Firm Requests Guidance on Issuance of Life Insurance Contracts

April 10, 2020

Ms. Angela Walitt
Attorney Advisor, Office of Tax Policy
United States Department of the Treasury
1500 Pennsylvania Avenue, NW
Washington, DC 20220

Re: Regulations on Transfer-for-Value Rule: Treatment of 1035 Exchanges

Dear Ms. Walitt,

We are writing on behalf of our clients, The Prudential Insurance Company of America and Financial Solutions Partners,¹ to request guidance on the tax treatment of exchanges of life insurance contracts in the context of the “transfer-for-value” rule of section 101(a)(2).² Specifically, we are requesting guidance that the issuance of a life insurance contract in a tax-free exchange under section 1035 is not a “transfer” of an interest in the contract to the owner for purposes of the transfer-for-value rule.

It appears that, in at least some cases, the recently-finalized regulations under section 101 regarding “reportable policy sales” treat a 1035 exchange as a transfer for value that can cause the death benefits to become taxable. This treatment appears to arise even where neither the contract given in the exchange nor any predecessor contract has been involved in a reportable policy sale. This is particularly problematic for businesses that wish to conduct 1035 exchanges of corporate-owned life insurance (COLI) contracts. However, the problem is potentially broader and could affect other types of 1035 exchanges as well.

We believe that treating a 1035 exchange as a transfer for value is inconsistent with the relevant statutes, congressional intent, sound tax policy, and long-standing interpretations of the law. Accordingly, we are requesting guidance to address this problem. The problem and our request for guidance are described in more detail below. We would greatly appreciate the opportunity to meet with you and your colleagues (by phone if necessary) to discuss this issue.

Background

Section 101(a)(1) excludes from gross income death benefits received under a life insurance contract. The exclusion is limited, however, to the extent that the contract is acquired in a transfer for valuable consideration before the death benefits are paid.³ Historically, certain exceptions to this “transfer-for-value rule” have been available.⁴ In 2017, Congress eliminated those exceptions for any transfer for value that constitutes a “reportable policy sale” (RPS). An RPS generally is the acquisition of an interest in a life insurance contract where the acquirer has no substantial family, business, or financial relationship with the insured.⁵ At the same time, Congress imposed new reporting requirements on certain parties to an RPS.⁶ As relevant here, the contract issuer generally must report on Form 1099-R certain information when death benefits are paid under a contract that was previously involved in an RPS.⁷ This helps ensure that the death benefits will be taxed appropriately under the transfer-for-value rule in cases involving an RPS.

Section 1035 provides that no gain or loss shall be recognized on the exchange of a life insurance contract for another life insurance contract covering the same individual. Congress enacted this long-standing rule to allow taxpayers to exchange their policies for ones better suited to their current needs without triggering tax.⁸ Mechanically, a policyholder effects a 1035 exchange first by assigning the existing policy to a new insurance carrier. The carrier then surrenders that policy and applies the cash proceeds as a premium under a new policy issued to the same owner on the same insured's life.⁹

The Problem Under the Final RPS Regulations

The final RPS regulations treat the mere issuance of a life insurance contract in a 1035 exchange as a “transfer” of an interest in the contract for purposes of the transfer-for-value rule. In particular, the regulations define the term “transfer of an interest in a life insurance contract” and state in relevant part 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 1035.¹⁰

The clear implication is that the issuance of a policy in a 1035 exchange, in and of itself, is a “transfer of an interest in a life insurance contract.” Significantly, such a newly issued policy is always issued for “valuable consideration,” namely, the owner's assignment of the old policy to the new carrier as described above. Thus, the effect of the regulations appears to be that a 1035 exchange can result in a transfer for value unless an exception to the transfer-for-value rule is available and applies under section 101(a)(2)(A) or (B). Those exceptions are unavailable for any transfer that is an RPS, meaning they are available only if the transferee has a substantial family, business, or financial relationship with the insured.¹¹ For some exchanges, such a relationship may exist. But for many others it may not. Consider the following example:

We respectfully submit that Congress did not intend for a 1035 exchange, in and of itself, to result in a transfer for value in any situation, and to the extent that the RPS regulations result in such treatment we respectfully request that corrective guidance be issued. Also, as discussed below, to the extent that the government is concerned about compliance with the new RPS reporting requirements in the context of 1035 exchanges, we think that concern can be addressed through a more targeted rule.

Issuing a Policy is Not a Transfer of the Policy

A “transfer” of property inherently involves two parties — one party who currently owns an interest in the property and a second party who acquires some or all of that interest from the first party.¹² This, in turn, presupposes the existence of property that the transferor owns prior to the transfer. A life insurance contract that is issued in a 1035 exchange does not exist until it is issued, and the issuer never owns a property interest in the contract. If the contract did not exist prior to the purported transfer and the purported transferor never owned an interest in the contract, we think it follows that the contract cannot properly be viewed as having been “transferred” merely by being issued.

Prior to the issuance of the RPS regulations, we think there would be general agreement — both from a tax and non-tax perspective — that no transfer occurs merely due to the issuance of a policy. The RPS regulations, however, deem a transfer to have occurred even though one has not occurred in form or substance. The reason for this, as discussed below, is that the Treasury Department and IRS were concerned that if a policy was actually transferred in an RPS and subsequently exchanged, the exchange might facilitate avoidance of the new reporting rules when death benefits are later paid under the policy received in the exchange.¹³

Although we are sympathetic to this concern, we are not aware of any guidance or other authority supporting the view that the mere issuance of a life insurance contract — in a 1035 exchange or otherwise — is a “transfer” of the contract for tax purposes. Indeed, in contexts other than 1035 exchanges, the final RPS regulations correctly conclude that the issuance of a new policy is not a “transfer.”¹⁴ There is nothing factually different between a policy issued in a 1035 exchange and a policy issued otherwise that would suggest one involves a “transfer” and the other does not.

