The IRS has issued proposed regulations (REG-108054-21) that would modify the final regulations on transferring interests in life insurance contracts under IRC Section 101 and conform the requirements for information reporting under IRC Section 6050Y. Under the proposed regulations, when a life insurance policy is exchanged for another similar contract under IRC Section 1035, there would be no reportable policy sale, no transfer for value under IRC Section 101(a)(2) and, therefore, no limitation on the death benefit exclusion under IRC Section 101(a)(2).

Currently, the final regulations under IRC Section 101 require a policyholder making an IRC Section 1035 exchange to have a substantial family, business or financial relationship with the insured to avoid treating the exchange as a reportable policy sale under IRC Section 101(a)(3).

The proposed regulations also address certain transfers of life insurance contracts from one C corporation to another in a tax-free reorganization under IRC Section 368(a) when there is a direct acquisition of life insurance contracts owned by the target corporation.

Comments on the proposed regulations must be submitted by July 10, 2023.

Applicability

The proposed regulations would apply to exchanges of life insurance contracts occurring on or after the date the final regulations are published in the Federal Register. Taxpayers, however, may choose to apply the proposed regulations under IRC Section 101 to all IRC Section 1035 exchanges occurring after December 31, 2017.

The proposed regulations would also modify the final regulations under IRC Section 6050Y (i.e., Form 1099 reporting) to reflect corresponding revisions to the final regulations under IRC Section 101 dealing with IRC Section 1035 exchanges occurring on or after the date the proposed regulations are published as final in the Federal Register. Unlike the changes to IRC Section 101, taxpayers may not apply the IRC Section 6050Y changes earlier than the date the final regulations are published in the Federal Register, presumably to avoid any potential corrections or late filings of Forms 1099 for prior years.

Background

The Tax Cuts and Jobs Act (TCJA) modified IRC Section 101 to add a new reporting requirement for the purchase of an existing life insurance contract that is treated as a "reportable policy sale" under new IRC Section 101(a)(3) and modified the transfer-for-value rules in IRC Section 101(a)(2) to include the transfer of an interest in a life insurance contract that is treated as a reportable policy sale. The TCJA also added IRC Section 6050Y, which requires that taxpayers that acquire a life insurance contract or any interest in a life insurance contract in a "reportable policy sale" to comply with certain reporting obligations (generally by furnishing and filing a Form 1099-LS, Reportable Life Insurance Sale).

The IRS issued proposed regulations addressing these provisions in March 2019 (see Tax Alert 2019-0747) and final regulations (TD 9879) in October 2019. Under Treas. Reg. Section 1.101-1(c)(2)(v), issuing a new policy in a tax-free IRC Section 1035 exchange is a transfer of an interest in a life insurance contract for valuable consideration and is a reportable policy sale unless the policyholder has a substantial family, business or financial relationship with the insured. Therefore, the new policy is subject to the transfer for value rule under IRC Section 101(a)(2) if it is treated as a reportable policy sale. There was no change proposed to the existing rule in paragraph (c)(2)(iv), which excepts the acquisition by the insurance company of the old interest in the policy from the definition of a reportable policy sale.

The final regulations also treated the direct acquisition of a life insurance contract in a tax-free asset reorganization as a reportable policy sale, whereas a similar transaction qualifying as a stock reorganization would likely not result in a reportable policy sale.

Reason for the proposed regulations

According to the preamble, the amendments effected under the proposed regulations, " … are intended to correct the unintended change" made by the final regulations that treated an IRC Section 1035 exchange as resulting in taxable income, "while continuing to address the concern that the reporting of death benefits paid under [IRC S]ection 6050Y(c) could be avoided by exchanging a policy transferred in a reportable policy sale for a new policy in a[n IRC S]ection 1035 exchange, as well as the concern that a policyholder could attempt to avoid the limitation on the excludability of death benefits resulting from the application of the transfer for value rule through a [IRC S]ection 1035 exchange."

After considering comments received before and after the final regulations were issued in 2019, Treasury and the IRS are now proposing a limited exception for certain direct acquisitions of interests in life insurance contracts from a C Corporation in a tax-free asset reorganization. Treasury and the IRS stated that " … C corporations are not frequently used as vehicles for investing in life insurance contracts covering insureds with respect to which the corporation does not have a substantial business, financial or family relationship at the time the contract is issued."

