FEDERAL REGULATORY AND LEGISLATIVE ISSUES AFFECTING BOLI

Transcription

1 FEDERAL REGULATORY AND LEGISLATIVE ISSUES AFFECTING BOLI By John T. Adney Bryan W. Keene Davis & Harman LLP Washington, DC Prepared for Clark Consulting s 2012 BOLI & Due Diligence Forum October 2, 2012 I. Introduction This outline briefly summarizes selected federal regulatory and legislative issues affecting purchasers and issuers of bank-owned life insurance ( BOLI ). Although the focus is primarily on BOLI, the issues discussed also affect non-bank corporations that purchase and benefit from life insurance, i.e., corporate-owned life insurance or COLI. The outline is organized into three main topics: (1) executive branch budget proposals affecting BOLI; (2) the Volcker Rule; and (3) recent private letter rulings from the Internal Revenue Service ( IRS ) with potential implications for BOLI. II. Obama Administration Proposals A. Introduction. (1) Each year since 2009, the Obama Administration has included in its annual budget various legislative proposals that, if enacted, could directly or indirectly affect BOLI owners. (2) The proposals are described in more detail below, but in brief they would: Limit the ability of BOLI owners to claim income tax deductions for interest expenses that are unrelated to their BOLI contracts, which could have an economic impact similar to imposing current taxation on the otherwise tax-deferred inside buildup in BOLI cash values; Reduce or eliminate income tax deductions that life insurance companies currently can claim with respect to separate account insurance products they issue (such as separate account BOLI), which could result in increased product costs being passed through to separate account BOLI owners; Page 1 of 15

2 (c) (d) Impose new reporting obligations with respect to certain separate account insurance products (such as separate account BOLI), which could result in increased tax audits of some BOLI owners; and Impose new reporting requirements on third-party purchasers of certain life insurance contracts and modify the transfer for value rule that applies to such third-party purchases, which could result in increased tax audits and denial of the normal income tax exclusion for life insurance death benefits in certain cases where a BOLI owner transfers the contracts it owns to a third party for value. (3) Despite the Administration re-proposing these legislative ideas each year since 2009, they have not been enacted into law. Indeed, only one of the proposals imposing the new requirements regarding third-party purchases of life insurance contracts described in paragraph (d) above has advanced to the point of being included in legislation that was considered by Congress. (4) Each of the proposals would raise a different amount of revenue for the federal government if enacted. The prospect of any of these proposals being enacted would likely depend on the amount of revenue it would generate as well as factors such as political support (or not). It is clear, however, that the next Congress will be seeking sources of increased revenue, and so all of the proposals are on the table. (5) Each proposal, if enacted in is proposed form, would apply prospectively. Nonetheless, the proposals could affect BOLI contracts that were in force on the date of enactment. For example, if an existing BOLI contract were materially changed, it likely would be subject to any new limitations on the interest expense deductions of BOLI owners. B. Interest Deductions for BOLI Owners. (1) Internal Revenue Code ( IRC ) section 264(f)(1) imposes restrictions on the deductibility of interest expenses by a business taxpayer that owns or benefits from life insurance contracts. An exception to this rule is provided under IRC section 264(f)(4)(A), which states that IRC section 264(f)(1) will not apply to any life insurance contract that is owned by an entity engaged in a trade or business if the contract covers only one individual who is, at the time first covered by the contract, a 20-percent owner of the entity or is an officer, director, or employee of the trade or business. (2) Each year since 2009, the Obama Administration s budget has included a proposed legislative change to the foregoing exception to IRC section Page 2 of 15

3 264(f)(1). The proposal would repeal the exception for contracts covering employees, officers, or directors, but would retain the exception for 20- percent owners of a business that is the owner or beneficiary of a contract. (3) The Treasury Department explanation of the proposal states the reasons for offering it as follows: Leveraged businesses can fund deductible interest expenses with tax-exempt or tax-deferred income credited under life insurance, endowment or annuity contracts insuring certain types of individuals. For example, these businesses frequently invest in investment-oriented insurance policies covering the lives of their employees, officers, directors or owners. These entities generally do not take out policy loans or other indebtedness that is secured or otherwise traceable to the insurance contracts. Instead, they borrow from depositors or other lenders, or issue bonds. (4) Given the Treasury Department s reference to leveraged businesses, it seems clear that BOLI is a main focus of the proposal, although it would affect any COLI owner with interest expenses. If the proposal were to apply to a BOLI owner, the bank would lose a portion of its federal income tax deductions for its interest expenses that are unrelated to the BOLI contracts, with the economic effect being similar to imposing a current tax on the inside buildup of the BOLI contracts. (5) The proposal would apply to contracts issued after December 31, 2012, in taxable years ending after that date. Existing contracts would be grandfathered, subject to a material change rule that would treat an existing contract as newly issued (making the exception unavailable) upon any material increase in the death benefit or other material change in the contract. The proposal is estimated by Treasury to raise $7.3 billion in federal tax revenues over 10 years. C. Separate Account Dividends Received Deduction (DRD). (1) Like all domestic corporations, domestic life insurance companies are allowed a tax deduction for a portion of dividends they receive on stock they hold in other domestic corporations. The general purpose of the dividends received deduction is to avoid triple taxation of dividends at the corporate payor level, the corporate receiver level, and the individual shareholder level. (2) For dividends a life insurance company receives on assets it holds in separate accounts supporting variable insurance products, the DRD is subject to a proration rule that is intended to approximate the insurance company s share of the dividends received and the policyholders share of the dividends received. The insurance company is allowed a DRD only for the company s share of dividends it receives, reflecting the fact that Page 3 of 15

