Monthly LRA Update

TAX DEVELOPMENT

Biden Budget Proposal On March 11 the Biden Administration released its budget for Fiscal Year 2025. The Treasury Department also released its General Explanations of the Administration’s Fiscal Year 2025 Revenue Proposals (so-called “Greenbook”).

This year’s materials included several budget proposals that have been put forth in prior years, including an increase in the Corporate Tax Rate from 21% to 28% and an expansion of the pro-rata interest expense disallowance for COLI. As a reminder, the proposed expansion of the pro-rata interest expense disallowance would be accomplished by removing the current exception applicable to insurance contracts that cover employees, officers or directors of a business. The proposal continues to be drafted to apply prospectively and, unless modified, would have minimal effect on existing BOLI/COLI programs.

This year’s materials included two additional proposals related to life insurance contracts.

Modify Rules for Insurance Products that Fail the Statutory Definition of a Life Insurance Contract

The Greenbook describes a product structure where certain foreign insurance companies have designed contracts that are referred to as “frozen cash value” (FCV) contracts to minimize the adverse tax effect of a life insurance contract that does not meet the IRC 7702 computational requirements.

In general, a life insurance contract that does not satisfy IRC 7702 requirements (e.g., the cash value accumulation test) will be subject to tax on the amounts by which the surrender value increases in a given taxable year. However, since the FCV contracts have been designed to have minimal growth in surrender values, there is minimal taxable “income on the contract.”

The Treasury proposes rule modifications to ensure that FCV contracts have taxation that is “intended” for life insurance contracts that fail the IRC 7702 computational requirements.

Likely in an effort to avoid broader utilization of FCV contracts pending statutory adjustments, the Greenbook states that this proposal would be effective for any such contracts issued on or after the date of publication of the Greenbook.

We are not aware of any instances where institutions have used FCV contracts and do not believe that these adjustments, if enacted, would have material effect on the BOLI/COLI industry.

Limit Tax Benefits for Private Placement Life Insurance and Similar Contracts

As we reported last month, Senate Finance Committee Chairman, Ron Wyden (D-OR) released a report questioning the appropriateness of current tax laws with respect to Private Placement Life Insurance (PPLI) and Private Placement Annuities (PPA). The report stated that the Finance Committee is working on legislation to curb the use of PPLI and described guiding principles of such legislation.

This year’s Greenbook includes a new section targeting PPLI. While we were previously of the understanding that the concerns were related to the High Net Worth individual PPLI market, the Greenbook’s description targets business-owned life insurance as well. For example, the excerpt below (emphasis added) asserts that institutions own more than half of the value of PPLI contracts.

PPLI contracts are highly investment-oriented policies, provide legally minimal life insurance protection relative to the amounts invested, and are available only to the wealthiest taxpayers to whom income tax and/or estate tax benefits are far more important than the provision of insurance for their heirs. PPLI is also distinguishable from other life insurance products because more than half of the value of such policies is held by institutions, such as large corporations, and not individuals. This type of policyholder uses PPLI death benefits and other distributions to fund executive compensation, employee benefits, and other corporate purposes unrelated to the impact on the business from the death of the insured.

Below we highlight elements of the proposal that is intended to curtail the utilization of PPLI.

Proposal

A new class of contracts (“Covered Contracts”) would be defined and subjected to adjusted tax treatment. Of primary note, the definition of Covered Contracts would include any PPLI contract that is 1) defined as a variable contract; 2) subject to SEC regulation as a security; 3) not registered with the SEC (i.e., is a private placement); and 4) requires the purchaser to be an accredited investor or qualified purchaser.

This definition would appear to capture Private Placement Variable Universal Life products commonly used in COLI, BOLI and I-COLI markets. The proposal also states that if a single policyholder (or group of related policyholders) represents at least 5% of the value of any distinct investment option within a separate account (presumably including in the context of a registered variable contract), that contract will also be treated as a Covered Contract.

The proposal outlines the tax treatment that Covered Contracts would be subject to, including

• Distributions would be subject to the income-first rule (i.e., similar to present MEC rules); however, distributions would include amounts payable as death benefits.
  • Such distributions would be taxable as ordinary income to the extent that the contract’s “investment value” exceeds the “investment in the contract.”
  • The “investment value” of a life insurance contract would be the greater of: (a) the contract’s cash value; and (b) “an amount equal to the contract’s death benefit, less the contract’s amount at risk (i.e., the amount of pure insurance protection).”
  • The “investment in the contract” would be determined under current law but would also be reduced by the amount of any mortality charges that have been assessed against the contract’s investment value.
• Amounts paid from a life insurance contract by reason of the insured’s death would be taxable as ordinary income, but only to the extent the beneficiary’s share of the contract’s investment value exceeds the beneficiary’s share of the contract’s investment in the contract.
  • NOTE: We are still digesting this language in the proposal; however, another passage in the Greenbook describes the intent as follows: “…while preserving a tax exemption for the pure life insurance benefits (amounts paid in excess of a contract’s cash value) received under PPLI contracts.” Therefore, we interpret death benefit gains, if applicable, as remaining tax exempt.
• An additional tax equal to 10% would be assessed on any taxable distribution (including taxable death benefits).

This proposal is written to be effective for Covered Contracts issued on or after the date of the Greenbook’s publication, so, as written, it would not impact any current BOLI, COLI or I-COLI contracts

Initial Observations

Similar to how the Volcker “Covered Fund” definition primarily related to whether certain exemptions from registration were relied upon, the proposed Covered Contract definition that hinges on whether the product is registered or private placement strikes us as arbitrary and ill-advised.

As drafted, this proposal would not impact General Account products or SEC-registered variable products, which can be offered as alternatives to PPVUL products.

We remain supportive of efforts to curb abuses in the individual High Net Worth marketplace. The longstanding investor control doctrine provides ample opportunity for the Service to achieve these ends.

We find the 5% maximum interest for a single policyholder in a separate account to be impractical and misguided on several levels. For example, for a new investment option to qualify, an insurer would either need to seed the account with a significant investment, or it would need to have 20+ like-size policyholders elect the allocation virtually simultaneously.

Likewise, if an investment option was previously diversified across enough policyholders, various transactions wholly outside the control of a given policyholder could result in the investment option no longer satisfying the constraint. Such transactions could include elective reallocations or transfers to other investment options, redemptions via contract termination, or redemptions due to death benefit payments.

The proposed adjustment to a policyholder’s “investment in the contract” (i.e., reducing such investment for mortality charges) is contrary to a provision enacted in the Tax Cuts and Jobs Act that expressly rejected such adjustments.

We are reaching out to leading PPLI product providers for further input on this budget proposal and will continue to monitor for any actual legislative proposals.

Revenue Estimates of Certain Proposals

Both the Budget and the Greenbook included summary tables with estimated tax revenue effects of the various proposals. For context, we highlight the magnitude (over 10 years) of some of these estimates:

• Raise the corporate tax rate to 28%: $1,350 billion
• Subtotal of provisions to “Strengthen Taxation of High-Income Taxpayers”: $1,834 billion
• Expansion of Pro-Rata Interest Expense Disallowance: $7 billion
• Limit tax benefits for PPLI: $7 billion
• Modify tax rules for FCVs: $0 billion (i.e., $185 million)

Overall, the budgetary effects of the insurance-specific provisions are modest.