Chapter 12: Taxation of life settlements.
With the annual turnover in the secondary market for life insurance policies estimated to be $13 billion, one would think that the basic tax issues surrounding life settlement transactions would be well settled. But that is not the case. Unfortunately for taxpayers, advisors, fiduciaries, beneficiaries, and all parties potentially involved in a life settlement transaction, the Service has yet to release detailed guidance on the tax consequences governing the sale of a life insurance policy in the secondary market.
Against this backdrop, Chapter 12 will attempt to provide clarity to what is a very complex area, and will focus on three main themes:
1. The taxation of life settlement proceeds received by selling policy owners.
2. The tax issues raised by premium financing and so-called stranger-owned/ stranger-initiated life insurance transactions (SOLI/SILI).
3. The tax issues raised for investors (foreign and domestic) in life settlement transactions.
Numerous examples and practice pointers are utilized throughout this chapter. The chapter concludes with a review of some of the important questions that all those in the transaction hierarchy are likely to face.
TAXATION OF LIFE SETTLEMENT TRANSACTIONS
Policy owners who receive funds after selling a policy on the secondary market may, in the hustle and bustle of getting the policy packaged and ready for sale, overlook the fact that tax must be paid on any gain after the policy is sold. Once the transaction closes and the funds are disbursed by the escrow agent, the parties typically have one question when they begin to focus on the taxation of the transaction: "How much do I owe?" In this regard, the marketing materials provided to policy owners may not be of much help, and often contain a standard tax disclosure that is similar to the following:
"The proceeds from a life settlement are generally tax-free up to the amount of the premiums paid for the policy. The difference between that amount and the cash surrender value is generally taxable as ordinary income. Amounts received in excess of cash surrender value are generally taxed as capital gain. Sellers are strongly encouraged to consult their own tax and financial advisors before completing a transaction."
The word "generally" and the strong encouragement to "consult your own tax and financial advisors" often leave policy owners looking for clarity where there may be little. The bottom line is that tax ramifications of life settlement transactions are far from clear or certain and nowhere near as simple as marketers would have either the client or other professionals believe. In an attempt to simplify the process, this chapter will focus on a five-step method that can be used to calculate the gain from a life insurance policy. Exhibit 12.1 contains a detailed overview of the five steps.
Calculate Policy Basis
The first step in determining the taxation of a life settlement is determining the policy owner's basis in the life insurance contract. Basis is of critical importance because the amount realized by the policy owner is reduced by the policy's adjusted basis, a concept that is illustrated in the following example:
Example: Assume a policy owner sells a policy with a $1 million death benefit for $500,000. Common sense indicates that it makes a significant difference to the policy owner's after-tax result whether the basis in the policy is, say $50,000, or $250,000 because of generally accepted tax principles, which say that basis is recovered income tax-free. (1)
How is Basis Determined?
Unfortunately for policy owners and advisors, the Internal Revenue Code does not contain a clear and concise definition of life insurance policy basis. Despite this fact, the starting point for those who need to calculate a seller's basis is "aggregate premiums" paid. Additional premiums paid for supplementary benefits (e.g., waiver of premium, double indemnity, accidental death protection and disability income) are excluded from aggregate premiums paid. In addition, nontaxable distributions (e.g., cash dividends, dividends used to purchase riders or accumulate interest, and nontaxable withdrawals) are generally subtracted from aggregate premiums paid as well. However, dividends used to purchase paid-up additional insurance or reduce premiums do not reduce basis. (2)
Practice Pointer: Policy owners could find it challenging to obtain an accurate snapshot of policy basis because the calculation is entirely dependent upon the accuracy of the insurance carrier's in-force administration systems. Further complicating matters is the fact that the basis rules are subject to carrier interpretation, and slight differences in interpretation can make a major difference in reported values. There may be additional complications if the policy was the subject of a Section 1035 exchange. In this case, the new carrier may have asked the replaced carrier for the old policy's basis so it could be accounted for in the carryover of reported values. If the policy has been exchanged multiple times, verifying basis could well be a time consuming and difficult proposition. Because basis is so important, all carrier statements should be carefully reviewed to ensure they are 100% accurate.
The Impact of "Cost of Insurance" Charges on Basis
One issue that has generated significant controversy among experts, and that could have a material impact on how much tax is ultimately paid on a life settlement transaction, is whether basis must be reduced by the policy's cost of insurance (COI) charges. If the policy's basis must be reduced by the COI charges, the gain could be and typically will be considerable, particularly where the policy has been in-force for some time. (3)
One of the earliest cases where basis and COI were at issue was Century Wood Preserving Co. v. Commissioner, (4) a case that involved a corporation that purchased life insurance policies on the lives of its officers and named itself beneficiary. The corporation later sold the insurance policies to the officers at a loss, and then attempted to deduct the loss. In denying the corporation's deduction, the court said that the part of the premiums that represented annual insurance protection had been earned and used, and required the cost of the annual insurance protection to be deducted from the premiums paid.
In recent guidance, the IRS followed the reasoning in Century Wood and took the position that the COI protection, provided up to the date of the sale, must be subtracted from the total premiums paid to arrive at the policy owner's investment in the contract. For example, Private Letter Ruling 9443020 involved a terminally ill individual who sold his life insurance contract for 63% of the contract's face value. The insured was required to include in income an amount equal to the difference between the amount he was paid by the viatical company for the contract and his adjusted basis. According to the Internal Revenue Service, the adjusted basis was equal to the premiums paid less the sum of (1) the COI provided through the date of the sale, and (2) any amounts (such as dividends) received under the contract that had not been included in gross income.
The IRS has continued to follow this logic in its more recent rulings. For example, Internal Legal Memorandum 200504001 followed the reasoning in Private Letter Ruling PLR 9443020 and held that "cost" is not the total amount paid in as premiums because, in the Service's view, continuing insurance protection is part of the consideration paid for the policy. In the Service's opinion, the part of the premiums that represents annual insurance protection has been earned and used; the other part of the premium is an investment built up as a reserve until the policy has matured or is surrendered. (5) The Service continued this line of reasoning in the final split dollar regulations, where it said that the fair market value of a life insurance contract is the policy's cash value less the value of current life insurance protection. (6)
Is the IRS Correct? Arguments against Reducing Basis by COI
Some commentators have strongly disagreed with the Service's position on basis and COI. These experts believe that reducing the seller's basis by the cost of insurance is not technically correct, and runs counter to the regulations under Section 72(e) and the holdings of at least three cases. (7) Should the cost of insurance decrease the basis of an insured's investment in a life insurance contract as the Service has mandated in private rulings? Commentators point out that the Service's rulings cite cases that dealt with loss transactions and have suggested that these cases should not be applicable to life settlements, which involve "gain" transactions. These experts believe that the adjusted basis of a life insurance contract should be computed in the same way whether it is surrendered for its cash value or sold, and that such treatment follows the Service's published guidance dealing with sales. (8)
Thus, practitioners are currently left with an uncertainly here that may have significant tax implications and might even impact the "hold-fold" decisional analysis. At the very least, clients contemplating life settlements must be alerted to the Service's position, the uncertainty in its wake, and its potential effects.
Determining the Character of the Gain
Once the amount of gain is calculated using the formula in Exhibit 12.1, characterizing how any resulting gain will be taxed is of critical importance because the success of any investment decision must be determined on an "after-tax" basis. Figure 12.1 contains what might be described as a "commonly accepted" model for taxing a life settlement transaction that many advisors currently follow. (9) Under this approach, the proceeds from a life settlement are generally considered to be tax-free up to the policy's basis. The difference between that amount and the cash surrender value (CSV) is generally taxable as ordinary income. Amounts received in excess of cash surrender value that can be shown to be generated by market forces are generally assumed to be taxed as capital gain.
Practice Pointer: Because of the lack of definitive guidance from the IRS on all of the issues addressed above, advisors may need to develop a "more likely than not" opinion on the tax treatment of life settlements. Whether or not the authority cited in the footnotes below meets this standard is something advisors must carefully weigh. The reasoning behind the "commonly accepted" (but not necessarily correct and/or not necessarily what the IRS will accept) formula for taxing settlement transactions in Figure 12.1 is addressed in an opinion letter issued by a national accounting firm to a viatical settlement company in 1997. The opinion letter is publicly available on the accounting firm's website. (10) But be sure to read the discussion of this contentious topic below!
The assumption that sale proceeds are tax-free up to the basis follows generally accepted tax accounting principles, which allow the owner of an asset to recoup the original investment at no tax cost. (11) Up to the point where gain represents the internal earnings of the contract since it was originally purchased, the gain represents ordinary income. The reasoning for this is the so-called "substitute for ordinary income" doctrine, which says that if a policy holder surrendered rather than sold the policy, gain would be ordinary. In other words, changing the form of the transaction should not change the tax result. (12)
Is the Gain Above Cash Surrender Value Capital Gain or Ordinary Income?
One critical question that remains undecided is the character of the gain realized when a policy is sold for an amount greater than that which would be received merely because of policy performance (i.e., the extra amount a life settlement company's investors are willing to pay to obtain the right to the proceeds at the insured's death).
As a general rule, an asset will qualify for capital gain treatment if was (1) owned for the requisite holding period (i.e., more than 12 months), (2) transferred in a sale or exchange, and (3) qualifies as a capital asset. (13) The gain from the sale of any asset held for the requisite holding period is capital gain unless the property is a type that is specifically excluded by the Internal Revenue Code from capital gains treatment. Life insurance policies do not fall within one of the statutory categories of property that are excluded from such treatment. (14)
Experts who claim that gain from the sale of a life insurance policy in excess of its cash surrender value is capital gain often point to the three key authorities:
1. In Jules J. Reingold v. Commissioner, a life insurance policy was sold for an amount that exceeded its cash surrender value and the court held that a life insurance contract is a capital asset that can qualify for capital gain treatment when sold. (15)
2. In Commissioner v. Phillips, the IRS conceded that gain from the sale of a life insurance policy can be capital in nature. (16)
3. In Chief Counsel Advisory Memorandum 200131028, the IRS addressed a "demutualization" transaction where insured policyholders of a mutual life insurance company received cash in connection with a conversion of the company to a stock insurance company. The IRS concluded that the taxpayers receiving cash for their interests in the company held via insurance policies incurred capital gain. The ruling concluded that equity interests in the mutual insurance company held in the policies are capital assets. (17)
Practice Pointer: Despite the lack of conclusive authority on this issue, it is imperative that advisors understand that the IRS has aggressively attacked attempts to convert the ordinary income inside a life insurance contract into capital gain simply by selling the policy. (18) The obvious reason is that capital gains are taxed at significantly lower rates.