4 some portion of the company s dividend income is used to fund taxdeductible reserves for its obligations to policyholders. (3) Over the past decade, the proration rules have been a contentious issue in IRS audits of life insurance companies. The life insurance industry has generally been successful in defending its interpretation of the DRD proration rules on appeal. An IRS directive to field auditors has largely conceded the issue, apart from unusual circumstances. (4) Each year since 2009, the Obama Administration s budget has included a proposed legislative change to the proration rules. The proposal would repeal the existing regime for prorating life insurance company investment income between the company s share and the policyholders share. (c) Limitations on DRD that apply to other corporate taxpayers would be expanded to apply explicitly to life insurance company separate account dividends in the same proportion as the mean of reserves bears to the mean of total assets of the account. The perceived effect would be that the separate account DRD would be greatly reduced or even eliminated for life insurance companies. The proposal would be effective for taxable years beginning after December 31, The proposal, along with a more favorable one relating to the proration rules that apply to general account products, is estimated by Treasury to raise $7.7 billion in federal tax revenues over 10 years. (5) The Treasury Department explanation of the proposal states that [t]he proration methodology currently used by some taxpayers may produce a company s share that greatly exceeds the company s economic interest in the net investment income earned by its separate account assets, generating controversy between life insurance companies and the Internal Revenue Service. The purposes of the proration regime would be better served, and life insurance companies would be treated more like other taxpayers if the company s share bore a more direct relationship to the company s actual economic interest in the account. (6) The proposal would potentially affect variable contract owners to the extent that insurers passed through the higher tax costs associated with the products. In this respect, the separate account DRD proposal may have an effect on policyholders similar to the so-called DAC tax rules enacted in (7) Because most variable BOLI contracts are supported by separate account investments that do not generate dividends (e.g., debt instruments), it is Page 4 of 15

5 not clear how much of an effect the DRD proposal which relates to the insurers ability to deduct dividends received in the separate account might affect product pricing. For example, if insurers are able and willing to allocate any increased tax costs only to owners of variable contracts that are supported by dividend-generating separate account investments, perhaps most variable BOLI products will remain unaffected. If insurers are unable or unwilling to allocate their increased tax costs in this manner, the proposal could affect variable BOLI product pricing. Likewise, in some cases a variable BOLI separate account could invest in dividendgenerating securities, in which case there could be some additional tax cost to the issuer that might or might not get passed through to the contract owner even if the issuer otherwise allocates such additional tax costs in the manner described above. D. Private Separate Account Reporting. (1) Each year since 2009, the Obama Administration s budget has included a proposed new information reporting rule that would require life insurance companies to report to the IRS certain information about owners of life insurance contracts that are based on private separate accounts. Under the most recent version of this proposal, for each contract whose cash value is partially or wholly invested in a private separate account for any portion of the taxable year and represents at least 10 percent of the value of the account, the issuing life insurance company would be required to report to the IRS the policyholder s taxpayer identification number, the policy number, the amount of accumulated untaxed income, the total contract account value, and the portion of that value that was invested in one or more private separate accounts. (c) For this purpose, a private separate account would be defined as any account with respect to which a related group of persons owns policies whose cash values, in the aggregate, represent at least 10 percent of the value of the separate account. Whether a related group of persons owns policies whose cash values represent at least 10 percent of the value of the account would be determined quarterly, based on information reasonably within the issuer s possession. The proposal would be effective for taxable years beginning after December 31, 2012, and is estimated by Treasury to raise $10 million in federal tax revenues over 10 years. (2) The proposal is intended to help the IRS enforce the so-called investor control doctrine. Page 5 of 15

