Clearly State Scope of Insurance Reporting Regs, Firm Says

May 8, 2019

Internal Revenue Service
CC:PA:LPD:PR (REG–103083–18)
1111 Constitution Avenue NW
Washington, DC 20224

Re: Comments on Reportable Policy Sale Proposed Regulations

Dear Sir or Madam:

We are writing on behalf of our client, MB Schoen & Associates, in response to the request for comment on the proposed regulations under section 101(a) regarding reportable policy sales.¹ We respectfully request clarifications to the regulations to confirm that a reportable policy sale will not arise merely because a life insurance policy is involved in (1) a transaction that pools bank-owned life insurance (“BOLI”) policies of multiple banks for their collective benefit, or (2) a tax-free exchange under section 1035.

BOLI Pooling Transactions

Businesses commonly promise certain pre- and post-retirement benefits to their employees, such as retiree health care benefits. These benefit promises can result in substantial liabilities for such businesses, which they must reflect on their financial statements. In order to fund those obligations informally and thereby establish assets on their financial statements to offset liabilities for the promised benefits, businesses often purchase permanent, cash value life insurance coverage on the lives of their officers, directors, and employees. Such coverage is colloquially known as a form of corporate-owned life insurance or “COLI,” and when purchased by a bank it generally is called BOLI.² BOLI owners typically hold their policies until the death benefits become payable, then use the cash flows provided via the death benefits to fund the costs of the employee benefits or to recover such costs after the fact.

In recent years there has been interest in transactions that pool the BOLI policies of multiple banks for the continued purpose of funding each bank's employee benefit liabilities, but in a more effective, centralized way. The transactions can be summarized as follows:

• Multiple unrelated banks previously purchased BOLI policies to informally fund their employee benefit liabilities. The original purchases complied with all applicable federal and state regulatory requirements, including employee notice and consent requirements and state law insurable interest requirements.

• The banks transfer some or all of their pre-existing policies to a partnership. In return, each bank receives a partnership interest that is proportional to the value of its contributed policies.

• The partnership holds and manages the contributed policies and distributes death benefits among the bank-partners pro rata based on their respective partnership interests. This pooling is expected to help normalize cash flows from the policies.

• The partnership retains a professional management team with extensive expertise in managing the risks and benefits associated with BOLI, which many banks may lack.

• The management team endeavors to maximize returns and limit the risks of BOLI ownership. This may involve exchanging some of the policies in transactions that satisfy the requirements of section 1035 and any applicable state insurable interest laws.

• The bank-partners use the cash flows from the partnership to informally fund the same employee benefit liabilities for which they originally purchased the policies.

• The partnership interests are not redeemable or transferable unless the manager consents. Consent will be granted only in rare and unusual circumstances, such as upon a bank-partner's dissolution by a regulator.

The IRS has issued private letter rulings addressing certain federal income tax implications of these types of arrangements.³ As relevant here, one such implication that the rulings confirm (directly in PLR 201308019 and indirectly in PLR 201152014) is that the carryover basis exception to the transfer for value rule in section 101(a)(2) applies to a bank's contribution of BOLI policies to the partnership, thereby preserving the tax-free character of the death benefits when paid to the partnership. This conclusion is consistent with the partnership tax rules, which generally provide for a carryover basis for property that a partner contributes to a partnership.⁴ The conclusion also is consistent with the congressional intent underlying the carryover basis exception, which is to provide a “complete exemption” from the transfer for value rule for “contracts which have been transferred for certain legitimate business reasons rather than for speculation purposes.”⁵

Of course, the Tax Cuts and Jobs Act modified these rules by limiting the carryover basis exception to transfers for value that fall outside the definition of a “reportable policy sale” in new section 101(a)(3). Although the legislative history of this change does not elaborate on its intent, it is widely understood to be aimed at ensuring enforcement of the transfer for value rule with respect to newer forms of speculative transfers involving life insurance policies, rather than imposing new restrictions on legitimate business uses of life insurance. The preamble to the proposed regulations implicitly acknowledges this, stating that some provisions are meant to ensure that “certain ordinary course business transactions” will not be treated as reportable policy sales.⁶ This is the case even though some of those business transactions conceivably could be treated as reportable policy sales if the purpose of the statutory changes were disregarded.

This is precisely the situation that the BOLI pooling transactions described above present. They are not speculative transactions. In substance, they are distinguishable from sales of policies to third parties because the intent and result is to pool the policies among all the original policyholders for the continued purpose of funding their employee benefit liabilities. In that regard, the bank-participants originally purchased the policies for the legitimate business purpose of funding those liabilities and will continue to use the policies for that purpose after entering into the transaction. The transaction is imbued with non-tax business purpose — to provide banks with a more effective, centralized way to manage their BOLI policies. In these circumstances, the transactions should not give rise to reportable policy sales.