If the Service ever decides to protect revenue on this issue, it could decide that all gain from the sale of a life insurance policy is ordinary income. If recent guidance is any indication, taxpayers could be in for an uphill fight. For example, in Technical Advice Memorandum 200452003, the taxpayer surrendered a block of corporate owned life insurance policies to the insurance carrier and argued that income on the surrender was capital gain. On audit, the Revenue Service determined that the includible portion should be reported as ordinary income rather than capital gain. In Eckersley v. Commissioner, (19) the Tax Court held that settlement proceeds received by the taxpayer with respect to a life insurance policy represented an extinguishment of the taxpayer's claim to ownership of the policy, as opposed to a sale or exchange of a capital asset, and characterized the proceeds as ordinary income.
The bottom line is that tax treatment of a life settlement is far from settled, and the general practitioner could easily overlook the fact that life insurance contracts are unique assets that have historically been subject to special tax rules. What this demonstrates is that the character of gain is quite uncertain. The one thing an advisor can assure a client of with regard to this issue is that "until a case or ruling deals directly with this issue, we will not be certain of the result."
Tax reporting is a critical, but often overlooked step in a settlement transaction. Before the transaction is consummated, the policy owner is typically asked to complete a W-9 form requesting the policy owner's taxpayer identification number. Customary industry practice is for the escrow agent to send a 1099 information return to the policy owner following the disbursement of the sale proceeds.
Practice Pointer: While there is an IRS form (1099-LTC) that viatical settlement providers must use to report viatical payments, there is no corresponding information return to report life settlement transactions. Consequently, follow-through on tax reporting varies widely throughout industry and in some cases the policy owner may find that a 1099 was not generated at all. But just because a 1099 was not prepared does not mean that the policy owner's obligation to report and pay any outstanding income tax liability does not exist. Those who do tax planning based on whether information returns are generated (or not) put themselves at great risk.
Practice Pointer: If the policy is ILIT-owned, it is critical to determine whether the trust is a "grantor" or a "nongrantor" trust. If the ILIT is a grantor trust, the trustee will receive the settlement proceeds and the insured could receive a hefty--and in some cases unexpected--tax bill. This outcome could come as an unpleasant surprise to unsuspecting and uninformed insureds. On the other hand, if the trust is a nongrantor trust, any tax liability could be "trapped" at the trust level and thus result in a very high income tax if the trust is in the highest trust income tax bracket.
All of the above underscores the importance having competent advisors and alerting clients to the income tax consequences of the proposed settlement before the transaction closes.
PUTTING IT ALTOGETHER WITH EXAMPLES
As demonstrated in Chapter 3, life insurance is purchased for a variety of personal, business, and charitable reasons. And policy owners come in all shapes and sizes. After a policy is purchased, the policy owner may find the original need for the policy no longer exists or the premiums have become unaffordable. When thinking about the tax consequences of life settlements, it is important to think of the variety of policy owners who can potentially be sellers. In this regard, sellers can be grouped into five groups:
3. For-profit entities
4. Executors of estates
5. Tax-exempt entities such as a 401(a) trust or 501(c) organization
Each of these policy owners approaches the question of taxation with a different agenda and from a different perspective. If the policy owner is tax-exempt, there may be few, if any, tax issues. Other owners (e.g., individuals, businesses, trusts, and estates) are not tax-exempt so their after-tax return on the disposition of a policy is of critical importance. Some owners (e.g., S corporations, LLCs, partnerships, and grantor trusts) are pass-through entities, pay no tax themselves, and report tax obligations to those with the ultimate responsibility for payment of the actual tax. Consequently, in the examples that follow, an attempt is made to highlight some of the important issues that are likely to surface.
Individuals (e.g., a spouse, child, parent, or grandparent) purchase life insurance for a variety of reasons, including survivorship income, estate equalization, and estate liquidity planning.
Example: Bob, age 77, purchased a $1 million face universal life policy 20 years ago to benefit his wife and children. Over the years, he found that he no longer needed the policy. When the policy was sold on the secondary market, it had cash surrender value of $175,000, total premiums paid of $160,000, and cost of insurance (COI) of $150,000. Bob received $305,000 at the closing.
Result with Basis Unreduced by Cost of Insurance Charges:
$160,000 received income tax-free as return of basis
$15,000 received as ordinary income
$130,000 received as capital gain
Note: basis = full premium unreduced by cost of insurance charges
Result with Basis Reduced by Cost of Insurance Charges:
$10,000 received income tax-free as return of basis
$165,000 received as ordinary income
$130,000 received as capital gain
Note: basis = premium ($160,000) minus cost of insurance charges ($150,000)
Trustees of life insurance trusts frequently purchase life insurance for estate liquidity, generation-skipping, or survivorship income purposes, but may find later that the policy is no longer affordable or needed.
Example: John and Mary, both age 76, established a life insurance trust 15 years ago naming their oldest son, Jack, as trustee. Over a 14-year period, John and Mary gifted $90,000 to the trust each year so Jack could pay the premiums on a $10 million survivorship, universal life policy. Cash surrender value was $1.3 million and COIs were $400,000 million. When the policy was no longer needed, Jack sold it for $3.25 million.
Result with Basis Unreduced by Cost of Insurance Charges:
$1.26 million received income tax-free as return of basis
$40,000 received as ordinary income
$1.95 million received as capital gain
Note: basis = full premium unreduced by cost of insurance charges
Result with Basis Reduced by Cost of Insurance Charges:
$860,000 received income tax-free as return of basis
$440,000 received as ordinary income
$1.95 million received as capital gain
Note: basis = premium ($1.26 million) minus cost of insurance charges ($400,000)
For Profit Entities
Businesses (e.g., corporations, partnerships, and limited liability companies) commonly purchase life insurance to protect against the loss of a key person or to fund business continuation agreements and executive benefit plans. In some cases, the insured may leave the company; in other cases, the company may be acquired. In either case, the original need for the policy may no longer exist and the policy could therefore be headed for the secondary market.
Example: When Bob was recruited to Acme Tool & Die 17 years ago, Acme purchased a $2 million universal policy on Bob's life to protect the company in the event of Bob's death. When Bob retired at age 69, Acme no longer needed the policy and sold it for $785,000. At the time of sale, Acme paid total premiums of $315,000, COIs were $150,000, and CSV was $215,000.
Result with Basis Unreduced by Cost of Insurance Charges:
$315,000 received income tax-free as return of basis
$0 received as ordinary income
$470,000 received as capital gain
Note: basis = full premium unreduced by cost of insurance charges
Result with Basis Reduced by Cost of Insurance Charges:
$165,000 received income tax-free as return of basis
$50,000 received as ordinary income
$570,000 received as capital gain
Note: basis = premium ($315,000) minus cost of insurance charges ($150,000)
Example: Until recently, John and Steve were equal partners in their CPA firm. To fund their trusteed cross purchase business continuation agreement, a trustee purchased a $1 million universal life policy on each of their lives. When they sold their practice, the trustee sold both policies for $225,000 each. John and Steve's policies had identical premiums ($95,000), COIs ($80,000), and CSV ($100,000).
Result with Basis Unreduced by Cost of Insurance Charges:
$95,000 received income tax-free as return of basis
$5,000 received as ordinary income
$125,000 received as capital gain
Note: basis = full premium unreduced by cost of insurance charges
Result with Basis Reduced by Cost of Insurance Charges:
$15,000 received income tax-free as return of basis
$85,000 received as ordinary income
$125,000 received as capital gain
Note: basis = premium ($95,000) minus cost of insurance charges ($80,000)
Planning Pointer: The tax classification of a trusteed buy-sell agreement is not clear. Would the IRS respect it as a formal trust arrangement or would it be considered an agency arrangement? If the former applies, further analysis would be needed to determine whether it is a grantor or nongrantor trust. If the latter applies, it is important to determine whether the entity was the agent for the insureds or for the business.
Example: To informally fund a supplemental executive retirement plan for senior management, Action Digital Graphics Corporation purchased a block of 75 corporate-owned life insurance (COLI) policies. When Action was acquired, the acquiring corporation decided to maximize shareholder value, eliminate the plan, and sell as many life insurance policies as could be sold on the secondary market.
Practice Pointer: Corporate capital gains are treated differently from those of individuals. For example, there is no favorable treatment as there is with individuals and regular rates apply. In addition, there is no deduction for capital losses that exceed capital gains.
Example: By reallocating Tier 1 capital, banks are able to enhance their income statements through the increased after-tax yields generated by bank-owned life insurance (BOLI). (20) While BOLI can be a useful tool for recovering employee benefit costs, if a bank determined that it no longer needed a BOLI policy, settlement may yield a higher after-tax return than a surrender of the policy. This is because BOLI is typically designed to be a modified endowment contract, and the 10% penalty should not apply to the settlement of the policy. (21)
Executors of Estates
Executors of estates may sell policies that the decedent owned.
Example: Mary Smith purchased a $2 million face universal life policy on her husband Dave. Before she died, Mary did not name a contingent owner in the policy application. Mary named her two adult children she had with Dave as the residuary beneficiaries of her estate. Mary's executrix, Jane, decided to sell the policy because she determined that it was no longer needed and its sale would maximize the value of the estate's assets. The total premiums paid were $200,000, COIs totaled $95,000, and CSV was $275,000. Jane sold the policy for $410,000.