6 In general terms, the investor control doctrine was developed by the IRS in a series of rulings beginning in the late 1970s to deny tax benefits for variable insurance products where, inter alia, the policyholder exerted sufficient control over the management of the separate account investments to be deemed the owner of those investments for federal income tax purposes. The Treasury Department explanation of the proposal states that [i]n some cases, private separate accounts are being used to avoid tax that would be due if the assets were held directly. Better reporting of investments in private separate accounts will help the Internal Revenue Service (IRS) to ensure that income is properly reported. Moreover, such reporting will enable the IRS to identify more easily which variable insurance contracts qualify as insurance contracts under current law and which contracts should be disregarded under the investor control doctrine. (3) While the focus of the proposal is not exclusively on variable BOLI products, such products often are supported by separate accounts that would meet the definition of a private separate account. To the extent that a BOLI contract was supported by a private separate account, the information reporting requirement would apply and the BOLI owner could become subject to a higher risk of audit by the IRS on investor control issues. E. Stranger-Owned Life Insurance ( STOLI ). (1) A life settlement can be described as a transaction in which a life insurance contract owner sells the contract to a third party, presumably for an amount that exceeds the contract s cash surrender value but is less than the expected death benefit. (2) In recent years, the market for life settlements has broadened to include STOLI, which has been described as life insurance contracts manufactured for the purpose of settling in the secondary market. The life insurance industry has advocated legislative and regulatory changes to curb perceived abuses involving STOLI. (3) Each year since 2009, the Obama Administration has included proposals in its budget that would affect STOLI, but would also affect sales of life insurance contracts to third parties more generally as well. The most recent versions of these proposals would: require information reporting by third-party purchasers of life insurance contracts that provide death benefits of $1 million or more, and Page 6 of 15

7 modify the transfer for value rule of IRC section 101(2) to ensure that exceptions to that rule would not apply to buyers of policies. That rule, where applicable, denies tax-free treatment for the death benefit under a contract purchased by the transferee. Under current law, the rule does not apply if the transferee acquires a tax basis in the contract equal to the transferor s basis, i.e., a carryover basis. (4) The proposals would apply to sales or assignments of interests in life insurance contracts and payments of death benefits in taxable years beginning after December 31, 2012, and is estimated by Treasury to raise $811 million in federal tax revenues over 10 years. (5) These proposals eventually served as the blueprint for two of three proposals contained in a revenue-raising amendment that was added to Moving Ahead for Progress in the 21 st Century Act in 2012 (the highway bill ). (6) The amendment was sponsored by Sen. Max Baucus (D-MT), the chairman of the Senate Finance Committee. (c) (d) (e) Implementing the Administration s proposal to modify the transfer for value rule, the amendment overrode the carryover basis exception to the rule where there was no financial or other preexisting relationship between the insured and the party acquiring the contract. The amendment also included a provision that would have reversed a position the IRS took in Rev. Rul , C.B. 1029, regarding how tax basis is determined for purposes of determining taxable gain when a life insurance contract is sold to a third party. The amendment was generally supported by the life insurance industry and the life settlement industry, and it met with little or no opposition. However, the amendment was not included in the final bill signed by President Obama on July 6, It was excluded for political reasons, i.e., a desire generally to avoid revenue-raising tax proposals in the bill. Given that the Chairman of the Senate Finance Committee has championed the STOLI proposals and that the life insurance and life settlement industries generally have supported them, this topic is likely to be revisited by Congress in later tax legislation. Page 7 of 15

8 (f) Although the proposals are directed primarily at STOLI, they could affect other types of life insurance contracts, including BOLI, to the extent that such contracts are sold to third parties, whether in a life-settlement type of transaction or otherwise. III. The Volcker Rule A. Background. (1) Section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the Dodd-Frank Act ) added new section 13 to the Bank Holding Company Act. The new provision enacted the so-called Volcker Rule, named after its proponent and former Federal Reserve Chairman Paul Volcker. (2) In general terms, the Volcker Rule prohibits all banking entities (including any affiliates) from (1) engaging in proprietary trading or (2) acquiring or retaining any equity, partnership, or other ownership interest in or sponsoring a hedge fund or a private equity fund, unless otherwise allowed as permitted activities. (3) Private equity funds and hedge funds are generally defined as issuers that would be investment companies under the Investment Company Act of 1940, but for the private placement exemptions under sections 3(c)(1) or 3(c)(7) of such Act, and similar funds to be defined by future rulemaking. (4) In light of the broad definition of private equity funds and hedge funds, some practitioners had questioned whether: insurance company separate accounts that are offered as private placements fall within the definition; and unregistered separate account products, including private placement variable BOLI, could be caught up in the prohibitions imposed by the Volcker Rule on sponsorship and ownership of interests in hedge funds and private equity funds. If so, this would lead to the question whether the availability of a stable value wrapper or general account guarantee could invoke application of the Volcker Rule. B Study and Recommendations. (1) In January 2011, the Financial Stability Oversight Council, created by the Dodd-Frank Act, released a study and recommendations on prohibitions on proprietary trading and certain relationships with hedge funds and private equity funds. Page 8 of 15

