation. [IRC 101(a)(3).]

Reportable Policy Sale Rules: A reportable policy sale is defined generally as the acquisition of an interest in a life insurance contract, directly or indirectly, if the acquirer has no substantial family, business or financial relationship with the insured (apart from the acquirer’s interest in the life insurance policy.) When a life insurance policy is acquired as part of a reportable policy sale the portion of the death benefit that exceeds the policy owner’s tax basis in the policy will generally be subject to income tax.

Substantial Family Relationship: This exclusion includes the following relationships between the acquirer of the policy to the insured: (i) the same person; (ii) a spouse or domestic partner; (iii) a parent, grandparent, great-grandparent, or the spouse of that person; (iv) a lineal descendant of (i), (ii) or (iii) or the spouse of such lineal descendant; or (v) any lineal descendant of a person described in (iv).
Substantial Business Relationship: This exclusion is available when: (i) the insured is a ‘key person’ or who materially participates as owner, employee or contractor in an ‘active’ trade or business owned directly, or indirectly, by the acquirer and at least 80% of the business is owned directly or indirectly by the acquirer or beneficial owners of the acquirer; or (ii) the life insurance is owned by a business that is acquired by the acquirer.
Substantial Financial Relationship: This exclusion between the acquirer and the insured exists if the acquirer: (i) acquires insurance to fund the purchase at the insured’s death of the insured’s assets, liabilities or interests in common investments with the acquirer; or (ii) is a charity to which the insured has been a substantial contributor or volunteer.
Gifts of the Policy: The definition of ‘reportable policy sale’ does not actually require a ‘sale’, only its acquisition. As such, an acquisition would include a gratuitous policy transfer if the acquirer of the policy lacks one of the substantial relationships with the insured. The amount of the death benefit proceeds excluded from income with respect to a gratuitous transfer that constitutes a reportable policy sale is determined by the amount that would have been excluded by the transferor had the transfer not occurred. Accordingly, a gratuitous reportable sale would not always translate into a taxable death benefit.

Impact of the “Reportable Policy Sale’ Rules: Prior to the reportable policy sale rules many transactions should not have caused the death benefit to become taxable under IRC 101, as it would likely have satisfied the carryover basis exception if the transferee takes the same tax basis in the policy as the transferor. Under these new reportable policy sale rules, because the Regulations identify the transfer as covered, no transfer-for-value statutory exception will apply to keep the policy proceeds from being subject to income taxation.

Examples of the Application of the ‘Reportable Policy Sale’ Rules: Last fall’s Final Regulations provide some examples on how the reportable policy sale rules can change the income tax consequences to a death benefit paid under a life insurance contract. (The following examples are mine, so blame me if your head starts to spin.)

