Application of new life insurance reportable policy sale rules to M&A transactions

By David Thornton, CPA, New York City

Editor: Howard Wagner, CPA

Recently issued proposed regulations under Sec. 101 (REG-103083-18) on the transfer of life insurance contracts create significant uncertainty regarding their application to tax-free asset acquisitions. These proposed regulations were issued to implement the newly enacted statutory provisions pertaining to "reportable policy sales" that arose as a result of modifications to Sec. 101 under the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97. If a transfer of a life insurance contract is a reportable policy sale, the death benefit ultimately received under the transferred policy is not tax-free. This is because the reportable policy sale rules override transfer-for-value exemptions that previously applied to tax-free corporate acquisitions under pre-TCJA law. The TCJA also enacted Sec. 6050Y, which requires reporting in the case of reportable policy sales and the payment of death benefits in the case of policies transferred in a reportable policy sale.

The proposed regulations provide that a "reportable policy sale" is an acquisition of an interest in a life insurance contract, directly or indirectly, if the acquirer has no substantial family, business, or financial relationship with the insured apart from an interest in the contract. As such, the new rule applies if (1) there is a transfer, and (2) the acquirer and the insured do not have one of these specified relationships. If there is a reportable policy sale, the contract is subject to the transfer-for-value rules of Sec. 101(a)(2). This will result in taxable income to the acquirer for the amount of death benefits received in excess of (1) the amount paid, or deemed paid, for the transfer of the policy, plus (2) any premiums paid by the acquirer subsequent to the transfer. While the reportable policy sale rules are intended to target a certain subset of potentially abusive transfers, the proposed regulations as written could result in the application of the transfer-for-value rules when there is a tax-free merger or acquisition.

As a general rule, Sec. 101(a)(1) provides that life insurance death benefits are not taxable. However, under Sec. 101(a)(2), transfers for value may render a portion of the death benefits paid under a life insurance contract taxable unless the contract has a carryover basis in the hands of the transferee or the transfer is to the insured or another qualifying person. Prior to the TCJA's enactment, this carryover basis exception generally meant that after a tax-free reorganization, the acquirer's receipt of death benefits with respect to insured individuals of an acquired corporation would be exempt from tax under Sec. 101(a)(1).

Enacted as part of the TCJA, new Sec. 101(a)(3) modifies the transfer-for-value rules to eliminate the exception to income tax for carryover basis transactions and transfers to the insured or another qualifying person in the case of a reportable policy sale. Sec. 101(a)(3)(B) defines a reportable policy sale as an acquisition of an interest in a life insurance contract, directly or indirectly, if the acquirer has no substantial family, business, or financial relationship with the insured apart from an interest in the contract. Accordingly, a direct or indirect transfer of a life insurance contact must be evaluated to determine whether it is a reportable policy sale.

Sec. 101(a)(3)(B) defines a reportable policy sale to include an indirect acquisition of a life insurance policy through an acquisition of an interest in a partnership, trust, or other entity that holds an interest in the life insurance contract, unless the acquirer bears one of the specified relationships to the insured. In March 2019, Treasury issued Prop. Regs. Sec. 1.101-1 to offer guidance on what transfers constitute reportable policy sales (REG-103083-18). In the preamble to these regulations, Treasury indicated that it intended to exclude certain acquisitions of "life insurance contracts, or interests therein, in certain ordinary course business transactions involving the acquisition of a trade or business." One provision that helps to accomplish this is Prop. Regs. Sec. 1.101-1(e)(3)(ii), which provides a blanket exemption from the reportable policy sale rules for a transaction in which the acquirer becomes a beneficial owner of a C corporation that holds an interest in a life insurance contract unless, immediately prior to the acquisition, more than 50% of the gross value of the corporation's assets consists of life insurance contracts. This exemption is sufficiently broad to eliminate the need to examine the relationships between the acquirer and the insured for corporate acquisitions where the target survives.