9 (2) The study notes that insurance companies interface with the Volcker Rule as market investors, but also provide products that are investment vehicles. (3) It points out that the Volcker Rule may apply to banking entities investments in insurance products. (4) The study says that federal agencies should examine this carefully so as not to preclude certain insurance products that may not have been intended to be limited by the Volcker Rule. (5) Finally, the study recommends that: the appropriate federal agencies should carefully monitor fund flows between banking entities and insurance companies, to guard against gaming the Volcker Rule, whether it is through innovative insurance products and financial instruments, like BOLI, or use of separate accounts; and federal agencies should work with the state insurance regulators in monitoring activity of bank affiliate insurance companies and captive insurers. C. Notice of Proposed Rulemaking. (1) On October 11, 2011, the OCC, the Federal Reserve Board, the FDIC, and the SEC published a Notice of Proposed Rulemaking to implement the Volcker Rule. The Notice was published in the Federal Register on November 7, (2) The proposed rule generally provides an exemption from the Volcker Rule for a banking entity: acquiring and retaining an ownership interest in a separate account which is used solely for the purpose of allowing the entity to purchase an insurance contract for which the entity is the beneficiary (i.e., BOLI), and acting as a sponsor to such a separate account. (3) The exemption is conditioned on the banking entity: not controlling the investment decisions regarding the underlying assets or holdings of the separate account; and holding its ownership interests in the separate account in compliance with applicable supervisory guidance provided by the appropriate federal regulatory agency regarding BOLI, i.e., the Page 9 of 15

10 D. Other Recent Developments. Interagency Statement on the Purchase and Risk Management of Life Insurance (Dec. 7, 2004) and any guidance from the entity s specific regulator. (1) On April 19, 2012, the Federal Reserve Board announced that an entity covered by the Volcker Rule has the full two-year period provided by the statute to fully conform its activities and investments unless the Board extends the conformance period. The date to fully conform would be July 21, (2) According to news reports on August 21, 2012, the Treasury Department is coordinating with the group of regulators writing the Volcker rule, and a final rule can be expected by year-end. IV. Recent IRS Private Letter Rulings with Potential Implications for BOLI A. Private Letter Rulings in General. (1) A private letter ruling (PLR) is a ruling that the IRS issues to a particular taxpayer based on that taxpayer s factual and legal representations. (2) When the IRS issues a PLR to a taxpayer, the taxpayer to whom the ruling is issued can rely on it, and the IRS is bound by the ruling when dealing with that taxpayer. However, other taxpayers cannot rely on it. In this sense, PLRs are non-precedential. See IRC section 6110(k)(3). (3) Despite generally being non-precedential, PLRs are often one of the only sources of information from the IRS regarding its views on a particular issue. As a result, tax practitioners often look to PLRs to gauge how the IRS might view similar transactions. B. BOLI Partnership Private Letter Ruling PLR (1) PLR (Sept. 22, 2011) addresses the federal income tax treatment of a partnership of banks (the Partnership ) that would be formed to pool and manage the banks existing BOLI contracts ( Policies ) and exchange some or all of them for new contracts. A brief summary of the ruling is provided below, and a memorandum with a more detailed discussion of the ruling is attached for your information. (2) The ruling addresses three aspects of the arrangement s tax treatment: The Partnership s treatment as a partnership as opposed to an investment company under IRC sections 721 and 351; Page 10 of 15

11 (c) The deductibility of interest expenses by the Partnership and its members under IRC section 264(f); and The excludability of death benefits under the Policies, which were employer-owner life insurance contracts under IRC section 101(j) when originally issued. (3) IRC sections 721 and 351 the partnership tax rules. (c) (d) IRC section 721 provides that no gain or loss is triggered when a person acquires a partnership interest by contributing property to the partnership. The partnership generally acquires the transferor s basis in the transferred property, i.e., the cost basis carries over to the partnership. IRC section 721 overrides this rule, however, if the partnership would be treated as an investment company within the meaning of IRC section 351 if it were incorporated. In such a case, the transfer of property to the partnership is taxable, and the transferor s basis does not carry over to the partnership. The ruling concludes that a bank s transfer of Policies to the Partnership would not be treated as a transfer to an investment company within the meaning of IRC section 351 if the Partnership were incorporated. This effectively confirms that the normal partnership tax rules will apply to the banks transfer of Policies to the Partnership. The ruling s conclusion appears to preserve the tax-free character of the death benefits that the Partnership will receive under the BOLI contracts contributed to it, as well as the pass-through of that tax-free character to the bank-partners when the Partnership distributes the death benefits to them. (4) IRC section 264(f) exchanges of the Policies. As noted in part II.B. above, IRC section 264(f)(1) imposes restrictions on the deductibility of interest expenses by a business that owns or benefits from life insurance contracts with unborrowed cash values, e.g., the typical BOLI contract. As also noted above, IRC section 264(f)(4)(A) provides an exception to this rule for any contract that covers a single insured who, at the time first covered by the contract, was a 20-percent owner of the entity or was an officer, director, or employee of the trade or business (collectively, an employee ). Page 11 of 15

