Life Insurance – New Transfer for Value Reporting

Take-Away: The IRS recently published proposed new Regulations with regard to reporting obligations with regard to the sale of a life insurance contract which are intended to define how much of a life insurance death benefit is to be reported as taxable income.

Background: One complicated area of the Tax Code is with regard to the taxation of a life insurance death benefit. As a general rule, the death benefit paid under a life insurance contract is income tax-free to the designated beneficiary under the life insurance policy. [IRC 101(a)(1).] The death benefit may be included in the insured-owner’s taxable estate, but the designated beneficiary of the policy does not have to report the death benefit received in the designated beneficiary’s taxable income.

Transfer-for-Value Rule: But there is also the transfer-for-value rule which provides that if a life insurance policy is purchased from another, such as the insured-owner, then the amount paid as the death benefit on the insured’s death, less the price paid for the policy and the future premiums the purchaser makes to sustain the life insurance policy, is reported as taxable ordinary income by the new owner-beneficiary. [IRC 101(a)(2).]

Exceptions to the Transfer-for-Value Rule: Where the complications come into play is that there are statutory exceptions to the transfer-for- value rule. Example: A partner can acquire the life insurance policy that insures the life of another partner, and the death benefit on that acquired life insurance policy will not be treated as taxable ordinary income, i.e. it is not treated as a transfer-for-value. The challenge often is trying to structure the transfer of a life insurance policy into one of the limited transfer-for-value statutory exceptions, akin to trying to put a square peg jnto a round hole to keep the death benefit income-tax-free.

Life Settlement Companies- Perceived Abuses: Congress over the years has felt that some life insurance contract acquisitions by life settlement companies has led to abuses, or more accurately, the avoidance of income taxes paid on the receipt of death benefits under life insurance policies that were ‘acquired.’ This led to yet another Tax Code section that denies the use of the statutory exceptions to transfer-for-value rules. Thus, the Tax Code formally defines a reportable policy sale which, in turn, is used to determine the amount of the death benefit paid that will be excluded from gross income of the recipient of the policy death benefit. [IRC 101(a)(3)(A).] The purpose of the definition of reportable policy sale is to expose life settlement companies to income taxation of the death benefit that is paid when a life insurance policy is purchased under a life settlement agreement while denying the use of the statutory exceptions to the transfer-for-value 

Exception to the Exception: Because IRC 101(a)(3)(A) is intended primarily to cover life settlement companies, a ‘carve out’ is created for a ‘C’ corporation if less than 50% of its revenues is derived from life insurance death benefits paid. This is intended to protect some C corporations that take out life insurance policies on their key employees.

Proposed Regulations: New proposed Regulation was just released by the IRS with regard to life settlement transactions. Proposed Regulation REG-103083-18 will require the acquirer of some (but not all) transfers-for-value of an interest in a life insurance policy to report the net payment that is made to each person who is involved in a reportable policy sale. These new proposed Regulations are intended to implicemtn the new policy reporting obligations under IRC 6050Y with regard to reportable policy sales of life insurance contracts the the payment of reportable death benefits. 

Taxable Amount: The proposed Regulations provide guidance on the amount of the death benefit that can be excluded from gross income under IRC 101 following a reportable policy sale.

Consumer Protection: As part of the information that must be reported by the life settlement company, these proposed Regulations also will require the life settlement company to report to the current owner of the policy the amount of the cash surrender value that the policy owner would have received had the policy owner simply surrendered the life insurance policy as opposed to selling the policy to the life settlement company.