Result with Basis Unreduced by Cost of Insurance Charges:
$200,000 received income tax-free as return of basis
$75,000 received as ordinary income
$135,000 received as capital gain
Note: basis = full premium unreduced by cost of insurance charges
Result with Basis Reduced by Cost of Insurance Charges:
$105,000 received income tax-free as return of basis
$170,000 received as ordinary income
$135,000 received as capital gain
Note: basis = premium ($200,000) minus cost of insurance charges ($95,000)
Practice Pointer: There are no reported cases or rulings dealing with the issue of whether basis in an inherited life insurance policy should receive a "step-up" in basis as a result of the policy owner's death. While this fact pattern will occur somewhat rarely, some commentators have suggested that Section 1014 (which adjusts the tax basis of property received from a decedent to its fair market value at the date of the decedent's death) should apply to life insurance policies just as it does to other assets of a decedent's estate. (22) If this is the correct result, the numbers in this example would change dramatically.
Tax-exempt organizations (e.g. churches, hospitals, colleges, or government entities) purchase life insurance to bolster an endowment, protect against the premature death of a key person, or fund an employee benefit program. Similar to other policy owners, the trustee of a pension trust or VEBA may consider selling life insurance if it is no longer needed.
Example: Over the years, various alumni made gifts of life insurance policies to New World College. When New World came upon hard times and needed cash to run its day to day operations, the board decided to sell the policies it owned.
Practice Pointer: When a fiduciary in a qualified retirement plan or welfare benefit plans desires to sell a life insurance policy on the secondary market, it is important to determine whether that individual has the authority to enter into a life settlement transaction.
TAX ISSUES RAISED BY PREMIUM FINANCING PROGRAMS
Over the past five years, marketing organizations have developed a variety of premium financing programs marketed to older age insureds in which the settlement of the policy can, and often does, play a prominent role. In some programs that utilize the policy's potential settlement value as collateral for the loan (a.k.a. "market value" lending programs), a life settlement is one of many potential exit strategies that can be used to repay the lender. However, in other programs that are often referred to as "stranger-owned" or "stranger-initiated" life insurance, a sale of the policy is intended from the outset.
Although the specific transaction steps vary from program to program, most programs involve a lender making a short-term loan (recourse or nonrecourse) to an irrevocable life insurance trust (ILIT) or other bankruptcy remote vehicle. During the term of the loan, if a "mortality event" (i.e., death) occurs the policy's death benefit will be split between the policy owner and the collateral assignee according to the terms of the collateral assignment. At the expiration of the loan term, the policy owner typically has three options: (1) keep the policy and repay the loan; (2) transfer the policy to the lender in satisfaction of the loan; or (3) sell the policy in the secondary market, repay the loan, and pocket the difference.
With the proliferation of first generation premium financing programs, some promoters began to disguise transactions using a variety of "stealth techniques." For example, instead of the policy being sold on the secondary market, a beneficial interest in the entity owning the policy (typically a nongrantor trust) would be sold to investors. Once the investors owned the entity that owned the policy, the investors could sell the policy or package it for resale in a so-called "securitized transaction." By selling a beneficial interest in the policy, as opposed to the policy inside the entity, promoters could counsel applicants to answer the carrier's application questions (e.g., "do you intend to transfer ownership in the policy") in the negative. Stealth transactions also make it difficult for carriers to detect whether the policy had undergone an ownership change. For instance, by selling an interest in a trust that owns a policy, rather than the policy itself, the transfer of beneficial ownership is obfuscated.
Other promoters developed premium financing programs where the future settlement value of the policy could be guaranteed by means of a "put" option. These programs were designed to overcome objections that the repayment risk was simply too great if the policy could not be sold on the secondary market or the secondary market did not exist in the future. In these programs, the policy owner would enter into a "put" option agreement with an investor group at the time the policy was applied for. Under the terms of the put option, the policy owner would purchase the right to sell the policy for a predetermined value to an investor group in an exercise period that typically lasted for 30 days from the policy's two-year anniversary date. The policy owner usually is not required to exercise the put option, and is free to sell the policy to other investors when the loan is due.
Often referred to by acronyms such as "SOLI" (Stranger-Owned Life Insurance) or "SILI" (Stranger- Initiated Life Insurance) or "SPIN-LIFE," these programs have generated significant controversy within the life insurance and advisor community. They also present many unresolved legal, ethical, and economic issues that are addressed in Chapter 5. These transactions raise significant, and in many cases, unresolved tax issues, which are discussed below.
Income Tax Consequences When a Policy Owner "Walks Away" From a Recourse or Non-Recourse Loan
Promoters may assure those who enter into premium financing transactions that they have no risk, and that they can simply "walk away" at the end of the loan term with the lender accepting the policy as full payment for the outstanding principal, interest, and all other fees and charges. But in reality, the exchange of a policy for the cancellation of a premium financing loan raises a number of unresolved income tax issues that may or may not be disclosed to prospective insureds, fiduciaries, or--perhaps most significantly--unsuspecting advisors such as attorneys or CPAs who are hired to review and opine on a specific transaction.
For purposes of determining gain, the regulations make an important distinction between the tax treatment of recourse and nonrecourse loans. (23) For premium financing programs that utilize recourse loans, the extent to which the forgiven debt exceeds the policy's fair market value is treated as discharge of indebtedness income. Consider the following example:
Example: In 2008, Frank transfers to a creditor an asset with a fair market value of $6,000 and the creditor discharges $7,500 of indebtedness for which Frank is personally liable. The amount realized on the disposition of the asset is its fair market value ($6,000). In addition, Frank has income from the discharge of indebtedness of $1,500 ($7,500--$6,000). As a result, the extent to which a premium financing loan exceeds the policy's fair market value is treated as "cancellation of debt" (COD) income, (24) and the extent to which the policy's fair market value exceeds basis is considered taxable gain.
The result is different for programs that utilize fully nonrecourse financing. In that situation, the difference between the amount of the cancelled debt and the policy owner's basis is taxable gain where the policy owner transfers the policy to the lender and simply walks away. (25)
The following example illustrates the issues raised when a policy owner decides to walk away from a nonrecourse loan.
Example: Assume a 70-year old individual establishes a nongrantor trust to purchase a $3 million, no-lapse, guaranteed universal life insurance policy. The annual premiums for the first two years are $250,000. The loan is non-recourse and loan interest is LIBOR plus 125 basis points. The closing and transaction fees are $22,000. Principal and accrued interest are due and payable on the second anniversary of the policy's purchase. The trustee of the ILIT borrows $522,000 to purchase the policy. On the second anniversary, the trustee has three options: (1) repay or refinance the loan; (2) allow the lender to sell the policy on the secondary market and use the sale proceeds to repay the principal, interest, and fees, with the balance being divided between the lender and the trustee; or (3) assign the policy to the lender for a discharge of the loan.
What are the tax consequences if the trustee chooses the third option, assigns the policy to the lender, and simply walks away? When a taxpayer uses nonrecourse financing to purchase property, the debt becomes part of the taxpayer's cost and is, therefore, included in the property's basis. (26) However, as was demonstrated above, when encumbered property is sold or otherwise disposed of, the extinguishment of the borrower's obligation to repay must be accounted for in the computation of the amount realized. In other words, the trustee must include in the amount realized the amount of the nonrecourse loan that is retired/extinguished by the lender. (27)
One factor that could have a critical impact on the outcome (as was previously demonstrated in the examples above) is whether the policy owner's basis must be reduced by COI charges. Consider the following results:
Result With Basis Unreduced By Cost of Insurance Charges Total Premium 500,000 Interest $30,158 * Loan Fees $22,000 Total Loan Balance $552,158 Less: Basis $500,000 ** Taxable Gain $52,158 * The interest calculation assumes interest accrues at 3.75% compounded annually (with two years of interest on first premium payment and loan fees and one year of interest on second premium payment). ** Basis = full premium unreduced by cost of insurance charges Result With Basis Reduced By Cost of Insurance Charges Total Premium $500,000 Interest $30,158 * Loan Fees $22,000 Total Loan Balance $552,158 Less: Basis $440,000 ** Taxable Gain $112,158 * The interest calculation assumes interest accrues at 3.75% compounded annually (with two years of interest on first premium payment and loan fees and one year of interest on second premium payment). ** Basis = premium ($500,000) minus cost of insurance charges for two years ($60,000).
What Happens if the Policy Owner Is Insolvent?
Some premium financing programs (such as the one in the previous example) utilize nongrantor trusts as the policy owner. According to the marketing materials that often accompany these programs, a nongrantor trust is recommended in order to "trap" gain inside the trust when the policy is transferred to the lender and the note is discharged. The expectation of the parties is that a nongrantor trust will insulate the grantor from any income tax burden when the note is discharged.
One factor influencing the decision to utilize a nongrantor trust is the so-called "insolvency exception" to the discharge of indebtedness income rules discussed above. In Revenue Ruling 58-600, the Service held that the cancellation of a taxpayer's indebtedness does not result in the realization of income where the taxpayer is insolvent before the debt cancellation and, after the debt cancellation, either remains insolvent or has no excess of assets over liabilities. (28) The insolvency exception applies only for cancellation of indebtedness income. For all other types of income (e.g., wages, rents, income, and gains from dealings in property), the solvency of the taxpayer is irrelevant. (29) Because a life insurance policy will typically be the only asset in a trust that could borrow hundreds of thousands of dollars to finance the planned premiums, the issue presented is whether the Service would respect the trust's tax status as a nongrantor trust, or whether it would look through the trust to the grantor for payment of any outstanding income tax liabilities. Some authorities (as noted directly below) are highly skeptical that the IRS will respect what could be considered a sham transaction.
Practice Pointer: Advisors must carefully weigh the efficacy of the insolvency exception against the fact that the Service and the courts have frequently disregarded sham trusts that lack economic substance apart from tax considerations. Where a trust is disregarded as a sham, trust income will be taxed to those who control the trust. (30)
The Tax Court looks at four factors when deciding whether a trust lacks economic substance: (1) whether the taxpayer's relationship to the property differed materially before and after the trust's formation; (2) whether the trust had an independent trustee; (3) whether an economic interest passed to other trust beneficiaries; and (4) whether the taxpayer felt bound by any restrictions imposed by the trust itself or by the law of trusts. (31) Because the Tax Court considers whether the taxpayer has a basic understanding of the trust's operations, (32) advisors and fiduciaries must carefully consider what is communicated to their clients.