12 (c) (d) (e) (f) (g) In Rev. Rul , I.R.B. 554, the IRS held that this exception is not available with respect to a new contract received in exchange for an existing contract if, at the time of the exchange, the insured is no longer an employee, but rather is a former or inactive employee, of the corporate policyholder. The rationale of this holding is that the insured was not an employee at the time first covered under the new contract. In its ruling request, the Partnership asked the IRS to construe the application of the IRC section 264(f) rules to its two current members, Bank A (the majority shareholder) and Bank B, as well as itself. First, the ruling concludes that due to Bank A s majority ownership position in the Partnership, an aggregation rule in IRC section 264(f)(8) will attribute the Partnership s ownership of the Policies to Bank A for purposes of IRC section 264(f)(1). Thus, a portion of Bank A s interest expense deductions could be disallowed by virtue of the Partnership owning the Policies. Second, the ruling concludes that because Bank B s Partnership interest is less than 50%, the foregoing aggregation rule will not apply to Bank B. As a result, Bank B s interest expense deductions will not be disallowed under IRC section 264(f)(1) by virtue of the Partnership holding the Policies. By implication, this same treatment would apply to Bank A after a sufficient number of additional banks join the Partnership that Bank A s interest is diluted below 50%. The conclusions under IRC section 264(f) would appear to facilitate the Partnership s ability to exchange the BOLI contracts without jeopardizing the bank-partners income tax deductions for their unrelated interest expenses, even in circumstances where IRC section 264(f) would disallow a portion of such deductions if the banks had continued to hold the contracts and conducted the proposed exchanges themselves (e.g., due to the fact that some, even many, of the insureds had become inactive employees). (5) IRC section 101(j) employer-owned life insurance. IRC section 101(j) imposes special requirements on employerowned life insurance contracts. (i) For example, the employer must satisfy certain notice and consent requirements prior to the time the contract is issued. See IRC section 101(j)(4). Page 12 of 15

13 (A) An exchange of an existing employer-owned life insurance contract will re-trigger these notice and consent requirements unless (1) the exchange occurs within a year of the issue date of the contract being exchanged and before the covered employee terminates employment, or (2) the exchange does not result in a material change in the death benefit or other material change in the contract. See Q&A- 9 and Q&A-16, respectively, of Notice , C.B (ii) In addition, the insured at issuance of an employer-owned life insurance contract must be a director, highly compensated employee, or highly compensated individual with respect to the policyholder. See IRC section 101(j)(2)(A)(ii). (c) If these requirements are not met, the contract s death benefit is taxable to the extent that it exceeds the policyholder s investment therein. See IRC section 101(j)(1). The ruling reaches two conclusions regarding the treatment under IRC section 101(j) of the Policies that the Partnership would hold as owner and beneficiary, including those it received in exchange for Policies contributed to it: (i) (ii) Each such Policy will constitute an employer-owned life insurance contract within the meaning of IRC section 101(j)(3)(A) if it covers the life of an insured who, on the date the Policy is issued, is (i) an employee of the Partnership, or (ii) an employee of Bank A. The conclusion regarding Bank A is based on aggregation principles under IRC section 101(j) that identify the applicable policyholder with respect to an employer-owned life insurance contract. Like the IRC section 264(f) aggregation rule, the IRC section 101(j) rule treats Bank A and the Partnership as the same taxpayer by virtue of Bank A s interest in the Partnership exceeding 50%. In contrast, a Policy will not constitute an employer-owned life insurance contract if it covers the life of an insured who, on the date the Policy is issued, is an employee of Bank B and not the Partnership. In other words, the aggregation rule does not apply to Bank B because it holds less than a 50% interest in the Partnership. By implication, this same treatment would apply to Bank A after a Page 13 of 15

14 sufficient number of additional banks join the Partnership to dilute Bank A s interest below 50%. (d) The conclusions under IRC section 101(j) would appear to facilitate the exchange of BOLI contracts by the Partnership without having to provide new notices of the coverage to the insureds or to obtain their consent to the issuance of the replacement contracts in circumstances where that statute otherwise would require such actions. C. Private Letter Ruling on Death Benefit Reductions PLR (1) PLR (Jan. 30, 2012) addresses the reasonable mortality charge requirements of IRC section 7702(c)(3)(B)(i), a component of the federal tax definition of life insurance contract. If a life insurance contract fails to meet this definition, its inside buildup is currently taxable. See IRC section 7702(g). (2) The taxpayer, a life insurance company, requested a ruling that a reduction in the face amount under a life insurance contract pursuant to the owner s request and with the company s consent would not cause the contract to be treated as newly issued for purposes of certain transition rules that apply to the reasonable mortality charge requirements. The contract involved was based on the 1980 CSO mortality table. If it were treated as newly issued (at any time after 2008), the contract generally would need to be based on a newer mortality table, i.e., the 2001 CSO table, for purposes of complying with the federal tax definition of a life insurance contract. (3) Under the applicable transition rules, set forth in section 5 of Notice , C.B. 848, certain types of changes to a life insurance contract do not cause the contract to be treated as newly issued, e.g., if the change was made pursuant to the terms of the contract. (4) The contract at issue in the ruling did not include a provision that explicitly stated the owner could request a decrease in coverage. As a result, the IRS ruled that the reduction in the face amount under the contract would result in an exchange, causing the contract to be treated as newly issued for purposes of the reasonable mortality charge requirements under IRC section 7702(c)(3)(B)(i). Page 14 of 15

