Generally, life insurance death benefits are not subject to income tax. However, the Tax Cuts and Jobs Act of 2017 enacted IRC Section 101(a)(3), which limits the exclusion for income received upon the death of an insured in the case of a reportable policy sale (RPS) and makes the RPS transactions reportable under IRC Section 6050Y. The U.S. Department of the Treasury and the IRS recently published final regulations implementing these provisions. Prior articles discuss the proposed regulations under IRC Section 101 and IRC Section 6050Y, which were published earlier this year. Following are highlights from the final regulations.
Definition of RPS
Generally, a transaction is not an RPS unless there is a direct or indirect transfer of a life insurance policy. Even if there is a transfer, the transaction is not treated as an RPS if the acquirer has a substantial family, business, or financial interest with the insured. The proposed regulations provided that an indirect acquisition of insurance policies through the acquisition of the stock of a C-corporation target is not treated as a transfer in an RPS if immediately preceding the acquisition not more than 50% of the target’s gross assets comprise investments in life insurance contracts. The final regulations do not adopt comments requesting expansion of this exception to cover all tax-free mergers. As a result, unless the relationship test applies, an acquisition that does not satisfy the exception for C-corporation targets will be an RPS.
The final regulations do, however, expand the relationships that satisfy the relationship test to include:
- A partnership or trust if all the partners or beneficiaries are family members or business associates
- A charity receiving a gift of life insurance to step into the shoes of the donor and that excludes from its gross income death benefits paid under the policy
- An acquirer that must satisfy future estate liabilities due at death
The final regulations also clarify that a tax-free exchange of a life insurance policy for a different policy on the same person is an RPS unless the policyowner has a substantial family, business, or financial relationship with the insured.
The proposed regulations provided that once an RPS occurs, the proceeds of that policy always will be subject to income tax and cannot later become tax-free even if the policy ownership is transferred back to the insured. The final regulations provide that the policy can be cleansed of the “taint” if the insured purchases the policy back at fair market value.
The final regulations provide the following exceptions to reporting:
- An RPS is not subject to reporting if the aggregate of payments made during the taxable year to a person other than the seller is less than $600.
- Reportable death benefits are not required to be reported if the payer never received, and has no knowledge of any issuer having received, a related RPS statement.
- Issuer reporting is not triggered unless the issuer receives notice of a transfer of a life insurance contract to a foreign person that includes foreign indicia. Foreign indicia include information provided for nontax purposes, such as a change of address notice to a foreign residence or mailing address for purposes such as sending statements.
The final regulations also provide streamlined rules for reporting by:
- Expanding when acquirers can report multiple transactions (or sellers) on a single report
- Providing that reportable death benefits paid to a foreign person that must be reported on Form 1042-S, “Foreign Person’s U.S. Source Income Subject to Withholding,” are not required to be reported on Form 1099-R, “Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, Etc.”
The final regulations add a requirement to report the amount of cash and the fair market value of any consideration transferred in a sale. In addition, an issuer is not considered a Section 6050Y(b) issuer if it provides notice of a transfer to a foreign person directly to the 6050Y(b) issuer responsible for administering the life insurance contract. This exception does not apply to the issuer responsible for administering the life insurance contract.
Effective date delay
The proposed regulations generally applied to RPSs occurring and reportable death benefits paid after Dec. 31, 2017. In response to comments, the final regulations delay application of these rules. Accordingly, the final regulations generally apply to RPSs made and reportable death benefits paid after Dec. 31, 2018, with certain transition rules for 2019 transactions. As a result, for an RPS occurring in 2019 an acquirer must do all of the following:
- File Form 1099-LS with the IRS by Feb. 28, 2020 (March 31, 2020, if e-filed).
- Furnish a copy of the Form 1099-LS to sellers by Feb. 28, 2020.
- Furnish copies of the Form 1099-LS to the issuer by the later of Dec. 31, 2019; 20 days after the RPS; or five days after an applicable state rescission period. But if any of these dates is after Jan. 15, 2020, copies must be furnished by Jan. 15, 2020.
In addition, limits on the tax-free treatment of proceeds of life insurance contracts are applicable to life insurance contracts transferred after Oct. 31, 2019, though taxpayers can rely on these rules for earlier periods.