The Code generally excludes death benefits from being treated as taxable income.1 However, there is a general exception to this exclusion for death benefits paid on contracts that were transferred for “valuable consideration.”2
This “transfer for value” rule (“TFV Rule”) generally applies to any “transfer” of a life insurance contract “by assignment or otherwise.” Thus, in the context of COLI/BOLI, it would generally apply (an important exception is described below) where one business acquires another business that owns COLI or BOLI. If the TFV Rule applies, the amount of tax-free death benefits with respect to any life insurance policy is limited to the amount of consideration paid for the policies plus the premiums3 that are subsequently paid by the person acquiring the policies.
The Code has an important exception to the TFV Rule for transfers where the acquirer’s tax basis in the acquired policies is determined “in whole or in part” by reference to the tax basis of the person transferring the policies.4 Coming back to the example of a business acquiring another business that has COLI or BOLI policies, the tax basis of the acquiring business in the COLI or BOLI is determined by reference to the tax basis of the acquired business, and the TFV Rule does not apply. Thus, the death benefits on these COLI or BOLI policies is not limited to the amount paid for the policies plus the amounts of premiums and “other amounts” paid subsequently by the acquiring company with respect to the policies.
Section 13522 of H.R. 1 adds a new wrinkle to the TFV Rule. It specifies that where there is a “reportable policy sale,” the exception to the TFV Rule described in the paragraph above does not apply. Thus, under section 13522, if a transfer of a life insurance contract is a “reportable policy sale,” the death benefits paid with respect to such transferred policy are only tax-free to the extent of the amount paid for the policies plus the amount of premium and “other amounts” paid with respect to the policy by the acquirer.
Under section 13522, a reportable policy sale is any acquisition of a life insurance contract where the acquirer has no substantial family, business, or financial relationship with the insured apart from the acquirer’s interest in the life insurance contract.5 This presents a problem for the COLI/BOLI marketplace. The following hypothetical demonstrates this problem.
Assume that the owners of Bank 1, a small community bank, are looking to exit the banking business. Bank 1 has BOLI policies, some of which are on the lives of current employees, officers, or directors, and others of which are on the lives of former employees, officers, or directors. In order to exit the business, the owners of Bank 1 find a potential buyer in a somewhat larger community bank, Bank 2, who wishes to enter the market that Bank 1 is in. The parties come to terms and the owners of Bank 1 sell Bank 1 to Bank 2.
Bank 1’s BOLI policies are transferred along with all of the assets of Bank 1. By virtue of the changes made by section 13522, the transfer of the BOLI policies with respect to former employees, officers, or directors is considered a “reportable policy sale” because Bank 2 has no substantial family, business, or financial relationship with the former employees, officers, and directors of Bank 1 but for its ownership of the BOLI on their lives.
Thus, notwithstanding the fact that Bank 2 meets all state-law requirements for owning the policies, and the fact that its tax basis in the BOLI is determined by reference to Bank 1’s tax basis in such BOLI, the indirect transfer of BOLI on the lives of former employees, officers, and directors is a transfer for value that is subject to the TFV Rule. Thus, any death benefits received by Bank 2 with respect to these particular policies are tax-free only to the extent of the amount that Bank 2 paid with respect to the policies plus the amount of premiums Bank 2 pays on such policies from the time it acquired them until the death benefits are paid. Such an outcome could obviously discourage companies from owning COLI or BOLI.
The industry has been aware of the potential for this problem for some time. In fact, the legislation introduced by Representative Pat Tiberi (R-OH) that originally proposed a provision similar to section 13522, H.R. 1262, included language that would have mitigated the problems discussed herein.
H.R. 1262 provided that with respect to “indirect” transfers of life insurance contracts by virtue of the transfer of an interest in a partnership, trust, or other entity owning the contracts, there would be no reportable policy sale where (i) the life insurance is on a current or former employee, officer, director, 5-percent owner, or independent contractor of the entity owning the insurance policy, and (ii) less than 50 percent of the gross value of the assets acquired from the entity consist of life insurance contracts (unless the acquirer can demonstrate to the satisfaction of the IRS that acquiring life insurance contracts is not the principal purpose of the acquired entity).
1 Sec. 101(a)(1).
2 Sec. 101(a)(2).
3 In addition to premiums, the sum also includes “other amounts” subsequently paid with respect to the policy, such as non-deductible interest paid or accrued on debt with respect to the policies. See sec. 101(a)(2) flush language.
4 Sec. 101(a)(2)(A). There is also an exception for transfers of policies to the insured, a partner of the insured, a partnership in which the insured is a partner, or a corporation in which the insured is a shareholder or officer. See sec. 101(a)(2)(B).
5 H.R. 1 (115th Cong.), sec. 13522(a) (proposing Code section 101(a)(3)(B)).
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