15 (c) This required the contract to be based on the 2001 CSO table in order to be in compliance with IRC section Although not addressed in the ruling, the result in some cases would be that the contract cannot comply with IRC section 7702 following the death benefit reduction. If the contract could comply with IRC section 7702 following the death benefit reduction, the substitution of the 2001 CSO table for the 1980 CSO table would generally reduce the contract s investment orientation, e.g., the amount of funding that IRC section 7702 would permit per dollar of death benefit would generally be decreased. (5) In practice, most universal life insurance contracts include an express right in the owner to reduce the face amount upon request. To the extent that BOLI contracts are universal life contracts or otherwise include such an express right, this ruling should not be of concern to BOLI owners. In some cases, however, a BOLI contract may not include an express right to reduce the face amount, and in such cases the IRS position appears to be that a face amount reduction would force the contract to switch to the 2001 CSO tables for purposes of testing compliance with the federal tax definition of life insurance, which in turn could cause some contracts to fail to qualify as life insurance. Page 15 of 15

16 TO: FROM: Kurt J. Laning, FSA President, Clark Consulting John T. Adney and Bryan W. Keene DAVIS & HARMAN LLP DATE: March 6, 2012 RE: PLR Analysis and Observations This memorandum responds to your request for our analysis and observations with respect to a private letter ruling recently issued by the Internal Revenue Service (the Service ) regarding a transaction involving bank-owned life insurance or BOLI. Specifically, PLR (the Ruling ) 1 describes a partnership of banks that would be formed to pool and manage the banks existing BOLI contracts and exchange some or all of them for new contracts. The Ruling addresses the treatment of the arrangement under sections 721 and 351, regarding the taxation of partnerships, section 264(f), regarding the deductibility of interest expenses by businesses that own life insurance, and section 101(j), regarding the excludability of death benefits under employer-owned life insurance contracts. 2 As discussed below, the Ruling s conclusions on these issues support three critical aspects of the arrangement from a federal income tax perspective: First, the conclusion under sections 721 and 351 would appear to preserve the tax-free character of the death benefits that the partnership will receive under the BOLI contracts contributed to it, as well as the pass-through of that tax-free character to the bankpartners when the partnership distributes the death benefits to them. Second, the conclusions under section 264(f) would appear to facilitate the partnership s ability to exchange the BOLI contracts without jeopardizing the bank-partners income tax deductions for their unrelated interest expenses, even in circumstances where section 264(f) would disallow a portion of such deductions if the banks had continued to hold the contracts and conducted the proposed exchanges themselves. Third, the conclusions under section 101(j) would appear to facilitate the exchange of BOLI contracts by the partnership without having to provide new notices of the coverage to the insureds or to obtain their consent to the issuance of the replacement contracts in circumstances where that statute otherwise would require such actions. 1 The Service issued the Ruling on September 22, 2011, and released it to the public on December 30, A private letter ruling cannot be cited as precedent or relied upon by anyone other than the taxpayer to whom it was issued. See section 6110(k)(3) of the Internal Revenue Code of 1986, as amended (the Code ). 2 Unless otherwise indicated, the term section refers to a section of the Code.

17 Thus, as summarized by the law firm of Locke Lord Bissell & Liddell LLP, which represented the parties in obtaining the Ruling, [t]he basic lesson to be drawn from PLR is that by utilizing a LLC, a bank may be able to manage its BOLI holdings in ways that it could not do on its own as a practical matter, given the constraints of sections 264(f) and 101(j). 3 Although the Ruling supports these results, there are several questions it does not address, which would need to be considered and resolved favorably for the proposed transaction to be viable. For example, the Ruling does not address: How state insurable interest laws would apply to the proposed exchanges, which could affect the arrangement s treatment under federal income tax law and the partnership s (and the bank-partners ) entitlement to the death proceeds under state law; or How regulators other than the Service, such as federal bank regulators or the Securities and Exchange Commission ( SEC ), would view the arrangement and what requirements, if any, they might impose on banks proposing to participate in it. These and other aspects of the arrangement presumably would need to be explored independently of the Service s conclusions in the Ruling before banks would be able to participate in the transaction with a high degree of confidence that the arrangement meets all regulatory requirements and provides the intended tax and non-tax benefits. 4 The remainder of this memorandum summarizes the facts of the Ruling and then discusses the issues the Ruling addresses as well as the questions it leaves unanswered. I. FACTS OF THE RULING The Ruling describes a limited liability company that proposes to be treated as a partnership for federal income tax purposes (the Company ). The Company s current partners technically, its members are a BOLI broker ( Managing Member ), a national bank ( Bank A ), and a financial holding company that is regulated by the Federal Reserve Board ( Bank B ). The bank-partners own BOLI contracts covering the lives of their current and former employees (the Policies ). Some of the Policies are based on the issuers general asset accounts, while others are variable contracts based on the issuers separate accounts. The banks will contribute Policies to the Company. In return, Bank A will receive a greater-than-50% partnership interest in the Company, and Bank B will receive a less-than-50% partnership interest. In the future, it is assumed that other banks will join the partnership, which will dilute Bank A s interest to below 50%. The Company will accept Policies only if (1) they have been in force for at least five years, and (2) the insureds were given notice of the coverage and consented thereto. In addition, the banks must represent that they will not transfer Policies 3 Kirk Van Brunt, Important IRS Private Letter Ruling on Bank-Owned Life Insurance Policies, LOCKE LORD QUICKSTUDY, CORPORATE INSURANCE PRACTICE (Jan. 11, 2012) (available at 4 See Matthew Schoen, New IRS PLR Portends Trickle of 1035 Exchanges, Not a Flood, INSURANCE BROADCASTING (Jan. 1, 2012) (available at (subscription required) (identifying the resolution of banking law and state insurable interest law as two items on the long list of steps to check off before proceeding with the transaction). Page 2 of 14

