SUMMARY: The tax treatment of corporate-owned life insurance (“COLI”) continues to receive scrutiny from congressional tax writers and the Obama Administration. While progress toward reform of the Internal Revenue Code (“IRC”) may slow in light of the upcoming congressional midterm elections, a proposal that would indirectly impose a tax penalty on owners of COLI continues to be considered for inclusion in draft tax reform language. This proposal, which is described in detail below, has been included as a revenue provision in each of President Obama’s budgets dating back to Fiscal Year 2010. The President’s Fiscal Year 2015 budget is slated for release on March 4th, and is expected to once again include this provision. The AALU has worked to expand upon our messaging in opposition to this proposal as consideration of tax reform has progressed. ThisWRNewswire bulletin provides context regarding the current status of tax reform as it pertains to the tax treatment of COLI, as well as an explanation of our associated messaging—which explores the relevant text of the IRC, the legislative history behind these provisions and other regulatory initiatives involving COLI, and why—based on history, public policy, and practice—attempts to change the tax treatment of COLI are misguided.

ANALYSIS: The Obama Administration has, on several occasions, proposed as a revenue measure an “expansion of the pro rata interest expense disallowance for COLI” (“The proposal”).

CITE: DEPT. OF THE TREASURY, GENERAL EXPLANATIONS OF THE ADMINISTRATION’S FISCAL YEAR 2014 REVENUE PROPOSALS, 77 –78 (2013);  Ken Kies, History of Corporate-Owned Life Insurance (COLI) Reforms (Dec. 2013);  AALU Policy White Paper, Reject the COLI Pro-Rata Interest Disallowance Proposal (Dec. 2013).

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MARKET TREND: As planning approaches and products become more complex, care must be taken to avoid the retention or acquisition by the insured of powers over the policies that would cause the proceeds to be included in the insured’s estate at death.  Product sophistication using long term care riders and investment approaches with high cash value products has increased the array of planning options, offering insureds more flexibility but higher risks as well.

SYNOPSIS: Life insurance proceeds will be included in the insured’s estate for federal estate tax purposes if, at death, the insured has any right to the economic benefits, so-called incidents of ownership, in the policy, even if the insured does not actually own the policy.  “Incidents of ownership” include the power, directly or indirectly, to change the beneficiary or the contingent beneficiary, surrender or cancel the policy, assign the policy or to revoke an assignment, pledge the policy as collateral for a loan, and obtain a loan from the carrier against the surrender value of the policy.  In order to avoid inclusion of the proceeds in the insured’s estate, the insured must avoid holding any and all such incidents of ownership, even if attributed indirectly.  For example, if the insured holds a controlling interest in a corporation that owns policies on the insured’s life, the proceeds will be included in the insured’s estate to the extent the proceeds are not payable to or for the benefit of the corporation.  Policies purchased with community property funds also may cause both spouses to have incidents of ownership in the policies.  Second-to-die policies may give both insureds incidents of ownership and generally should not be transferred to an ILIT of which one of the insureds is a beneficiary.

TAKE AWAYS:  Inclusion of life insurance death benefits in the insured’s estate will occur if the insured holds any incidents of ownership in the policy.  “Incidents of ownership” encompass far more rights than actual policy ownership, including the ability to name policy beneficiaries or pledge a policy for a loan.  In addition, incidents of ownership may be attributed to an insured indirectly depending on the acquisition or ownership structure, such as with a corporate-owned policy where the insured is a majority shareholder, or a trust-owned policy where an insured is a trustee of the trust.  Thus, advisors can add value to the services they provide by helping clients identify situations where the insured may have retained or may acquire an incident of ownership and reviewing alternatives to eliminate the possibility for incidents of ownership and the potential estate tax exposure. 

MAJOR REFERENCES: IRC §2042; Private Letter Ruling 201327010; Chief Counsel Advice 201328030. 

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