Monthly LRA Update

TAX DEVELOPMENTS

Reportable Policy Sale Proposed Update

On May 10 the IRS published a proposed rule in the Federal Register to amend the existing regulations relating to section 1035 exchanges of life insurance and certain other life insurance contract transactions. These regulations are sometimes referred to as the Reportable Policy Sale rules. The Tax Cuts and Jobs Act added IRC 101(a)(3) established the term Reportable Policy Sale which limits the applicability of the previously existing exemptions from the so-called transfer for value rules if a transfer of life insurance contracts constitutes a Reportable Policy Sale.

In 2019 the IRS finalized regulations to implement the new legislation. Interested parties submitted comments in response to the final regulations (particularly relating to 1035 exchanges and mergers and acquisitions). In 2021 the IRS published a Priority Guidance Plan indicating its intention to revisit these topics.

Proposed Rule for 1035 Exchanges

The 2019 final regulations staked a position that policies acquired in a 1035 exchange constituted a transfer of an interest in a life insurance contract. As such, they had to be tested for whether the policyowner had a substantial business, family or financial relationship with the insured.

In the proposed rule, the IRS looks to adjust that portion of the prior regulations while also preventing policyowners from using 1035 exchanges to cleanse policies previously transferred in Reportable Policy Sales. Specifically, the proposed rule would

• Clarify that the issuance of a policy from an insurer to a policyholder is not a transfer of an interest in a life insurance contract (without qualification); and
• Establish a new rule that the old contract’s basis and death benefit tax treatment is carried forward to the new contract.

We fully support both aspects of the proposed rule for 1035 exchanges. These changes largely restore the tax treatment of exchanges to the same position that applied prior to the enactment of the Reportable Policy Sale rules under TCJA.

Exchanges (including those on former employees) remain complex; insurable interest, insured notification/consent, IRC § 264(f) and other qualitative and quantitative hurdles remain.

Proposed Rule for Mergers and Acquisitions

In the proposed rule, the IRS reiterated its previous rationale for different treatment of stock and asset reorganizations:

• An acquirer of an interest in an entity has limited ability to determine the types of assets an entity owns; and
• The IRS had not identified any clear policy reason why the complete exclusion of death benefits from policies held by a corporation should carry over when ownership of the insurance policy is transferred but a substantial business or financial relationship does not exist between the acquirer and insured.

Subsequent to the 2019 final regulations, the IRS received a comment letter describing issues the life insurance industry was encountering due to the disparate treatment. The author of the comment letter suggested the addition of an exception from the RPS rules for acquisitive transactions involving entities that own a de minimis amount of life insurance (e.g., less than 5% of total value).

The IRS is proposing a new exception for a direct acquisition of an interest in a life insurance contract from a C corporation by a C corporation, subject to the following requirements (emphasis added):

1. The acquisition results from a transaction that qualifies as a reorganization under section 368(a)
2. Immediately before the acquisition,
   • The interest is held by a C corporation involved in an active trade or business
   • The C corporation does not engage in a trade or business of investing in interests in life insurance contracts
   • No more than 5 percent of the gross value of the assets of the C corporation consists of life insurance contracts
3. Immediately after the acquisition,
   • The acquiring C corporation does not engage in a trade or business of investing in interests in life insurance contracts
   • No more than 5% of the assets consist of life insurance contracts

We are supportive of this proposed amendment as well. However, it is our understanding that the proposed exception is only applicable to tax free reorganizations (i.e., under Section 268(a)). Thus, taxable acquisitive transactions of substantially all assets of an

institution appear to not be in scope. Additionally, the acquisitive transactions exempted from Reportable Policy Sale treatment under this new rule would still need to qualify for the existing transfer for value exceptions (e.g., a carryover basis transaction).

Effective Dates

The new rules are proposed to be effective on or after the date the Treasury adopts final regulations; however, the proposal notes that taxpayers may choose to apply or rely on the proposed regulations to all section 1035 exchanges and acquisitions occurring after December 31, 2017.

Comment Period

The proposed regulations are open to public comment through July 10, 2023.

JUDICIAL DEVELOPMENTS

COI Litigation Update – Jury Finds in Favor of Plaintiffs

On May 25 a jury verdict of $6 million was reached in favor of plaintiffs in the matter of Meek v. Kansas City Life (“KCL”). Plaintiffs were challenging KCL’s determination of Cost of Insurance (COI) rates for certain universal life insurance policies. In a procedural step, the Court had previously ruled that KCL should have determined the COI rate using only age, sex and risk class. The COI provision in the specimen policy attached to the complaint was as follows:

The cost of insurance on any monthly anniversary day is equal to

Q x (R – S)

“Q” is the cost of insurance rate (as described in Section 3).

“R” is the insured’s death benefit on that day divided by no less than 1.0024663.

“S” is the cash value (as described in Section 10.2) prior to subtracting the cost of insurance.

Section 3 of the policy included the following language:

The cost of insurance rate on each monthly anniversary day is based on the Insured’s sex, age and risk class. Age means the age on the Insured’s last birthday. The guaranteed maximum monthly cost of insurance rates per $1,000 shown in the table below are based on the Commissioners 1958 Standard Ordinary Mortality Table, age last birthday.

Monthly cost of insurance rates actually used will be determined by us based on our expectations as to future mortality experience, but these rates will never be greater than those shown below. However, the guaranteed maximum monthly cost of insurance rates for special risk classes will be adjusted appropriately.

The Court left for trial determinations about whether KCL’s consideration of other factors such as anticipated persistency of the policies (e.g., lapse rates and surrender rates), anticipated interest rates, competition factors, etc. had the effect of increasing or decreasing the COI rate for policyholders such that they were damaged or may have even received some financial benefit by KCL having not limited its COI calculations to age, sex and risk class alone.

The certified class is comprised of roughly 6,000 members. The litigation commenced in 2019.

Docket: Meek vs. Kansas City Life Insurance Company, Case No: 4:19-cv-00472-BP