18 to the Company as a means of increasing their BOLI holdings beyond the limits prescribed by bank regulators. 5 The stated purpose of the Company is to provide the bank-partners with a more effective, centralized way to manage Policies and, where appropriate, to negotiate the terms of new Policies (i.e., via exchange) or renegotiate the terms of existing BOLI holdings. In that regard, the parties expect that the Company will exchange all or a substantial portion of the Policies for new ones. The Managing Member and the Company s Management Committee will decide whether to retain or exchange Policies after they are contributed to the Company. The Company will collect death benefits as they are paid under the Policies and distribute them (plus any other profits, net of any losses and presumably net of Company expenses) to the bank-partners in accordance with their percentage interests in the partnership. The Company may incur immaterial interest expenses on indebtedness unrelated to the Policies. The banks partnership interests in the Company will not be redeemable. Instead, any bank wishing to withdraw from the partnership would need to sell its interest to another bank after obtaining the Managing Member s consent to do so. The Managing Member is expected to grant such consent only in rare and extraordinary circumstances. The Company made several factual and legal representations to the Service in support of the requested rulings, including: (1) the Policies, at issuance and upon transfer to the Company, meet all applicable state insurable interest laws; and (2) the Company s exchanges of the Policies will comply with any applicable state insurable interest laws. As discussed below, these two representations are critical to the arrangement s viability, and ascertaining their accuracy in all bank-participants circumstances would be vital to banks successful participation in the arrangement. II. DISCUSSION As indicated above, the Ruling addresses the treatment of the arrangement under sections 721 and 351, regarding the taxation of partnerships, section 264(f), regarding the deductibility of interest expenses by businesses that own life insurance, and section 101(j), regarding the excludability of death benefits under employer-owned life insurance contracts. The Ruling s conclusions on these issues are summarized below, along with our analysis and comments thereon, followed by few final observations and a brief conclusion. A. Sections 721 and 351 The Partnership Tax Rules (1) The Ruling s Conclusion The Ruling concludes that the banks transfer of Policies to the Company would not be treated as a transfer to an investment company, within the meaning of section 351, if the 5 See, e.g., Interagency Statement on the Purchase and Risk Management of Life Insurance, OCC Bull , at 5 (Dec. 7, 2004) (stating that it is generally not prudent for an institution to hold BOLI with an aggregate [cash surrender value] that exceeds 25 percent of the institution s capital as measured in accordance with the relevant agency s concentration guidelines. ). Page 3 of 14

19 Company were incorporated. Section 721 provides that no gain or loss is triggered when a person acquires a partnership interest by contributing property to the partnership. Section 721 overrides this rule, however, if the partnership would be treated as an investment company within the meaning of section 351 if it were incorporated. In this respect, the Ruling confirms that sections 721 and 351 will not preclude the normal partnership tax rules from applying to the banks transfer of Policies to the Company. (2) Analysis and Comments Transfer for value rule Although not expressly stated in the Ruling, the Service s conclusion on sections 721 and 351 likely relates to the treatment of the transaction under the transfer for value rule of section 101(2). Under that rule, if a life insurance contract or any interest therein is transferred for a valuable consideration, the income tax exclusion for the contract s death benefit is limited to the consideration and any subsequent premiums the transferee paid for the contract. Absent an exception, this rule would likely apply to each bank s transfer of Policies to the Company in exchange for a partnership interest, making the death benefits taxable to the extent they exceed the transferee s investment therein. An exception would appear to be available, however, if the normal partnership tax rules govern the transfer of Policies to the Company. This is because the transfer for value rule does not apply if the transferee s basis in the contract is determined in whole or in part by reference to the transferor s basis. 6 Such carryover basis treatment normally applies under section 723 when property is contributed to a partnership. Thus, as long as the transfer of Policies to the Company is treated as a contribution of property to a partnership, the transfer for value rule would not apply. 7 In that regard, the investment company rules of sections 721 and 351 can operate to tax property when contributed to a partnership. If the contribution is a taxable event, the contributor s basis in the property would not carry over to the partnership. This, in turn, would make the carryover basis exception to the transfer for value rule unavailable. Hence, the parties likely sought confirmation that the investment company rules will not apply in order to support the position that the carryover basis exception to the transfer for value rule will apply. The Policies are not stock and securities The Ruling s conclusion that the investment company rules do not apply is groundbreaking. The Ruling states that, because the Company s assets will consist solely of the Policies and minimal cash, more than 80% of the Company s assets will not be comprised of stock and securities. 8 This necessarily means that the Service does not view the Policies as 6 Section 101(2)(A). 7 Rev. Rul. 72, C.B. 23 (concluding that the carryover basis exception to the predecessor provision of section 101(2) applied to the contribution of a life insurance contract to a partnership because the partnership tax rules provide for a carryover basis with respect to property contributed to a partnership). 8 Under section 351(e) and Treas. Reg. section (c)(1)(ii), if more than 80% of a corporation s assets (continued ) Page 4 of 14

