In its recently released General Explanation of the Administration’s Fiscal Year 2010 Revenue Proposals (the "Green Book"), the United States Department of the Treasury detailed the White House’s tax revenue proposals. Amongst a litany of proposed closures of tax loopholes and measures to combat under-reporting by way of offshore accounts and entities, there are several tax increases the White House aims to push through in order to fund its planned reform of the U.S. healthcare system. One area where tax increases are put forward is in the life insurance industry, where the Green Book details proposals to curtail tax breaks for either purchasers of certain life insurance products or life insurers themselves.

Specifically, the Green Book contains three proposals that: (1) modify the rules that apply to life settlements; (2) modify the dividends-received deduction ("DRD") for life insurance company separate accounts; and (3) expand the pro rata interest expense disallowance for corporate-owned life insurance ("COLI").

(1) Modify the rules that apply to life settlements

Under the current law, the seller of a life insurance policy usually includes in his/her taxable income the difference between the amounts received from the buyer and the adjusted basis in the policy, unless the buyer is a viatical settlement provider and the policyholder is terminally or chronically ill. Under a transfer-for-value rule, the buyer of a previously-issued life insurance contract usually includes in his/her taxable income the difference between the death benefit received and the sum of the amount paid for the policy and the premiums subsequently paid by the buyer. For further discussion on the current position of the IRS, see our prior discussion here.

According to the Green Book and other media sources, to minimize tax liability, deals involving the purchase of life insurance policies are often structured as partnerships between the buyer and the policyholder. The Green Book proposal works to eliminate this exception as well as (a) requires increased reporting to the IRS by the buyers of life insurance policies with a death benefit equal to or exceeding $1 million, and (b) requires increased reporting to the IRS by an insurer upon the payment of any policy benefits. The insurer’s increased reporting responsibility would include its estimate of the buyer’s basis.

(2) Limit the dividends received deduction for life insurers

Corporate taxpayers may generally qualify for a DRD in regard to dividends received from other domestic corporations, thereby avoiding double taxation. With regard to a life insurer, the DRD is only permitted for the insurer’s share of the dividend, as a portion of the dividends are used to fund the tax-deductible reserves for the insurer’s obligations to its policyholders.

According to the Green Book, the computation used to determine the insurer’s share is sometimes the source of controversy between life insurers and the IRS, as some tax payers claim a DRD that greatly exceeds the company's economic interest in the net investment income. The Green Book proposal aims to quell this controversy by bringing the company's share more in line with the company’s actual economic interest in the investments generating the dividend income.

(3) Limit the deduction for interest paid to finance the purchase of COLI

Under the current tax law, interest on policy loans or other indebtedness with respect to life insurance, endowment or annuity contracts is generally not deductible unless the insurance contract insures the life of a key person of the business. Further, the interest deductions of a business other than an insurer are reduced to the extent the interest is allocable to unborrowed policy cash values based on a statutory formula unless the contracts cover individuals who are officers, directors, employees, or 20-percent owners of the taxpayer.

Currently leveraged companies can fund deductible interest expenses with tax-exempt or tax-deferred income under investment-oriented COLI policies, a form of tax arbitrage. The Green Book asserts that such tax arbitragers generally do not take out policy loans or other indebtedness that is secured or otherwise traceable to the insurance contracts, but rather borrow from depositors or other lenders, or issue bonds. Similar results occur when an insurer invests in certain insurance contracts that cover the lives of their employees, officers, directors or 20-percent shareholders and fund deductible reserves with tax-exempt or tax-deferred income. To prevent this, the Green Book proposes, with some exceptions, to limit the interest expense for any borrowing for companies using COLI.