The only “transfer” that could even arguably occur in a 1035 exchange is the owner's assignment of the old policy to the new carrier. But the RPS regulations also correctly conclude that such an assignment is not an RPS.¹⁵ This reflects the fact that, by accepting the assignment (and temporary ownership) of the old policy, the new carrier is merely facilitating the policyholder's exchange of property and continued ownership of an interest in life insurance, consistently with the legislative purpose underlying section 1035. In short, there is no transfer of an interest in life insurance, but rather the retention of such an interest by the original owner via the new policy.

The Adverse Implications for COLI Exchanges

Businesses commonly promise certain pre- and post-retirement benefits to their employees. Those promised benefits create substantial liabilities for the businesses. To fund those obligations and offset those liabilities, businesses often purchase COLI on the lives of their officers, directors, and employees. In order for the section 101 exclusion for death benefits to apply, a business cannot acquire COLI on an employee's life without first obtaining the employee's consent, including advance consent for the business to retain the coverage if the employee later leaves the job.¹⁶

In that regard, COLI owners typically retain their coverage when an insured employee leaves employment, because the business continues to have employee benefit liabilities that the coverage is funding (whether or not such benefits are owed to the former employee). If the business later chooses to exchange that policy for a new one that better suits its needs, it may do so tax-free pursuant to section 1035. State laws on insurable interest and COLI govern an employer's right to own life insurance on current and former employees, with many states permitting insurance on former employees. Therefore, an exchange of a policy covering a former employee can be accomplished consistently with state law.¹⁷

By treating the mere issuance of a policy in a 1035 exchange as a “transfer” of the policy, the final RPS regulations significantly hinder COLI owners' ability to exchange policies covering their former employees. This is partly because the COLI owner would not have a substantial family, business, or financial relationship with the former employee under the final regulations, despite having an insurable interest under state law.¹⁸ But the problem is potentially broader and stems primarily from the fact that the regulations treat the mere issuance of the policy in the exchange as a transfer in the first instance.

In our view, applying the transfer-for-value rule merely because a contract is exchanged for a new one inappropriately subverts the intent of section 1035. That intent is to ensure that as policyholders' needs change, they are able to obtain life insurance better suited to those needs without having to recognize gain. This is precisely the reason a COLI owner would exchange a policy. In assessing whether to undertake an exchange of a policy covering a former employee, the business would weigh any other tax implications of the exchange. For example, pursuant to IRS guidance, such an exchange would trigger a reduction in the business's otherwise-deductible interest expenses under section 264(f), which is an especially important deduction for leveraged businesses such as banks that often own COLI.¹⁹ The fact that a COLI owner would proceed with an exchange despite such tax consequences further demonstrates that the new policy must provide significantly improved non-tax benefits that better suit the owner's current needs, thereby directly fulfilling the tax policy underlying section 1035.

With respect to section 264(f), we further observe that the IRS guidance mentioned above did not conclude — or suggest in any way — that a 1035 exchange of a COLI policy covering a former employee involves a “transfer” of the policy. If the issuance of the new policy in the exchange were a transfer, presumably the transfer-for-value rule would have applied even prior to the 2017 statutory amendments regarding reportable policy sales. Specifically, the “transfer” would be for valuable consideration, and it appears that neither the “carryover basis” exception nor the “transfer to the insured” exception would have applied.²⁰ If the exchange did not result in a transfer for value under the prior IRS guidance (which we think clearly was correct), it should not do so now, especially considering that the 2017 statutory amendments did not change or address the meaning of the term “transfer” as used in section 101(a)(2) (or otherwise).

Proposed Solution

For the reasons discussed above, we respectfully request an amendment to the final RPS regulations, or the publication of other guidance, to confirm that the issuance of a life insurance contract in a 1035 exchange is not a transfer of an interest in the contract for purposes of the transfer-for-value rule in section 101(a)(2). Such guidance would facilitate the continued achievement of the tax policy goals underlying section 1035 without implicating the concerns that led to the adoption of the RPS rules, which we understand relate primarily to actual sales of existing policies to third parties, especially in speculative transactions.

We also understand and appreciate the concern at which the section 1035 rules in the RPS regulations are directed. The preamble describes that concern as relating to the potential use of a 1035 exchange to avoid the new RPS reporting requirements. Specifically, the concern was that, if a taxpayer engaged in an RPS with respect to a policy and then exchanged that policy for a new one, the issuer of the new policy may not know that the old policy was involved in an RPS and therefore would not report the future death benefits as “reportable death benefits.”²¹

We respectfully submit that this concern can be adequately addressed in a more narrowly tailored way, without the inappropriate (and presumably unintended) consequences outlined above. For example, RPS treatment could be treated as another “tax attribute” that carries over in a 1035 exchange. This would be consistent with other tax attributes, such as “investment in the contract” under section 72 and a contract's status as a modified endowment contract (MEC) under section 7702A, that carry over in any 1035 exchange.²² When a carrier issues a new contract in a 1035 exchange, it generally must obtain this type of tax attribute information from the old carrier in order to comply with its reporting obligations with respect to future distributions from the policy.²³ The RPS attribute is no different in that regard.

We appreciate your consideration of our request for guidance. We will follow up with you soon regarding the possibility of a meeting (by phone if necessary) to discuss these issues. In the meantime, if you have any questions, please contact either of the undersigned.

Sincerely,

Bryan W. Keene
bwkeene@davis-harman.com

Craig R. Springfield
crspringfield@davis-harman.com

Davis & Harman LLP
Washington, DC

cc:
Alexis A. MacIvor (IRS)
Kathryn M. Sneade (IRS)