Changes to the final regulations

Treasury and the IRS proposed four categories of changes to the final regulations.

First, the proposed regulations would revise Treas. Reg. Section 1.101-1(e)(2), which defines a transfer of an interest in a life insurance contract, to remove the words "other than the issuance of a policy in an exchange pursuant to section 1035" from the last sentence. This change would remove the exchange of a life insurance contract in a tax-free IRC Section 1035 exchange from being treated as a reportable policy sale.

Second, the proposed regulations would add Treas. Reg. Section 1.101-1(b)(iv), which would apply to an IRC Section 1035 exchange of an old interest in a life insurance policy for a new interest in the policy. The purpose of this change is to make sure that any limitation on the death benefit of the old interest in a policy is carried over as an attribute of the new interest in the policy. Under this proposed rule, if at the time of the exchange the death benefit proceeds of the old interest in the policy would have been excludable from gross income under IRC Section 101(a), the entire amount of the proceeds of the new interest in the policy is excludable from gross income. However, if less than the full death benefit of the old interest in the policy would have been excludable from gross income under IRC Section 101(a), the limitation on the old interest policy carries over to the new interest in the policy to limit the amount of death benefit to be excluded from gross income under IRC Section 101(a).

Third, the proposed regulations would add new paragraph (c)(3) to Treas. Reg. Section 1.101-1(c) to establish that when a newly issued policy is received in an IRC Section 1035 exchange and any portion of the death benefit excludable from gross income is limited, the new interest is similarly treated as having been previously transferred for valuable consideration in a reportable policy sale. In addition, the proposed regulations would revise subparagraph (c)(2)(v) to add an exception dealing with direct acquisitions of life insurance contracts in certain tax-free asset reorganizations. The exception would apply if (1) the acquisition results from an IRC Section 368(a) reorganization, (2) immediately before and after the acquisition, the interest in the life insurance contracts is held by a C corporation that conducts an active trade or business that is not investing in interests in life insurance contracts, and (3) no more than 5% of the gross value of the assets of the target C corporation consists of life insurance contracts.

Fourth, the proposed regulations would conform several definitions in Treas. Reg. Section 1.6050Y-3 and the reporting rules under Treas. Reg. Section 1.6050Y-3 and -4 to reflect the new rules for proper reporting of reportable death benefits paid under contracts issued in IRC Section 1035 exchanges. The IRC Section 1035 exchange rules of Treas. Reg. Section 1.101-1(c)(3) would not apply, however, for purposes of Treas. Reg. Section 1.6050Y-2, and no reporting would be required at the time of the IRC Section 1035 exchange by the acquirer. Instead, the issuers of both the old interest and the new interest in an IRC Section 1035 exchange would have a reporting obligation on a Form 1099-SB, Seller's Investment in Life Insurance Contract, if they are aware of the exchange.

Implications

The proposed regulations are a welcome modification of the final regulations implementing the reportable policy sale rules under IRC Section 101(a)(3). Clarification that IRC Section 1035 exchanges do not themselves result in a transfer for value under IRC Section 101(a)(2) is a significant step forward in aligning the intent of Congress in enacting the new reporting requirements with the need for insurance companies and their policyholders to make changes in life insurance contracts without inadvertently tainting the death benefit as taxable. The treatment of any limitation under IRC Section 101(a)(2) on the death benefit of an existing life insurance contract as an attribute that carries over to a newly issued life insurance contract in an IRC Section 1035 exchange is consistent with the IRS's prior treatment of other characteristics of life insurance contracts so received, such as date of original issue.

The proposed exception from treatment as a reportable policy sale of a direct acquisition of life insurance contracts pursuant to a tax-free asset acquisition should help a number of corporate transactions to be structured without risk of tainting the exclusion of the death benefit of the acquired life insurance contract from gross income; however, it will be interesting to see what comments are submitted, if any, regarding the 5% threshold of value of gross assets.

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Published by NTD’s Tax Technical Knowledge Services group; Andrea Ben-Yosef, legal editor