Income Tax Consequences Where a Policy Owner "Walks Away" from a Hybrid Loan
Premium financing programs have evolved away from strictly "all-or-nothing" recourse and nonrecourse designs. In today's marketplace, so-called "hybrid" programs have become quite popular. In a hybrid program, the loan is structured so that some portion will be recourse and the remaining portion will be nonrecourse. This development is due in part to carriers refusing to allow their policies to be utilized in nonrecourse arrangements and demanding that insureds have some "skin in the game."
While there are no reported decisions or IRS rulings involving the taxation of gain when a policy owner walks away from a hybrid life insurance loan, the Service has ruled on this issue in the context of commercial real estate loans. By applying the Service's rationale from its treatment of partial recourse and nonrecourse commercial real estate transactions, it is possible to develop an understanding of how the Service might approach discharge of indebtedness taxation in the context of hybrid life insurance loans.
When a debt is partially recourse and partially nonrecourse in the commercial real estate field, the Service's position is that the discharge of debt by a transfer of the property (which in this case could be the policy) must first be allocated to the nonrecourse portion of the debt. Only if the value of policy exceeds the nonrecourse portion of the debt will any of the discharged debt be considered as cancelling the recourse portion. (33) In the Service's view, a debtor should not be able to impair a creditor's rights simply by asserting that a settlement must first be applied against the recourse portion of a debt. To the extent possible, the tax treatment of the transaction should be consistent with the presumed result under state law.
Where a policy owner transfers the policy to discharge the nonrecourse portion of the debt, as well as cash to retire the recourse portion of the debt, determining the fair market value of the policy is of critical importance. (34) Where the nonrecourse debt amount exceeds the value of the transferred policy, the policy owner's gain will be the difference between the amount of nonrecourse debt and the policy's basis. Discharge of indebtedness income will be recognized to the extent that discharged debt exceeds the nonrecourse amount. On the other hand, where the value of the policy transferred is equal to or greater than the nonrecourse debt amount, the policy owner's gain will be the difference between the policy's value and its basis. In this case, discharge of indebtedness income will be recognized equal to the extent the sum of the total recourse and nonrecourse debt exceeds the value of the policy transferred. (35) In a hybrid walk- away, another unresolved issue is whether the discharge of indebtedness gain will be treated as ordinary income or capital gain.
INVESTOR TAX ISSUES
Although most of the literature devoted to life settlements focuses on the "sell" side of the secondary market, it goes without saying that without active buyers, there would not be a secondary market. Almost from inception, investment banks and hedge funds were not traditional players in the retail side of the life insurance business. Over the past five years, though, all of this has changed, and the list of firms now involved in the settlement business reads like a who's who of major financial firms. Life settlements became attractive to institutional investors, but particularly so to hedge funds, because returns from life settlements are not correlated with the movement of the stock market. As a result, many financial institutions have started "longevity" divisions that seek to profit from various aspects of the life insurance business, particularly premium financing and life settlement transactions. While this section will discuss the major issues that domestic and foreign investors in life settlements must address, the complexity of these rules makes a detailed treatment of all of the issues beyond the scope of this chapter.
How Do Investors In Settlements Profit?
Investors in life settlement transactions profit in one of three ways. The first is to hold policies to maturity under the assumption that the death benefits will ultimately exceed acquisition and carrying costs. The second method is to package and re-sell blocks of policies at a mark-up over the investor's acquisition and carrying costs. A third way is to use life insurance polices in a so-called "securitization transaction" whereby the policies are transferred to a "special purpose vehicle" that issues securities (typically bonds) backed by the cash flows of the underlying insurance policies.
TAXATION OF DOMESTIC INVESTORS IN LIFE SETTLEMENTS
Hedge funds and private equity funds investing in life insurance policies issued by United States carriers on the lives of United States residents will typically do so through the use of pass-through entities to avoid entity level taxation and to preserve the tax character of distributions made to investors. Pass-through entities are principally used for funds aimed at U.S.-based, tax paying investors because the investors will receive relatively favorable tax treatment in the United States. The general partner of a limited partnership will typically be the investment manager, and the investors will typically be limited partners, although other structures may be utilized as well.
Investors that Purchase and Hold Policies for Mortality Gain
If the entity purchases policies for mortality gain, taxable income is measured by the spread between the death proceeds and the initial purchase price plus carrying costs. If the investor uses leverage to acquire mortality gain, Section 264 bars a deduction for any interest paid, although nondeductible interest should increase the amount excludable from income for amounts "subsequently paid" by the investor under the so-called "transfer for value" rule of Section 101(a)(2). The tax treatment of mortality gain is far from settled, but would appear to be ordinary income on account of the transfer for value rule in Section 101(a)(2) as well as the lack of a "sale or exchange" to which Section 1222 could apply. (36)
Investors that Purchase Policies for Re-Sale
If an entity, such as a hedge fund, purchases policies for re-sale, how it manages its portfolio will be of critical importance to its investors. The Internal Revenue Code distinguishes between a fund's management expenses that are incurred to carry on a "trade or business" as opposed to those expenses that are incurred for the "production of income." In the former case, the management fees will constitute an "above-the-line" deduction under Section 162; the later qualify as a miscellaneous itemized, "below the line" deduction under Section 212, and will be deductible only to the extent that the fees exceed two percent of adjusted gross income. (37) If the fund is operating as a trade or business, distributable losses could be made nondeductible as a result of the passive activity rules unless the fund does not have other income. (38)
Another issue that will have a significant impact on an investor's overall after-tax return is the treatment of post-acquisition costs. While many hedge funds use leverage to increase their internal rates of return, interest paid would not be currently deductible as Section 264 generally denies a deduction for interest paid or accrued on a policy in which a taxpayer is the beneficiary. (39) If policies were purchased for mortality gain, interest paid would reduce taxes on the gain as a result of the so-called "transfer for value" rule in Section 101(a)(2).What is not clear is whether basis would be increased by premiums and nondeductible interest if the fund purchased policies for subsequent resale. With regard to post-acquisition premiums, there is a risk that the Service could rely on the Century Wood and London Shoe line of cases cited above to prevent these premiums from being capitalized into the fund's basis--although these cases are distinguishable by the fact that the fund is not the original owner and is paying the premiums not for "protection" purposes but rather to maintain its investment. (40)
Funds that invest in life settlements also need to be cognizant of the tax status of their investors. For example, a tax-exempt entity is subject to excise tax if it has unrelated business taxable income (UBTI). Under the so-called "dealer UBTI" rules, income distributed by a fund that is in the business of purchasing polices for resale would be excludable by tax-exempt entities from the calculation of unrelated business taxable income. (41) On the other hand, income from mortality gain is not specifically excluded from the calculation, as is mortality gain with respect to which there has been acquisition indebtedness at any time during the taxable year. (42)
TAXATION OF FOREIGN INVESTORS IN LIFE SETTLEMENTS
The appetite for life insurance policies has not been limited to the United States. After the United States, the world's second and third largest markets, respectively, for life settlements are Japan and Great Britain. Since its formation in 1999, the secondary market in Germany has also developed rapidly. (43) In addition to the establishment of vibrant secondary markets outside of the United States, a number of foreign settlement firms focus on purchasing life insurance inside the United States. (44) In this regard, life settlements were particularly favored among certain German closed-end funds structured through limited partnerships (Kommanditgesellschaft) and companies (Gesellschaft). (45)
Foreign investment firms sourcing policies issued by United States carriers on the lives of United States citizens will generally not be subject to United States tax on income derived from their U.S.-sourced life settlement business if they qualify for tax treaty benefits and do not maintain a fixed place of business in the United States. (46) Foreign funds need to be quite careful that those sourcing policies on their behalf are truly operating independently and cannot be considered under their control. (47) Although the regulations appear to consider mortality gain to constitute "fixed or determinable annual or periodical" income ("FDAP") that is subject to tax at a flat 30% rate, (48) this result can be overridden with a favorable treaty provision. By contrast, if a fund purchases policies for resale, the regulations appear to deem its income to be FDAP. (49)
TAXATION OF SPONSORS OF SECURITIZED LIFE SETTLEMENT TRANSACTIONS
During the life settlement sales process, policy owners are frequently known to ask, "What will the buyer do with my policy?" If policy owners had any understanding of the field of securitized transactions and asset-backed securities (ABS), they would no doubt be amazed with what some buyers do once they take ownership of their life insurance policy. ABS have historically been issued based on a variety of marketable securities, but recently aggregators have been purchasing large numbers of life insurance policies on the secondary market with an eye towards repackaging them in securitized transactions. (50) The process of securitizing life settlement transactions has been referred rather unflatteringly to as "death bonds" and "mortality futures" by some commentators. (51)
The Tertiary Market: Where Polices Are Pooled, Securitized, Rated, and Traded
The interest in settlements has been so significant that a tertiary market has been created where portfolios of securitized policies come back into the market and are traded by financial institutions. (52) A number of international financial institutions have been actively accumulating portfolios of life insurance policies, (53) and both Moody's and A.M. Best have developed sophisticated models to rate securities that are backed by life insurance policies purchased on the secondary market. In 2004, Legacy Benefits was reported to have issued the first rated pool, and a number of rated and unrated securitizations are reportedly being prepared for market. (54)
The acquisition of policies for securitization is subject to a number of uncertainties, (55) and A.M. Best issues three types of analyses: (1) a "preliminary assessment" for securities that are to be backed by a portfolio of settlements that will be purchased over a specified time period; (2) an "indicative rating" once the issuer has purchased 75%-85% of the targeted policies; and (3) a "long-term" debt rating when 100% have been purchased.
