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IRS Issues Important Regulations on Reportable Policy Sales and Clawback by Thomas F. Commito, JD, LLM, CLU, ChFC, AEP
Vol. 74, No. 2 | pp. 14-17
This issue of the Journal went to press in February 2020. Copyright © 2020, Society of Financial Service Professionals. All rights reserved.
ABSTRACT
In late 2019, the IRS finalized two important
regulations that impact financial advisors.
The first dealt with clarifying the “report-
able sales rules” that impact reporting in
life settlement sales. The second regulation
addressed the clawback problem inherent
when a lifetime transfer is made when the
exemption is higher and then the client dies
in a future year when the exemption is lower.
Overview In late 2019, the IRS finalized two important reg- ulations that impact financial advisors. The first dealt with clarifying the “reportable sales rules” that impact reporting in life settlement sales. The second regulation addressed the clawback problem inherent when a life- time transfer is made when the exemption is higher and then the client dies in a future year when the exemption is lower. The regulations will be addressed separately.
Reportable Policy Sales and Transfer-for-Value The Tax Cuts and Jobs Act of 2017 (TCJA) mod- ified the prior-law exceptions of the transfer-for-value (TFV) rules to include a new reportable policy sale requirement that is applicable to all transfers of life in- surance policies for “valuable consideration.” In March 2019, the IRS proposed regulations detailing how this new provision interacts with existing TFV rules. In general, the TFV rules result in the value of death benefits being included in taxable income. Un- less an exception applies, under the TFV rules, the tax-free death benefit of a transferred life insurance policy is limited to the amounts paid for the transfer- ee to obtain the contract and any premiums paid by the transferee. The rules apply in any transfer where valuable consideration is paid to obtain the policy. Courts have ruled that the payment of future premi- ums on a policy meets the valuable consideration test.
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Under the statutory changes enacted by the TCJA, a reportable policy sale occurs whenever there is a direct or indirect transfer of a life insurance pol- icy. However, under IRC 6050Y, an exception to a reportable policy sale occurs when an acquirer of the life insurance has a “substantial family, business, or financial relationship with the insured apart from the acquirer’s interest in the life insurance contract.”1
The reportable policy sales rules require that when a policy is transferred, and the transfer is subject to the rules, a detailed reporting requirement occurs from the policy issuer to the IRS. In addition, when the death benefit is paid, there is an additional set of reporting requirements. These rules are designed to result when- ever there is a “life settlement”; the IRS is notified of the sale, and then in conjunction with the TFV rules, all or a portion of the death benefit becomes taxable.
Exceptions to the Reporting Rule: Direct or Indirect Acquisitions Under the statutory changes enacted by the TCJA, a life insurance policy has been transferred pursuant to a reportable policy sale if there is a direct or indirect transfer of a life insurance policy. If the transfer is not a direct or indirect transfer, then the transfer is not treated as a reportable policy sale. It is important to note that the TFV rules can still apply if the transfer is not covered by an exemption that existed under the pre-TCJA TFV rules. In instanc- es where an acquirer purchases a pass-through entity through a stock transaction, any policies transferred to the acquirer through that purchase are exempt from the reportable policy sale rules, so long as the pass-through entity corporation held an interest in the life insurance policies prior to January 1, 2019. It is important to note that pass-through entities pur- chased through asset sales will not qualify for this exemption. C corporations will also not qualify, re- gardless of whether the transaction is executed as a stock transaction or an asset sale. However, C cor- porations have their own, separate exception. This exception provides that there is no “indirect trans-
fer” of life insurance where (a) the acquirer becomes a beneficial owner of a C corporation that owns life insurance contracts, and (b) life insurance contracts do not comprise more than 50 percent of the gross value of assets of such C corporation immediately be- fore the acquisition. Again, it is important to note that if there is no direct or indirect acquisition, the reportable policy sales rule does not apply.
Exceptions to the Reporting Rule: Substantial Business or Financial Relationship An exception to the reporting rule occurs when an acquirer in an indirect acquisition is deemed to have a substantial business or financial relationship with the insured so long as the acquired entity has a substantial business or financial relationship with the insured both immediately before and immediately after the acquisition.
A Substantial Business Relationship Exists: a. Where the insured is a “key person” of the ac-
quired business or “materially participates” in the acquired business, and the acquirer owns at least 80 percent of the acquired business, or
b. Where the acquirer acquires an active business, and the insured is an employee of the acquired business immediately before the acquisition or was a director, highly compensated employee, or highly compensated individual of the acquired business, there is no reporting requirement. Another provision of this rule requires that im- mediately after the acquisition the acquirer has ongoing financial obligations to the insured with respect to the insured’s employment, and the ac- quirer carries on the acquired business or uses a significant portion of the acquired business’s as- sets in an active business (not including investing in life insurance contracts).
