TCJA Creates BOLI Confusion

By Marvin D. Hills, CPA/PFS, CLU, ChFC, and Sheryl Vander Baan, CPA
| 8/30/2018
The sweeping Tax Cuts and Jobs Act (TCJA) signed into law in late 2017 includes a provision that appears to apply to bank-owned life insurance (BOLI), which often is used as a tax-free investment for banks (sometimes, but not always, coupled with an employee benefit program). The new provision could have unintended consequences for bank mergers and acquisitions.

The TCJA created IRC Section 6050Y and changed IRC Section 101(a) to impose income tax on certain life insurance policies. The provision appears primarily intended to thwart tax-avoidance techniques used in transactions involving the sale of life insurance by individuals to unrelated investors in the so-called “viatical,” or secondary market. But the language seems broad enough to apply to a corporate acquisition, such as the acquisition by one bank of another bank that owns BOLI. If so, the transfer of ownership of the BOLI as part of the bank acquisition might be considered a newly coined “reportable policy sale.” As such, certain information reporting requirements would apply, and, more importantly, the tax treatment of the BOLI policy death benefit proceeds would change.

The previous rules
If these new rules are interpreted by the IRS as applying to bank acquisitions, it would represent a significant shift. BOLI death benefit proceeds generally have been tax-free, except in the case of a transfer for valuable consideration (that is, the purchase of an existing policy, rather than a newly issued policy). Under IRC Section 101(a)(2), any future death benefit on the acquired policy generally is taxable to the new policy owner, but only to the extent the death benefits received exceed the sum of the amount the new owner paid for the policy and any subsequent premiums paid.

However, several exceptions to the transfer for valuable consideration rule allow the death benefits to remain tax-free, despite the way the policy was acquired. For example, benefits remain tax-free if the policy was acquired in a transaction involving carryover basis, where the acquirer’s basis in the policy is equal to the transferor’s basis in it (for example, a tax-free merger or acquisition). Another exception that allows the death benefits to remain tax-free applies to situations where the transfer of ownership is to the insured, a partner of the insured, a partnership in which the insured is a partner, or – as very typical in bank mergers – a corporation in which the insured is a shareholder or officer.

New rules and their impact
Under the TCJA, the previously mentioned exceptions to taxability still exist, but they no longer apply if the acquisition of the life insurance contract would constitute a reportable policy sale.

The TCJA defines a reportable policy sale as the acquisition of an interest in a life insurance contract where the acquirer has no substantial family, business, or financial relationship with the insured other than the acquirer’s interest in the contract. These relationship terms are undefined, but it seems possible that a transaction involving policies on individuals who will continue as employees, directors, or shareholders of the acquiring bank may be considered to have the requisite business or financial relationship, and, as such, presumably would not constitute a reportable policy sale. However, absent a substantial relationship, it appears policies acquired in corporate mergers and acquisitions would have taxable death benefits.

It does not appear that Congress intended to create a reportable policy sale in connection with the acquisition of a business, but the TCJA does not include a specific carve-out. Thus, there would be reporting requirements (under IRC Section 6050Y) at the time of the change in ownership, and then the acquirer would recognize some taxable income (under IRC Section 101(a)) when payment is received upon death of the insured. The taxable amount would be the death benefits in excess of the amount the acquirer is treated as paying for the policy, plus any subsequent premiums paid after acquisition.

Financial statement impact
Prior to TCJA, most banks did not carry any deferred tax liabilities on the cash surrender value asset recorded in their financial statements because they planned to hold those policies and receive tax-free death benefits. Banks acquiring policies in a reportable policy sale will have to record deferred tax liabilities on any subsequent cash surrender value increases in excess of additional premiums paid, since a like amount of death benefits ultimately would be taxable. Also, they will need to consider if any portion of the cash surrender value recorded at acquisition date requires a deferred tax liability. Last, banks taking a position that any acquisition of policies was not via a reportable policy sale transaction will need to consider whether such a position is more likely than not to be sustained upon a tax authority audit, given the lack of clarity about what constitutes a substantial family, business, or financial relationship.

Information reporting requirements
Under Section 6050Y, acquirers and insurance companies are subject to new information reporting requirements for any reportable policy sale. Acquirers must report certain information to the IRS and to the insurance company that issued the policy. Upon receipt of such information from the acquirer, the insurance company must report certain information to the IRS and to the seller of the policy. The insurance company will have additional reporting responsibilities, to the IRS and the acquirer, when paying death benefits under a policy that was transferred in a reportable policy sale.   

IRS guidance
The IRS has responded to the uncertainty about whether or how the new rules will apply by issuing Notice 2018-41. 

According to the notice, the IRS intends to issue proposed regulations to provide guidance on the application of the reporting rules of Section 6050Y, and requested comments regarding how best to address the modifications to the transfer for valuable consideration rules. It is possible that this guidance will exempt BOLI policy acquisitions occurring as part of a corporate acquisition. Alternatively, it could apply the rules in some cases but not others.

For example, it might depend on whether the insured employee continues employment with the new bank after the acquisition. As indicated previously, employment seems to constitute a business or financial relationship that would prevent the acquisition from constituting a reportable policy sale. On the other hand, if the insured has no business or financial relationship to the acquiring bank, the acquisition might be a reportable policy sale, and thus the death benefits would be taxable to the acquirer to the extent the death benefits received exceed the amount the acquirer paid for the policy plus any subsequent premiums paid.

The new rules originally were intended to apply to any transaction (either acquisition of a policy or death of an insured individual) occurring after Dec. 31, 2017. The IRS has delayed the implementation of IRC Section 6050Y (the reporting requirement portion of the law) until final regulations are issued. However, the taxability of death benefits under new Section 101 provisions does not appear to be delayed. Thus, companies have no respite from addressing the impacts on financial statements. Normally, regulations first are released as proposed or temporary, and only after a comment period are they re-issued as final regulations. As of this time, no proposed regulations have been released, so it will be at least several months before final regulations are issued.

Prepare to comply
Until further guidance is available, all corporate transactions that include a transfer of ownership (directly or indirectly) of BOLI should be reviewed and monitored. Organizations that identify potential reportable policy sales within their transactions must make sure all of the reportable information required by Section 6050Y is retained in case the final regulations require reporting retroactively back to Jan. 1, 2018. They also should consider the potential implications to their taxable income and any related financial statement recording of taxes.