Although rating agencies prefer to-rate "home grown" portfolios (i.e., polices that have been purchased one-by-one in a year or less), they will rate existing portfolios. Rating agencies typically will not rate a pool unless it has at least 200 lives. (56) The chart below gives some indication of the complexities involved in bringing a block of life insurance policies to market, from the initial purchasing of the policies to the point when bonds/notes are actually issued. Although rating firms have recently come under increased scrutiny for their role in rating certain collateralized obligations, (57) the risk to portfolios backed by death benefits would appear to be minimal provided the policy stays in-force. Over the long term, what may prove more problematic is the accuracy of life expectancy calculations. (58)
The structure of asset-backed transactions involving life settlements is relatively straightforward. In most cases, the transaction begins when an originator/investor establishes a "special purpose vehicle" (SPV), which is typically a pass-through entity that will issue securities using life insurance policies as collateral. The bonds/notes issued by the SPV are typically structured to appeal to various types of investors since institutions, hedge funds, and high net worth individuals often have disparate investment objectives. As a result, there may be different "tranches" (i.e., portions) possessing degrees of seniority with respect to the underlying cash flows of the policies. In many cases, the SPV will utilize some type of "stop loss" cover that is designed to protect investors from longevity risk; credit enhancement mechanisms and liquidity facilities are also utilized.
In most securitized transactions, an assortment of third parties (e.g., collateral managers, custodians, trustees, tracking agents, auditors, etc) are used to service the block of in-force polices. Premiums and death benefits will be monitored to ensure the integrity of the cash flows both into and out of the SPV. This function is critical in the case of life insurance where persistency is an important determinant of the overall success of the asset-backed structure. (59) Rounding out the list of players, private placement agents will underwrite and distribute the bonds/notes issued by the SPV.
Issuers of asset-backed securities have many goals, but from a tax perspective one of the first is to utilize a structure that ensures that the entity not subject to tax on income on the underlying investment vehicles. If an issuer were to incur tax on cash flows collected on the life insurance policies, the resulting tax "drag" would likely render the SPV economically unfeasible. As such, issuer-level taxation is typically avoided by structuring the SPV as a pass-through entity, typically, as a grantor trust.
The SPV issuing asset-backed securities has choices regarding the types of securities that will be utilized. Where life insurance policies are the underlying collateral, pass-through certificates are not the logical choice as they represent actual ownership interests in the life insurance policies that are owned by the SPV. Instead, so-called pay-through bonds are often utilized as they do not entitle the holder to ownership of the underlying life insurance policies; rather, they entitle the holder to cash distributions in excess of the SPV's expenses and debt service payments. (60)
Issuers of pay-through bonds must plan for certain tax risks, specifically that: (1) the pay-through bonds will be considered by the Service as debt and not equity; (2) timing mismatches from the receipt of death benefits and the deduction of interest payments will create phantom income; and (3) the transaction will be respected by the Service as a financing as opposed to a outright commercial sale. (61)
Interest on pay-through bonds after the date of purchase is included in income as it accrues in the case of investors who are on the accrual method and when received in the case of investors on the cash method. (62) If the bond was not purchased at a premium, principal payments constitute non-taxable return of basis. If the bond was purchased at a premium, investors may elect to amortize the premium over the remaining life of the bond. (63) If the bond was issued at a discount, investors must include the amount of original issue discount in income over the life of the bond. (64)
On the sale of the bond, interest accrued to the date of the sale, but not yet paid, is added to the purchase price and is included in the seller's income as interest. Sale proceeds equal to the investor's adjusted basis are recovered income tax-free, and amounts in excess of basis are typically treated as capital gain (long or short-term), depending upon the investor's holding period. (65) Financial institutions that trade asset-backed securities on the tertiary market are typically taxed at ordinary income rates if they are considered "securities dealers" and could also be subject to the mark-to-market rules. (66)
QUESTIONS AND ANSWERS
Question--Can a life settlement qualify for Section 1035 exchange treatment?
Answer--Marketing organizations have suggested that the purchase of a new policy with life settlement proceeds can qualify for Section 1035 exchange treatment. A sale-purchase departs significantly from the standard industry practice used to effectuate Section 1035 exchanges. Under the classic "direct exchange" approach, the policy owner assigns the policy to the new carrier, the new carrier surrenders the policy with the replaced carrier, and the new carrier then applies the surrender values from the old contract to the new policy. Under the direct exchange method, the policy owner is never in receipt of the surrender proceeds, a fact that has figured prominently in the Service's favorable private rulings involving Section 1035.
In Greene, (67) a decision involving annuity contracts, the Tax Court held that a transaction qualified for Section 1035 treatment where a policy owner took receipt of an annuity's surrender proceeds and used them to purchase a comparable annuity with a new carrier. Although a policy owner could argue that an escrow agent was in receipt of the settlement proceeds that were then applied to the new policy, it remains to be seen whether the Service would rule that this transaction qualifies for Section 1035 treatment. (68) In a Section 1035 exchange, the replaced carrier typically issues a Form 1099R and enters Code 6 in Box 7 to identify the transaction as a tax-free exchange of life insurance. It is not clear how an escrow agent that uses settlement proceeds to purchase a new contract would report the transaction for 1099R purposes.
Question--If a prospective insured is offered a rebate or an inducement to participate in a premium financing program, what are the tax consequences?
Answer--At the front-end of a SOLI/SILI transaction, the prospective insured may be offered one or more of the following options upon qualification: (1) two years of "free" life insurance for which there is no out-of-pocket outlay; (2) an up-front cash payment (promoters use various terms to describe these payments such as "advances," "participation fees" and "sign here" incentives, which frequently comprised 1.5% to 3% of the death benefit); (3) a free luxury automobile; or (4) a free cruise. (69)
Life insurance rebates have generally been held by the courts to be non-deductible by the payor (70) and taxable ordinary income to the recipient. (71) Participation fees may constitute a rebate if they offer an advantage or benefit to an applicant that is not contained in the contract, or if they offer a method of purchasing coverage that is not presented to similarly situated applicants.
Even if the insured never intended to keep the policy and never expected to pay any premiums after the policy was taken over by either the investors through the life settlement company or by the lender, who then transfers it to the investors, the risk to the insured is that the IRS would tax the insured on the full amount of the first two years' premiums. In other words, the IRS could argue that whether or not the taxpayer intends to renew the insurance policies after year two is of no consequence.
The case of Wentz v. Commissioner raises just this possibility. (72) In Wentz, the IRS determined that the taxpayers realized taxable income on an insurance kickback scheme that was measured by the value of the life insurance coverage received. The Service also determined that the value of the insurance in each year was equal to the premium paid to the insurance company, which, in turn, was kicked back by the agent. The taxpayers had argued (1) that the kickback was merely a nontaxable rebate, and that the purchase price, or lack thereof, was bargained for and, alternatively (2) if the receipt of the insurance policy was taxable, it should be valued as a 1-year term policy because they never intended to renew or otherwise treat the policies as whole life policies and they served only as term insurance.
The court held that the taxpayers had the burden of showing that they were not required to recognize taxable income in the amount of their kickbacks. The Service pointed out that the insurer didn't authorize the kickback so there was no valid rebate. The court concluded that, "Petitioners were compensated with the annual benefits of whole life insurance policies, thus triggering a taxable event." There are many other cases that provide cautionary examples for insureds who find themselves trapped in a "free insurance" scheme where the deal is "too good to refuse." (73)
Question--Some programs offer "free" insurance coverage to participants. Can life insurance ever be "free" and what are the income tax issues?
Answer--In the typical "free" life insurance program, neither the insured nor the policy owner makes any out-of-pocket premium payments towards the cost of the policy's death benefit protection. The IRS could take the position, as it does with split-dollar and group life insurance plans, that the enjoyment of insurance coverage that the insured never paid for is a currently taxable and measurable economic benefit to the participant. This could mean that the value of the economic benefit, however measured, would be taxable to the insured or the policy owner as ordinary income.
Question--Do "free" life insurance programs raise transfer tax issues?
Answer--Assuming the actual owner of the policy is not the insured but a life insurance trust, LLC or FLP, the IRS could maintain that there is a constructive annual gift from the insured to the beneficiaries of the insurance trust during the period of "free" insurance. In a public ruling, the IRS said that a "deemed" gift was made in the context of a split-dollar arrangement, and the logic of this "deemed" gift theory could easily be extended to "free" life insurance transactions. (74)
Question--Is there a risk a SOLI/SILI program could be characterized as a split dollar arrangement?
Answer--Some commentators have questioned whether the Service could argue that SOLI/SILI transactions are governed by the split-dollar regulations. In Bulletin 06-137, the Association for Advanced Life Underwriting concluded that these transactions could fall within the definition of "split-dollar life insurance arrangement" that are subject to the regulations under Section 7872. If that were the case, the fact that the loan is non recourse and secured only by the policy raises the specter that the transaction is subject to the so-called "contingent interest" rules in Section 7872. Under the contingent interest rules, all interest is ignored for purposes of determining whether the loan is a below market, even if interest is currently paid or accrued. The loan is calculated by computing the present value of the payments at the applicable AFR. This is the "imputed" loan. The difference between the value of the imputed loan and the face amount actually loaned is treated as an imputed transfer at the time the loan is made.
There are two exceptions that could prevent the application of the Section 7872 contingent interest rules to these transactions. Under the first exception, if the parties attach a statement to their return each year representing that a reasonable person would expect that the loan will be paid when due, the contingent interest rules do not apply. Under the second exception, Treasury Regulation Section 1.7872-5T takes the position that loans from are not subject to Section 7872 if they are "made available by the lender to the general public on the same terms and conditions which are consistent with the lender's customary business practice." The application of these exceptions is not clear at this time.
Question--If the loan in a premium financing program is not "bona fide," what is the tax result?
Answer--Although the marketing materials in a SOLI/ SILI transaction may use the term "loan," that characterization does not make it dispositive for income tax purposes. In certain non recourse transactions, the loan arrangement may be designed so that the insured and the policy owner are never out-of-pocket for the premiums, interest or other fees and charges.
If the loan is not deemed to be "bona fide" because there is no repayment risk to the lender, these premium "loans" could be re-characterized by the IRS as taxable income. (75) Taxpayers would naturally counter that the lender is a third party dealing at arms' length and that the documents each has signed clearly indicates an intent and legal requirement that the loan be repaid or that the collateralized policy be given to the lender in satisfaction of the debt.