Life Policy Exchanged for Stock: Albert is the initial policyholder of a $100,000 life insurance policy on his own life. Albert contributes the policy to a C corporation, SalesCo, Inc., in exchange for stock in SalesCo. After the policy acquisition, Albert owns less than 20% of SalesCo’s outstanding stock, and Albert owns less than 20% of the combined voting power of SalesCo. Consequently, Albert is not a ‘key person’ [defined in IRC 264] with respect to SalesCo. SalesCo’s tax basis in the life insurance policy is determinable in whole or in part by reference to Albert’s basis in the policy. There is no substantial family, business or financial relationship between Albert and SalesCo. As such, Albert’s contribution of the life insurance policy to SalesCo, in exchange for his stock, is a reportable policy sale. On Albert’s death, SalesCo receives proceeds of $100,000 under the policy that it owns. The amount of death benefit that SalesCo can exclude from its gross income is limited to the actual value of the stock it exchanged for the life insurance policy, plus any premiums that SalesCo paid with respect to the policy after its acquisition. Note that the ‘shareholder or officer’ exception to the basic transfer-for-value rule does not apply because Albert’s transfer to SalesCo is a reportable policy sale. [Treasury Regulation 1.1010-1(g)(12)(Example 12).]
IRC 1035 Exchange: Alvin works for MoneyWiz, Inc. Alvin is a ‘key person’ employed by MoneyWiz. MoneyWiz acquires a life insurance policy on Alvin’s life while he is employed as a ‘key person.’ Alvin eaves MoneyWiz’s employment for a new job. Later, MoneyWiz enters into an IRC 1035 like-kind-exchange of the life insurance policy on Alvin’s life. At the time of the policy exchange, MoneyWiz had no substantial business or financial relationship with Alvin, the insured. Because MoneyWiz lacks a substantial business or financial relationship with Alvin, the insured, the replacement of the original life insurance policy will be considered a reportable policy sale. Typically there is no transfer of policy interests or ownership in an IRC 1035 exchange of policies, where one policy is replaced by another policy. However, the replacement of a policy can invoke the reportable policy sale rules if the policy owner lacks a substantial family, business or financial relationship with the insured at the time of the like-kind-exchange, because the policy owner is ‘acquiring’ a life insurance policy as a consequence of the exchange.
Insured Reacquires Policy for FMV: Annie owns a $100,000 life insurance policy on her own life. Annie later ‘sells’ the life insurance policy to Ben for $6,000, which is the policy’s fair market value at the time. Ben has no substantial family, business or financial relationship with Annie at the time of his purchase of the life insurance policy. Annie’s transfer of the life insurance policy to Ben is a reportable policy sale. Before Annie’s death, Ben sells the life insurance policy back to Annie for $8,000, again the policy’s fair market value at the time of the sale. Annie’s estate receives the $100,000 death benefit on her death. The transfer of the policy from Ben to Annie is not a reportable policy sale because Annie has a ‘substantial family relationship with the insured’, i.e. herself. Although Ben’s sale of the policy back to Annie follows a reportable policy sale, i.e. the initial sale of the policy from Annie to Ben, Annie’s estate may exclude all of the policy death benefit from gross income. [Treasury Regulation 1.101-1(g)(6).]
Insured Reacquires for less than FMV: Same fact-pattern with the Annie example just provided. However, when Annie purchases the policy back from Ben, she does not pay him the full fair market value for the policy at that time, i.e. she pays less than $8,000. In this situation some portion of the $100,000 death benefit paid to Annie’s estate will be taxable income to her estate. [ Treasury Regulation 1.101-1(g)(6).] The only way to ‘cure’ a reportable policy sale is for the insured to pay full and adequate consideration for the life insurance policy. [Treasury Regulation 1.101-1(g)(6) and (7).]

Exceptions to the Reportable Policy Sale Rules: If all of this was not already confusing enough, the Final Regulations that describe and implement that reportable policy sale rules provide several exceptions.

Transfers between entities with the same beneficial owners, but only if the ownership interests of each beneficial owner in both the transferring and transferee entities do not vary by more than 20%.
Transfers among corporations that are members of an affiliated group that files a consolidated income tax return in the year the transfer of the policy takes place.
A person acquires ownership interest in a partnership or trust or other entity (directly or indirectly) that owns a life insurance policy if the entity acquired the policy either (i) before January 1, 2019, or (ii) in a reportable policy sale and complied with the reporting requirements for such sales.
A person acquires an ownership interest in a C corporation and 50% or less of the gross value of the corporation’s assets consists of life insurance contracts immediately before the person acquires its interest.
Acquisition of a life insurance policy by an insurance company that issues life insurance contracts in an exchange per IRC 1035.
Acquisition of a life insurance policy in an IRC 1035 exchange if the policy holder has a substantial family, business, or financial relationship with the insured at the time of the exchange.
Immediately before a person acquires an interest in a partnership, a trust, or an entity owning an interest in the life insurance policy: (i) no more than 50% of the gross value of the assets held by the partnership/trust/entity consists of life insurance contracts; (ii) following the acquisition, the person acquiring the interest in the partnership/trust/entity and his or her family members own, in the aggregate, 5% or less of the voting power (S corporations) , or corpus and annual income (trusts) or capital interests and profits (partnership.)

Conclusion: In sum, what was complicated before, just got even more complicated. We start with the basic rule that the death benefit paid under a life insurance contract is normally income tax-free. [IRC 101(a).] But if the life insurance policy was purchased from another, like the insured, in a transfer-for-value transaction, then the excess of the death benefit received over the purchase price paid plus post-purchase premiums paid, will be taxable income to the policy beneficiary. Yet even when the policy was purchased from another, there exist statutory exceptions to the transfer-for-value rule, e.g. policy transfers to partners, partnerships, corporations where the transferor is a shareholder or director, and carryover basis situations such as the straight gift of the policy by its owner to another. [IRC 101(a)(2).] Now we have the reportable policy sale rules that ‘override’ many of the transfer-for-value statutory exceptions, thus making the death benefit paid at least partially taxable when in the past the death benefit would have remained tax-free. [Treasury Regulation 1.101-1(b)(1)(ii)(B)(i).]