Example 8 of Prop. Regs. Sec. 1.101-1(g) describes a tax-free reorganization in which a target that holds a life insurance policy on a former employee is absorbed by the acquirer. The example concludes that there is not a reportable policy sale because, in the specific fact pattern of the example, there is a substantial business or financial relationship after the merger. Under these facts, the example could be read to suggest that if the substantial financial and business relationship did not exist, the reorganization would result in a reportable policy sale.

Thus, when there is a tax-free merger of one corporation into another, the result under the proposed regulations appears to be a deemed direct transfer of the life insurance contract that is a reportable policy sale unless a substantial business relationship exists with respect to the insured. Without the ability to rely upon a blanket exemption for mergers and acquisitions, where the target does not survive, acquirers in a tax-free asset acquisition must evaluate each of the acquired insurance policies to determine if the policy qualifies for exemption based upon a substantial family, business, or financial relationship between the acquirer and the insured, or some other exception applies.

Under Prop. Regs. Sec. 1.101-1(d)(2)(ii), a substantial business relationship generally exists if the target acquires an active trade or business and acquires the interest in the life insurance contract as part of that acquisition if the insured:

  • Is an employee (within the meaning of Sec. 101(j)(5)(A)) of the acquired trade or business immediately preceding the acquisition; or
  • Was a director, highly compensated employee, or highly compensated individual within the meaning of Sec. 101(j)(2)(A)(ii) of the acquired trade or business, and the acquirer, immediately after the acquisition, has ongoing financial obligations to the insured with respect to the insured's employment by the trade or business (e.g., the life insurance contract is maintained by the acquirer to fund current or future retirement, pension, or survivorship obligations based on the insured's relationship with the entity or to fund a buyout of the insured's interest in the acquired trade or business).

In addition, the acquirer must either carry on the acquired trade or business or use a significant portion of the acquired business assets in an active trade or business that does not include investing in interests in life insurance contracts.

The proposed regulations make clear that the acquisition of a life insurance policy in a tax-free reorganization is not a reportable policy sale if the insured is employed by the target corporation immediately before the acquisition. It is also clear that there is not a reportable policy sale if the insured is no longer employed but formerly was a director, highly compensated employee, or highly compensated individual, and the acquirer has ongoing financial obligations to the insured.

There are situations in which the application of the rules is less clear with respect to former employees. First, consider a situation in which an individual was formerly a director, highly compensated employee, or highly compensated individual of the target corporation. The individual was not an employee of the target corporation at the time of the reorganization, and at the time of the acquisition, the company did not have an ongoing financial obligation to the former employee. In this case, the regulations suggest that the acquisition of the life insurance contract on the life of the former employee as part of a tax-free asset acquisition would be a reportable policy sale as a result of the lack of an ongoing financial relationship.

Second, consider a situation in which an individual was not a director, highly compensated employee, or highly compensated individual of the target corporation. The individual was not an employee of the target corporation at the time of the reorganization, and at the time of the acquisition, the company had an ongoing financial obligation to the former employee. In this case, the regulations would also suggest that the acquisition of the life insurance contract on the life of the former employee as part of a tax-free asset acquisition would be a reportable policy sale because the former employee was not a director, highly compensated employee, or highly compensated individual with respect to the acquired corporation.

The proposed regulations for the Sec. 6050Y reporting provisions are effective for reportable policy sales after Dec. 31, 2017. The proposed regulations also provide that, for other purposes, the regulations will not be effective until they are finalized. It is unclear how taxpayers can realistically comply with the reporting requirement if the portion of the proposed regulations defining reportable policy sales will apply only from the date the regulations are finalized. As a result, acquirers in tax-free asset acquisitions should review transactions entered into after Dec. 31, 2017, to evaluate whether a target's life insurance policies satisfy the relationship test or meet another exception under the proposed regulations.

EditorNotes

Howard Wagner, CPA, is a partner with Crowe LLP in Louisville, Ky.

For additional information about these items, contact Mr. Wagner at 502-420-4567 or howard.wagner@crowe.com.

Unless otherwise noted, contributors are members of or associated with Crowe LLP.

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