Such treatment is already supported by the proposed regulations, but a clarification is warranted to eliminate any doubt. The proposed regulations, like the statute, provide in relevant part that a direct or indirect acquisition of an interest in a policy is a reportable policy sale if the acquirer has, at the time of the acquisition, no substantial financial relationship with the insured apart from the acquirer's interest in the policy.⁷ The proposed regulations further provide, however, that such a financial relationship exists if the “acquirer maintains the life insurance contract on the life of the insured to provide funds to purchase assets or satisfy liabilities following the death of the insured.”⁸

These provisions should apply to the BOLI pooling transaction as follows. When a bank contributes BOLI policies to the partnership, the proposed regulations indicate that the partnership directly acquires an interest in the contributed policies.⁹ However, the partnership will maintain the policies to satisfy liabilities following the death of the insured, namely, the exact same employee benefit liabilities of the bank-partners for which they originally purchased the policies. Likewise, to the extent that the partnership holds other BOLI policies at the time a bank contributes its own policies, the proposed regulations indicate that the bank indirectly acquires an interest in those other policies.¹⁰ However, the bank will maintain its indirect interest in those policies (and in the policies it contributed) to continue funding the same employee benefit liabilities. Use of the partnership is not intended to divest the value of a partner's interest, but rather to diversify and manage that interest for legitimate non-tax reasons. In these circumstances, neither the direct acquisition by the partnership nor the indirect acquisition by a bank-partner should be a reportable policy sale.

We respectfully request a clarification to the regulations to confirm this treatment. This could be accomplished by adding additional language to the “substantial financial relationship” provision or by adding an example that applies that provision to the BOLI pooling transaction.¹¹ Alternatively, a separate exception to the reportable policy sale definition could be added. In that regard, the proposed regulations currently list specific transactions that are not reportable policy sales, and the BOLI pooling transaction could be added to that list.¹²

Section 1035 Exchanges

The preamble to the proposed regulations asks for comment on whether they “should include additional provisions regarding the treatment of section 1035 exchanges of life insurance contracts.”¹³ In that regard, the proposed regulations include only one reference to section 1035, stating that: “The following events are not a transfer of an interest in a life insurance contract: . . . the issuance of a life insurance contract to a policyholder, other than the issuance of a policy in an exchange pursuant to section 1035.”¹⁴ The italicized statement suggests that the mere issuance of a new life insurance policy in a section 1035 exchange could (or perhaps would) give rise to a reportable policy sale. We respectfully submit that such treatment is unnecessary and would be inappropriate.

Mechanically, a section 1035 exchange is typically accomplished by the policyholder assigning the existing policy to the new carrier. That policy is then surrendered and the new carrier applies the cash proceeds as a premium under a new policy issued to the same owner on the same insured's life.¹⁵ In a hyper-technical sense, the new carrier acquires an interest in the old policy, but that interest is immediately extinguished. In addition, in the case of an external exchange involving a new, different carrier, the exchange already must be reported to the IRS and the policyholder on a Form 1099-R.¹⁶ As a result, there is no need to treat the exchange itself as leading to a reportable policy sale in order to serve any information collection purpose. Furthermore, even if an exchange were viewed as potentially meeting the definition of a reportable policy sale, the new carrier should properly be viewed as having a substantial business or financial relationship with the insured, considering that the carrier just issued a new policy on that individual's life. This causes the exchange to fall outside of the definition of a reportable policy sale.

Accordingly, the statement in the proposed regulations regarding section 1035 exchanges should be deleted or amended to eliminate any suggestion that such transactions, by themselves, can lead to reportable policy sales. If there are specific transactions involving section 1035 exchanges that fall outside the normal situation described above, and the IRS and Treasury Department determine that such atypical scenarios might give rise to reportable policy sales, it would be more appropriate to expressly limit the scope of any resulting provision to those particular transactions, so that doubt will not be cast on everyday policy exchanges.

* * * * *

We appreciate this opportunity to comment and thank you in advance for considering the clarifications we have requested. If you have any questions or if we can be of any assistance as you work to finalize the regulations, please contact us.

Sincerely,

Bryan W. Keene
bwkeene@davis-harman.com

Craig R. Springfield
crspringfield@davis-harman.com

Davis & Harman LLP
Washington, DC