The IRS could argue that the flaw in that position is that both parties knew at the inception of the transaction that, at the end of two years, the policy would have nowhere near enough cash value to fully pay off the sum of any loans and origination/ termination fees, and so the transaction was in reality something other than an intent to create a normal loan that would be repaid. (76) If the lending institution would do this only if, behind the scenes, there was a guarantee by the investors waiting to obtain the policy on the insured's life, or there was a separate policy of insurance protecting the lender, the IRS's position could be strengthened. This uncertainty underscores the fact that the loan documents must be carefully reviewed to ensure that there is repayment risk and that the loan would be respected.
Question--In some SOLI/SILI programs, investors purchase the participant's beneficial interest in a trust as opposed to the policy itself. What are the tax consequences of a beneficial interest transaction?
Answer--The IRS and the courts have held that that the sale of legal/equitable interests in trusts can be capital assets. (77) Because of the possibility that the entire sales proceeds being capital, the risk is whether the Service would look through the trust and assert that what was sold was the policy.
Question--What is the potential tax result if the life insurance contract in a SOLI/SILI program does not qualify as "life insurance" for purposes of the Internal Revenue Code?
Answer--To receive preferential income tax treatment, a life insurance policy must meet specific tests contained in Section 7702(a). In addition to meeting these so-called "tax tests," an often overlooked fact is that a life insurance policy must also qualify as "life insurance" under applicable state law. (78) Insurable interest is a pre-condition to the establishment of a valid life insurance contract. If it is later determined that the policy in a SOLI /SILI program fails to meet the state law definition of insurable interest, the policy will not have qualified as life insurance for federal income tax purposes--from the date it was issued. If a policy in a SOLI transaction lacks Section 7702(a) protection, the taxation of the death benefit and cash value build-up is far from clear.79
Question--Could SOLI/SILI programs be deemed to be a tax shelter by the IRS?
Answer--Over the past five years, Congress has given the IRS powerful tools to identify and shut down abusive tax shelters. Individuals who participate in transactions that are "reportable" or "listed" may be required to report the details of their participation to the IRS.80 In this regard, some promoters claim that making the trust that owns the policy a "nongrantor" for income tax purposes will effectively isolate any tax liability within the trust. Some promoters have led insureds to believe this will insulate the trustee insured from income tax and personal liability.
The risk to the insured lies where the trust is left with no assets to pay any income tax or penalties. Could the IRS deem similar transactions to be tax shelters that trigger reporting? In its recent rulings, the IRS has been very concerned about abusive grantor trusts, and the bigger risk is whether a particular program could be considered a "conspiracy" to evade income tax. If the IRS ever deemed a program to constitute a reportable or listed transaction, insureds may be required to disclosure the details of their participation on Form 8886. If this occurred, the failure to file may subject the participant to significant penalties. (81)
Question--Can a participant in a SOLI/SILI transaction obtain an opinion letter from a law firm or accounting firm?
Answer--An insured may be inclined to ask his or her attorney for an opinion letter for protection against penalties in the event the IRS challenged a transaction. With the publication of IRS Circular 230,82 however, an opinion letter may be unavailable or prohibitively expensive. It may expose other parties in the transaction to IRS penalties as well. (83) Even if the insured can obtain a "more likely than not" opinion letter, it is questionable whether the law firm will have expressed definitive answers about many of the tax results. As we point out, many of the tax implications of even legitimate and appropriate life settlement transactions are far from clear.
Question--What are the risks to advisors issuing opinions on SOLI/SILI programs?
Answer--If the Service determines that a transaction is a "reportable" or "listed" transaction, one risk is whether the attorney would be deemed to be a "material advisor" who would be required to report the details of his/her participation to the IRS. (84) In an attempt to rein in practitioners who have disregarded their ethical obligations regarding abusive tax shelters, the Treasury and IRS changed the rules regarding the written advice tax professionals provide to clients in 2004. Effective June 21, 2005, detailed revisions to Circular 230 apply to written federal tax advice provide to clients. (85) If an advisor issues an opinion involving a SOLI / SILI transaction, the advisor must decide and disclose whether that opinion is a so-called "covered" opinion, "limited scope" opinion or "other written tax advice."
Question--What is the risk that a SOLI/SILI policy's death benefit will be included in the insured's taxable estate?
Answer--Because investors typically look for insureds with a projected life expectancy of 120 months or less, the documents related to the transaction must be closely reviewed to evaluate the risk that the death benefit will be included in the insured's gross estate if death occurs during this period.
For example, do the mechanics of the loan and any options given to and powers over the trust held by the insured or his trustee constitute retained powers under IRC Section 2042 (or other Code sections) causing inclusion of the policy in his or her estate? This would cover the first 24 to 30 months until the insured transfers ownership to the investors. If Section 2042 applies, is there a possibility that IRC Section 2035 might also apply when the policy is transferred to the investors? This can add three years to the risk of estate inclusion, and a great deal depends on the wording of the documents.
If the insured must approve the trustee's decision to either sell the policy to a life settlement company, walk away, and then let the lender take the policy in return for the debt or to repay the loan, will this retained right and power cause the policy to be included in the insured's taxable estate under IRC Section 2036 until the transfer and thereby cause IRC Section 2035 to apply for an additional three years after the "free" insurance period? These possibilities could cause 100% estate inclusion of the death benefit. If the insured has a sincere desire to continue this life insurance as part of his or her estate plan, as opposed to selling the policy for a profit, the added tax risk of inclusion in the estate is a high price to pay. Based on life expectancy calculations, the overall risk to the insured's estate may be as high as 30-40%.
Question--Some SOLI/SILI promoters provide participants with sample trusts; many condition participation on the use of their particular trust. What are the tax issues raised by these "off the shelf" trusts?
Answer--Some promoters provide sample irrevocable life insurance trusts that are warranted to be a nongrantor trust for income tax purposes. Some program sponsors recommend the trust that owns the policy be a nongrantor trust to "trap" any income tax liabilities inside the trust. Promoters may claim that when the policy is sold or released in satisfaction of the debt, all liability for any tax will lie within a nongrantor trust whose only asset is the insurance policy. (86) Alternatively, the promoter may provide a standardized LLC membership agreement or statutory business trust that is designed to achieve the same goal of trapping income tax liability. Many programs require that the insured use its trust or LLC document. In addition to insulating the insured from taxable income such as the kind that could arise from a so-called "walk away," these special purpose entities also serve to obscure the purpose of and who is behind the arrangement.
Despite representations that the insured will have no tax liability and that the IRS will be left "holding the bag," it is far from clear that these special purpose entities would be respected by the IRS. Some promoters have implied that the IRS has no way to collect any taxes due from the trust, LLC, or other ownership vehicle. But certainly, the IRS could challenge the entity's tax status. (87) This issue creates another friction point between the insured and the insured's advisor, and highlights another legal issue and area of malpractice exposure that should be of concern to advisors. When the policy is sold or released in satisfaction of the debt by the owning entity, the insured's expectation is that all liability for any tax will lie within a nongrantor trust whose only asset is the insurance policy. However, that is likely not to be the case.
Question--What other tax risks do clients and advisors face by the use of specimen trust documents?
Answer--A difficult issue the advisor will need to research is what provisions were included in the trust to make it a nongrantor trust. Many "off the shelf" trusts utilize a provision whereby premiums are to be paid out of principal and not out of income to avoid activating IRC Section 677(a)(3). Inexperienced advisors will be surprised to learn that this may not work. In Private Letter Ruling 8839008, the Service stated that even though trustees of a life insurance were using trust principal to pay the premiums for trust accounting purposes, for tax purposes they were still using trust income. The IRS held that the trusts in question were grantor trusts, despite the lack of trustee authority to make the payments. (88) This issue illustrates the challenges advisors face when reviewing a SOLI transaction. This issue creates yet another friction point between the insured and the insured's advisor, and highlights yet another legal issue and area of malpractice exposure that should be of concern to advisors in SOLI programs. It also underscores the importance of the advisor's role in identifying who his/her client is: the insured, the trustee, the trust's beneficiaries and/or the client's spouse.
Question--Could SOLI/SILI programs be subject to an excise tax?
Answer--Advisors need to weigh the risk that Congress will eliminate these transactions through the imposition of an excise tax. Congress could easily place a 100% excise tax on the purchase price and ongoing premium payments of an in-force life insurance policy purchased in the secondary market during the first five years after the policy's issuance. (89) Previous proposals would have applied an excise tax to the policy's death benefits or inside buildup, so advisors clearly need to keep an eye on developments in Washington.
Some commentators believe that the secondary market and SOLI invite re-examination of the tax-advantaged status of life insurance because traditional notions of insurable interest are broken, and because life insurance could be viewed as an investment product rather than a product that protects families and businesses from an insured's premature death. (90)
Question--If an exempt organization uses non recourse financing to purchase and potentially sell life insurance policies, what are the tax issues?
Answer--Congress considered imposing an excise tax on abusive financed, charitable life insurance programs (often referred to as "CHOLI"). However, the Pension Protection Act of 2006 imposed just a reporting requirement on exempt organizations that acquire life insurance after August 17, 2006 and before August 17, 2008, that is part of a structured transaction involving a pool of contracts. Under Section 6050V, certain exempt organizations that acquire direct or indirect interests in "applicable insurance contracts" must file a return containing detailed information about the exempt organization, the insurance contracts as well as the parties to the transaction. (91) Financed life insurance may also raise unrelated business income tax issues for the exempt organization, particularly if "acquisition indebtedness" is used to purchase the policies. (92)
Question--If a state enacted a law that prohibited life insurance polices that were funded with certain types of non recourse financing from being sold in a specified timeframe, would foreign investors barred from selling have any recourse?
Answer--International investors could explore filing a complaint with the World Trade Organization alleging unfair trade restrictions. (93)
(1.) IRC Section 1001(a) provides that the gain from the sale or other disposition of property is the excess of the amount realized over the adjusted basis provided in IRC Section 1011. IRC Section 1001(b) provides that the amount realized from a sale or other disposition of property is the sum of any money received plus the fair market value of the property (other than money) received. IRC Section 1001(c) provides generally that the entire amount of the gain realized under IRC Section 1001(b) must be recognized. See Maule, "Income Tax Basis: Overview and Conceptual Aspects, 560 BNA Tax Management Portfolios (2000).