A Substantial Financial Relationship Exists: a. Where the acquirer (or its beneficial owners) has
a common investment with the insured and it is
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1035 Exchanges of Life Insurance Policies The final regulations clarify the requirements with respect to Section 1035 exchanges of life insurance policies. The rule is twofold. First, for a life insurance company that is party to a Section 1035 exchange, the rule provides that its acquisition of the old policy is not treated as a reportable policy sale. However, for the ex- changing policyholder, the rule provides that the acqui- sition of the new policy is treated as a reportable policy sale unless the policyholder qualifies for one of the “substantial relationship” exemptions described above. Thus, for Section 1035 exchanges on policies on the life of a former employee, for example, the exchanging pol- icyholder may lack a sufficient substantial relationship with the insured in order to avoid reportable policy sale status, making the death benefit partially taxable.
The Final Clawback Regulations The final clawback regulations reiterated the basic rule that if a lifetime transfer is made under a higher exemption, and death occurs at a time of a lower exemption, the difference will not be clawed back in the estate tax return. The final regulations also addressed two additional situations:
1. Spousal Portability Clarification As AALU recommended in a comment letter, the final regulation clarifies that the portability provision relating to the deceased spousal unused exclusion should include any amount added to the decedent’s exemption through the use of the portability provi- sion. For example, if a married taxpayer dies in 2019 with a personal exemption of $5 million, and in addi- tion has acquired $5 million from a deceased spouse through the portability provision, then the exemption carried forward for post-2025 years is the total, or $10 million, even under a lower exemption level in effect in the death of the surviving spouse in the future.
2. Availability of Inflation Adjustments Post-Sunset
The final regulations clarify that taxpayers are
reasonably foreseeable that in the event of the in- sured’s death his or her interest will be bought out by the coinvestors, or
b. Where the acquirer is a charitable organization of the type described in IRC 170, IRC 2055, or IRC 2522 and the particular organization had previ- ously received a substantial amount of financial support or significant volunteer support from the insured, or
c. Where the acquirer or the acquiree has the life in- surance contract on the insured to provide funds to purchase assets of or satisfy liabilities of the insured or the insured’s estate, heirs, legatees, or successors in interest or to satisfy other liabilities arising upon or by reason of the death of the insured.
In addition, a direct or indirect acquisition is ex- empt from the reporting where the acquisition meets any of the following tests:
De Minimis Acquisition. This exception is for de minimis acquisitions of any entity that owns life in- surance. It applies where not more than 50 percent of the gross value of the entity’s assets are life insurance contracts and the acquirer (and any family members, if the acquirer is a natural person) own 5 percent or less of the entity (as measured after the acquisition).
Same Beneficial Owners. Another transactional ex- ception to reportable policy sale status is for transfers of interests in life insurance contracts between entities with the same beneficial owners. This exception ap- plies where the ownership interest of each beneficial owner in the transferor entity does not vary by more than 20 percent from that person’s ownership interest in the transferee entity. For these purposes, transito- ry transfers are ignored—only the interest in the first and last entity that holds the insurance are examined.
Consolidated Entities. A further exception to re- portable policy sale status applies to transfers of life insurance contracts between entities that are consoli- dated for tax purposes.
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exemption face a “use-it-or-lose-it” scenario. In other words, taxpayers may not make lifetime gifts using that portion of the exemption which is increased and may preserve the original exemption for use at a later date. For example, assume a taxpayer has gifted $0 prior to 2020, but then makes a gift of $7 million in 2020, when the maximum allowable exemption was $11.58 million. The taxpayer makes no more gifts until after December 2025. The IRS has clarified that use of credit “draws up from zero.” Therefore, the 2019 gift of $7 million uses “the first $7 million of the exemption available.” When the exemption drops back down after 2025, there will be no more available exemption to use in 2026 and later (until inflation adjustments carry the exemption to a level beyond the $7 million 2020 gift). n
Thomas F. Commito, JD, LLM, CLU, ChFC, AEP, is director, sales concepts in Lincoln Financial Distributors’ Advanced Sales Group and is an associate editor of the Journal. He has 40 years’ experience in advanced sales, life insurance prod- ucts, and life insurance marketing. Tom is an author of two books and numerous articles on tax and financial planning. He can be reached at tom.commito@lfd.com.
(1) IRC Sec. 101(a)(3)(B).
governed by the upper limit of the exemption at the time of a lifetime gift. Assuming the exemption de- creases in 2026, the taxpayer does not get to use any indexing until the post-2025 exemption exceeds what was gifted away in the pre-2026 period. For exam- ple, assume that a taxpayer uses a full lifetime gift exclusion under the increased exemption levels in 2020 ($11.58 million), and makes no further gifts. In 2026, the exemptions return to $5 million, which, adjusted for inflation, is $6,650,000 (assuming a 2 percent chained-CPI). The taxpayer dies in 2026 with a taxable estate of $1 million. Since the taxpayer used during life an exemption in excess of the current applicable exemption, the taxpayer’s estate will owe an estate tax of $400,000 (40 percent x $1 million) in 2026. So, even if the exemption goes up after the lifetime gift is made, any past increases are disregard- ed. It is worth noting that the presently doubled ex- emption levels will continue to increase by inflation adjustments through the sunset in 2025.
3. Ordering the Application of the Exclusion The final regulations clarify that use of the ex- emption draws up from zero. Therefore, taxpayers wishing to take advantage of the higher pre-2026
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