(2.) For additional guidance on basis calculation, see IRC Sections 72(c)(1,) 72(e)(4)(B) and 72(e)(6); Treas. Reg. [section]1.72-6(a)(1); Rev. Rul. 55-349, 1955-1 C.B. 232; Estate of Wong Wing Non. v. Comm., 18 TC 205 (1952).
(3.) See S. Simmons, "Simmons on Settlements," Steve Leimbergs Estate Planning Newsletter, Issue # 664.
(4.) 69 F.2d 967 (3rd Cir. 1934). Other cases denying basis credit for COI charges include: London Shoe Co. v. Comm., 80 F.2d 230 (2nd Cir. 1935), Appeal of E.A. Armstrong, 1 BTA 296 (1925), Standard Brewing Co. v. Comm., 6 BTA 980 (1927), Keystone Consolidated Publishing Co. v. Comm., 26 BTA 1210 (1932).
(5.) In AALU Bulletin 05-19, the Association for Advanced Life Underwriting (AALU) suggested that the holding in Internal Legal Memorandum 200504001 could erode the general rules of IRC Section 72(e), which say that the taxpayer's "investment in the contract" includes the aggregate amount of premiums or other consideration paid for a contract. The AALU viewed the specific language of Section 72(e) as controlling on the question of the taxpayer's basis in ILM 200504001 and that the policy owner should have been able to receive tax-free the entire amount paid as premiums on both policies.
(6.) Treasury Regulation [section]1.61-22(f)(2).
(7.) "IRS Ruling on Accelerated Death Benefits Fuels Policy Debate," Tax Notes Today, 94 TNT 222-10, Nov. 14, 1994; Gallun v. Comm., 327 F.2d 809 (7th Cir. 1964), Comm. v. Phillips, 275 F.2d 33 (4th Cir. 1964); Est. of Crocker, 37 TC 605 (1962).
(8.) See Gans and Soled, "A New Model for Identifying Basis in Life Insurance Policies: Implementation and Deference," Florida Tax Review, Volume 7, Number 9, 2006. Gans and Soled suggest the use of a hypothetical term method that would be applied to all taxpayers who dispose of a policy by sale or by pre-death surrender to the insurance company in order to eliminate the inequity of treating taxpayers differently based on whether they sell or surrender the policy. They suggest Congress should amend IRC Section 72 and replace it through the promulgation of new regulations with a hypothetical term method similar to the Table 2001 computation of economic benefit, which is used in split-dollar and pension transactions.
(9.) Frankel, "Life Settlements: Sale of Life Insurance Policies in the Open Market," 40th Heckerling Institute on Estate Planning H 900 (2005). See also J. Raby and W. Raby, "The Tax Treatment of Life Settlements," 19 Insurance Tax Review 385 (2000); Simmons, "Life Settlements, Senior Settlements, and Other Variations on Viatical Sales," ALI-ABA 2-04 (2004).
(10.) www.logos4me.com/Life%20Settlement/Peat%20Marwick. htm.
(11.) This general rule can be found in IRC Section 1001(a).
(12.) U.S. v. Midland-Ross Corp., 381 U.S. 54, 57 (1955); Crocker v. Comm., 37 TC 605, 610 (1962); Roff v. Comm., 36 TC 818, 824 (1961).
(13.) IRC Sec. 1222; Treas. Reg. [section]1.1221(a).
(14.) IRC Sec. 1221.
(15.) BTA Memo 1941-319 (1941).
(16.) 275 F.2d 33, 36 (4th Cir. 1960).
(17.) Not all policies purchased on the secondary market are permanent life insurance policies. Buyers sometimes do purchase term insurance, and in cases where the policy has conversion privileges, buyers will convert their term policies to permanent coverage. Because a term policy has no cash value component, all of the sale proceeds in excess of the policy's basis should be eligible capital gain treatment under the commonly accepted tax model described above.
(18.) Gallun v. Comm., 327 F.2d 809 (7th Cir. 1964); First National Bank of Kansas City v. Comm., 309 F.2d 587 (8th Cir. 1962); Phillips v. Comm., 275 F.2d 33 (4th Cir. 1960); Arnfield v. U.S., 163 F.Supp. 865 (Fed. Ct. Cl. 1958); Bolling Jones, Jr. v. Comm., 39 TC 404 (1962); Roff v. Comm., 304 F.2d 450 (3rd Cir. 1962); Crocker v. Comm., 37 TC 605 (1962); Neese v. Comm., TC Memo 1964-288.
(19.) TC Memo 2007-282.
(20.) "Capital Adequacy Ratios," Insights for Bank Directors: A Basic Course on Evaluating Financial Performance and Portfolio Risk, Federal Reserve Bank of Kansas City, at www.stlouisfed.org/ col/director/Materials/alco_capitaladequacy_ratios.htm.
(21.) IRC Sec. 72(v).
(22.) See Zaritsky and Leimberg, Tax Planning with Life Insurance, 1|2.20[c] (Boston, MA: Warren, Gorham, Lamont; 2nd ed., updated yearly)("Adjusted Basis for an Inherited Life Insurance Policy"). As the authors point out, a life insurance policy should not be an item of income in respect of a decedent (IRD) because the policy was not a right to income to which the decedent was entitled during lifetime. Rather, it is merely an appreciated asset of the decedent's estate.
(23.) Treas. Reg. [section]1.1001-2(a)(2).
(24.) Treas. Reg. [section]1.1001-2(c), Example 8.
(25.) Treas. Regs. [section][section]1.1001-2(a)(4)(i), 1.1001-2(c), Example 7. The regulations give the following example: In 1974, E purchases a herd of cattle for breeding purposes. The purchase price is $20,000 consisting of $1,000 cash and a $19,000 note. E is not personally liable for repayment of the liability and the seller's only recourse in the event of default is to the herd of cattle. In 1977, E transfers the herd back to the original seller, thereby satisfying the indebtedness pursuant to a provision in the original sales agreement. At the time of the transfer the fair market value of the herd is $15,000 and the remaining principal balance on the note is $19,000. At that time E's adjusted basis in the herd is $16,500 due to a deductible loss incurred when a portion of the herd died as a result of disease. As a result of the indebtedness being satisfied, E's amount realized is $19,000 notwithstanding the fact that the fair market value of the herd was less than $19,000. E's realized gain is $2,500 ($19,000--$16,500).
(26.) Comm. v. Tufts, 461 U.S. 300 (1983); Treas. Reg. [section]1.1001-2(c), Example 7.
(27.) U.S. v. Hendler, 303 U.S. 564 (1938).
(28.) See Haden Co. v. Comm., 118 F.2d. 285 (5th Cir. 1941); Texas Gas Distributing Co. v. Comm., 3 TC 57 (1944).
(29.) Est. of Delman v. Comm., 73 TC 15, 32 (1979).
(30.) Olaf C. Akland v. Comm., 767 F.2d 618 (9th Cir. 1985); U.S. v. Landsberger, 534 F. Supp. 142 (D.C. MN 1981); Carl M J. Aagaard v. Comm., TC Memo 1985-194; Eugene H. Whitehead v. Comm., TC Memo 1991-455; Rev.Rul 2006-19, 2006-15 IRB 749.
(31.) Kevin D. Castro v. Comm., TC Memo 2001-115; Robert A. Lund v. Comm., TC Memo 2000-334; Prindle International Marketing v. Comm., TC Memo 1998-164, Roland R. Fox v. Comm., 229 F3d 1157 (9th Cir. 2000); Louis Markosian v. Comm., 73 TC 1235 (1980); Frank Muhich v. Comm., TC Memo 1999-192 ; Greg William Gouveia v. Comm., TC Memo 2004-256.
(32.) Frank Muhich v. Comm., TC Memo 1999-192.
(33.) See TAM 8348001 (1983); Focht v. Comm., 68 TC 223 (1977), acq, 1980-2 C.B., Est. of Delman v. Comm., 73 TC 15 (1979).
(34.) "Tax Aspects of Restructuring Financially Troubled Businesses," BNA Tax Management Portfolios, 541 II (Sept. 2007).
(35.) Ring and Siegert, "Taxation of Life Insurance Policies in an Evolving Secondary Marketplace" Insurance Studies Institute, March 3, 2008.
(36.) Investors could argue that Section 1234A warrants capital gain treatment, but the Service may not equate the payment of a death benefit with a "right or obligation." See, e.g., Technical Advice Memorandum 200452003, in which the Service rejected the argument that IRC Section 1234A applied to the surrender of a block of corporate-owned life insurance policies.
(37.) Shapiro, "Vulture Capital Tax Manual: A Brief Guide to the Tax IssuesAssociated with Financial Investments in Life Settlements," Journal of Taxation of Financial Products, Volume 6, No. 3 (2007).
(38.) IRC Sec. 469.
(39.) IRC Sec. 264(a)(4). If the policy was purchased to be held until death, interest paid would reduce the ultimate income tax as a result of the so-called "transfer for value" rule in IRC Section 101(a).
(40.) See D. Shapiro, supra, at p. 8.
(41.) IRC Sec. 511(b)(5)(B).
(42.) IRC Sec. 512(b)(4).
(43.) Bundesverband Vermogensanlagen, "The Secondary Market for Life Insurance Policies," at www.bvzl.de/cms/upload/pdf/ Publikationen/BVZL_Imagebroschure_engl.pdf.
(44.) The Life Settlements Report, Vol. 1, No.1 (April 5, 2007), and Vol. 1, No. 7 (July 2007).
(45.) It is an urban myth that German pension funds were purchasing policies in the United States. As has been demonstrated, there are practically no German pension "funds," as German pension obligations are normally unfunded and reserved for in the balance sheet of the employer-company. See Pollath and Rodin "Privately Placed Closed-End Funds for Crossborder Investment From and Into Germany" paper published by Pollath + Partners (www.pplaw.de/library/m_a.html).
(46.) Article 21, U.S. Model Income Tax Convention of September 20, 1996; at www.irs.gov/pub/irs-trty/usmtech.pdf.
(47.) Article 5(6), U.S. Model Income Tax Convention of September 20, 1996.
(48.) Treas. Reg. [section]1.1441-2(b)(1)(i).
(49.) Treas. Reg. [section]1.1441-2(b)(2)(i).
(50.) Securitization is a structured finance process whereby assets, receivables or financial instruments are acquired, classified into pools, and offered as collateral for third-party investment, and involves the selling of financial instruments which are backed by the cash flows and/or value of the underlying assets. Black's Law Dictionary (7th ed.).
(51.) Goldstein, "Profiting from Mortality," Business Week, July 30, 2007, at www.businessweek.com/magazine/content/07_31/ b4044001.htm.
(52.) Dorr, "Longevity Trading: Bridging the Gap between the Insurance Markets and the Capital Markets," The Journal of Structured Finance, Summer 2007.
(53.) Portfolios can also be hedged with derivatives and/or leveraged to create even higher returns. See Mott, "New Swaps to Hedge Alpha and Beta Longevity Risks of Life Settlement Pools," The Journal of Structured Finance, Summer 2007.
(54.) Of the total pool, $70.3 million reportedly received an A1 rating with the remaining $8.5 million receiving a Baa2 rating. Life Settlements Report Vol. 1. No. 1, April 5, 2007.
(55.) "Ritchie Bankruptcy Not Expected to Slow Life Settlements Market" The Life Settlements Report, Vol. 1, No. 7, July 5, 2007, p. 1.
(56.) "Life Settlement Securitization" A.M. Best, September 1, 2005, p. 10.
(57.) On September 5, 2007, the Financial Services Committee held a hearing entitled, "Recent Events in the Credit and Mortgage Markets and Possible Implications for U.S. Consumers and the Global Economy."
(58.) "Suit Reveals Fraudulent Scheme in Life Settlement Industry," at www.oag.state.ny.us/press/2006/oct/oct26a_06.html.; "SEC Obtains Emergency Orders Shutting Down Mutual Benefits Corp., Alleges Fraud and Contempt of Prior Injunction in Connection with Sale of Viatical Securities," at www.sec.gov/news/digest/ dig050704.txt.
(60.) Nirenberg and Peaslee, Federal Income Taxation of Securitization Transactions p. 25 (Frank J. Barbozz1 Associates, 3rd edition, 2001).
(61.) Id., at 30, 56, 98.
(62.) Treas. Reg. [section]1.61-7.
(63.) IRC Sec. 171(c)(2).
(64.) Treas. Regs. [section][section]1.1271-1 through 1.1275-7.
(65.) IRC Secs. 1(h), 1001, 1222.
(66.) IRC Secs. 475(c)(2)(E), 475(a)(2). Dealers claiming to hold securities as investments and not for sale to customers must comply with specific identification requirements to avoid ordinary income treatment. J.C. Bradford. v. U.S., 444 F.2d 1133 (Ct Cl. 1971); Nielsen v. U.S., 333 F.2d 615 (6th Cir. 1964).
(67.) Greene v. Comm., 85 TC 1024 (1985), acq., 1986-2 CB 1.
(68.) Magner and Leimberg, "Life Settlement Transactions: Important Tax and Legal Issues to Consider," Estate Planning, April, 2007.
(69.) Harrison, "Casey Jones: Who is Driving That Insurance Train: Letting an Investor Bet on "When You Will Die," A Paper Presented to The Chicago Council on Planned Giving (March 14, 2006); Duhigg, "Late in Life, Finding a Sudden Bonanza in Life Insurance," New York Times, December 17, 2006, p. 1. One promoter placed an advertisement in a Florida newspaper offering qualifying individuals two years of free life insurance, and a Bentley. See also Leimberg, Investor- Initiated Life Insurance: Really a 'Free Lunch' or Prelude to Acid Indigestion, 41 Heckerling Institute on Estate Planning 1300 (2007); Kingma, "Update on Insurable Interests," 47th Annual Michigan Probate & Estate Planning Institute 16-1 (2007); Jensen and. Leimberg, "Stranger-Owned Life Insurance: A Point/Counterpoint Discussion," 33 ACTEC Journal II (2007); Leimberg, "Planners Must Be Aware of the Danger Signals of 'Free' Insurance," Estate Planning, Vol. 34, No. 2, Feb. 2007; Jones, Leimberg, and Rybka, "'Free' Life Insurance: Risks and Costs of Non-Recourse Premium Financing, Estate Planning, Vol. 33, No. 7, July 2006, p. 3; and Leimberg, "Stranger-Owned Life Insurance (SOLI): Killing the Goose that Lays Golden Eggs", Estate Planning, Vol. 32, No. 1, January 2005, p. 43, reprinted as Leimberg, "Stranger-Owned Life Insurance (SOLI): Killing the Goose that Lays Golden Eggs," Tax Analysts/The Insurance Tax Review, Vol. 28, No. 5, May 2005.
(70.) See Custis v. Comm., TC Memo. 1982-296 (where the Tax Court allowed an agent who rebated premiums to deduct the amount of rebates as business expenses but only after he proved that the state did not generally enforce its anti-rebating laws). According to Commissioner v. Glenshaw Glass, 348 U.S. 426 (1955), the insured taxpayers have accession to wealth and complete dominion and control over the insurance policies, thus requiring that they recognize income from the free insurance that they received. "Free insurance" is often defined as a sale at or below cost, so there may not be a statutory "inducement" where the full premiums specified in the contract are paid.
(71.) Haderlie v. Comm., TC Memo 1997-525; Compare Wentz v. Comm. 105 TC 1 (1995) to Woodbury v. U.S., 72 AFTR2nd 193-6140, aff'd per curium, 27 F.3rd 572 (8th Cir. 1994) where the court took a harsher view on similar facts and held--as it did in Haderlie--that the full amount of the premium was the measure of the insured's reportable income.
(72.) Wentz v. Commissioner, 105 TC 1 (1995). Zaritsky and Leimberg, Tax Planning with Life Insurance, (Boston, MA: Warren, Gorham, Lamont; 2nd ed., updated yearly).
(73.) See Charles F. Sutter v. Comm., TC Memo 1998-250; Woodbury v. Comm.,
(72.) AFTR 2d 93-6140, aff'd per curium, 27 F.3rd 572 (8th Cir. 1994); and TAMs 9214006, 9214007 and 9214008. Supra, at note 34.
(74.) Rev. Rul. 78-420, 1978-2 CB 67. In a paper presented at the 2005 ACTEC Summer Meeting, ("Casey Jones, Who's Driving that Insurance Train") Louis Harrison suggested that the gift of insurability would not be taxable.
(75.) Let. Rul. 9719005, Dan Warden v. Comm., TC Memo 1988-165; Charles Columbo v. Comm., TC Memo 1975-162, Anthony Romano v. Comm., TC Memo 1980-323; Robert Miller v. Comm., TC Memo 1989-128.
(76.) See Sutter v. Comm., TC Memo 1998-250.
(77.) Est. of F.S. Bell v. Com., 137 F.2d 454 (8th Cir. 1943); Rev Rul. 72243, 1972-1 CB 233; McAllister v. Comm., 157 F.2d 235 (2nd Cir. 1946), Allen v. First National Bank & Trust Co., 157 F.2d 592 (5th Cir 1946), Jones v. Comm., 330 F.2d 302 (3rd Cir. 1964).
(78.) See Let Rul. 9840040, and Burstein, "What Is Insurance?" 11 Insurance Tax Review 25 (Jan. 1997).
(79.) See IRC Section 7702(g).
(80.) Treas. Reg. [section]1.6011-4(b).
(81.) IRC Section 6011.
(82.) See Blattmachr, Gans, and Rios, The Circular 230 Desk Book (Practicing Law Institute 2006).
(83.) Circular 230 (T.D. 9165, 65 Fed. Reg. 75839, December 20, 2004) allows the IRS to hold accountants and attorneys legally responsible for not only what they present in their tax and legal opinions, but for omissions of material information.
(84.) IRC Sec. 6012; Treas. Reg. [section]301.6012-1(c)(2).
(85.) IR-2004-152, Dec. 17, 2004, at www.irs.gov/irs/ article/0,,id=132445,00.html.
(86.) Because carriers are aware of SOLI transactions, many conduct post-issue ownership investigations.
(87.) Sham trusts that lack economic substance will not be recognized. See Frank Muhich v. Comm. TC Memo 1999-192.
(88.) See Zaritsky and Lane, Federal Income Taxation of Estates and Trusts, Section 10.05, (RIA Thomson).
(89.) Discussions reportedly occurred between the life insurance industry and members of the Senate Finance Committee's staff when Section 212 of H.R. 4297, enacted as part of the Tax Relief Act of 2005, was being debated in the Senate. The excise tax provision was dropped in conference when some felt it went too far.
(90.) See, e.g., Fitch Ratings Special Report, Fatal Attraction: Risks in the Secondary Market for Life Insurance, p.1, September 12, 2007; and Frank Keating, President ACLI, Letter to Wall Street Journal, August 10, 2006, at www.acli.com/ACLI/Newsroom/ Letters+to+the+Editor/LTR06-013.htm.
(91.) See IRS Form 8921 at www.irs.ustreas.gov/pub/irs-pdf/f8921. pdf.
(92.) IRC Section 512(b).
Figure 12.1 THE "COMMONLY ACCEPTED" FORMULA FOR TAXING A. Recovery of basis Income tax-free B. Basis up to cash surrender value Ordinary income C. Amount in excess of cash surrender value Capital gain 5-Step Method for Calculating Gain From A Life Settlement Transaction STEP 1 Calculate policy basis STEP 2 Subtract policy basis from payment STEP 3 Identify cash surrender value segment and subtract from payment STEP 4 Subtract any remaining amount from payment STEP 5 Characterize the gain
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|Publication:||Tools & Techniques of Life Settlement Planning|
|Date:||Jan 1, 2008|
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