20 stock and securities within the meaning of section 351(e). This is noteworthy because section 351(e) takes a broad view of what constitutes stock and securities. In particular, the list of investments that section 351(e) deems to be stock and securities includes (1) money, (2) stocks and other equity interests in a corporation, (3) evidences of indebtedness, and (4) any equity interest or other arrangement that is readily convertible into cash. 9 The Policies have attributes that make them similar to these types of investments in certain respects. For example, general account Policies are solely an obligation of the insurer s general asset account in a manner somewhat similar to a debt obligation, although the obligation is not treated as debt for tax purposes. Likewise, variable Policies are treated as securities under federal securities laws, and the separate account investments supporting them presumably are either debt instruments or stocks and other equity interests. In addition, both general and separate account Policies can be converted to cash through surrender or withdrawal. The Ruling implicitly confirms that these characteristics are insufficient to cause the Policies to fall within the definition of stock and securities in section 351(e). Prior to the Ruling, the Service had not addressed this issue. Unfortunately, the Ruling does not elaborate on the Service s reasoning. (c) Other partnership tax rules In addition to the investment company rules discussed above, there are several other exceptions to the normal partnership tax rules regarding carryover basis of contributed property. These include: the disguised sale rules of section 707(2)(B), which treat certain contributions of property to a partnership as taxable sales of the property; the anti-abuse regulations under Treas. Reg. section , which permit the Service to recharacterize partnership transactions that are considered abusive of the partnership income tax regime, e.g., using that regime to avoid an otherwise applicable federal income tax requirement rather than to achieve pass-through tax treatment; and the publicly-traded partnership rules of section 7704, which treat certain partnerships as corporations for federal income tax purposes. Presumably, the parties found these rules clear enough to obviate the need or desire to obtain confirmation from the Service regarding their application to the proposed transaction. As a result, the Ruling does not address them. Nonetheless, a bank would likely want to consider these rules before deciding to participate in the Company. are comprised of stock and securities, and certain other requirements are met, the company is treated as an investment company. The Service s conclusion that the Policies are not stock and securities obviated the need for it to consider the other factors that apply in determining whether a company is an investment company. 9 Section 351(e)(1)(B)(i), (ii), and (iv). Page 5 of 14

21 (d) Sale of a bank s interest in the Company to another bank As indicated above, interests in the Company are not redeemable, so any bank-partner wishing to withdraw from the partnership would need to sell its interest to another bank. This presents the question of whether the sale of the partnership interest will be treated as a sale of a proportionate share of the Policies that the Company holds. If so, the transfer for value rule might apply upon the sale of the partnership interest, causing some or all of the death benefits under the Policies to lose their section 101(1) income tax exclusion. In general, when a person sells a partnership interest to a third party, the partnership interest itself is the property that is treated as sold, rather than a proportionate share of the partnership s assets. 10 This reflects the entity theory of partnership taxation, under which a partnership is regarded as an entity separate from its partners, such that the partners are not deemed to have a direct interest in partnership assets or operations, but only an interest in the partnership entity separate and apart from its assets and operations. 11 Some courts, however, have instead applied the aggregate theory of partnership taxation to sales of partnership interests. Under that theory, a partnership is merely a conduit for its individual partners, each of whom is deemed to own a direct undivided interest in partnership assets and operations. Thus, under the aggregate theory, a sale of a partnership interest would be treated as a sale of the partnership s assets. 12 In the specific context of a sale of an interest in a partnership that owns life insurance contracts, it appears that no court has had occasion to consider whether the entity or aggregate approach should apply, i.e., whether the transaction should result in a deemed sale of the underlying life insurance contracts that might trigger the transfer for value rule under section 101(2). The Service, however, has addressed this point in a private letter ruling that applied the entity theory under the facts involved. 13 Presumably, the Service would reach a similar conclusion with respect to a bank s sale of its partnership interest in the Company, but the Ruling does not address this question. B. Section 264(f) Exchanges of the Policies (1) The Ruling s Conclusions The Ruling reaches the following conclusions regarding the consequences under section 264(f) of the Company s proposed exchanges of Policies: 10 See section 741 (generally adopting an entity approach for transfers of partnership interests); compare section 751 (generally preventing the conversion of ordinary income into capital gain via the sale of a partnership interest). 11 See William S. McKee, William F. Nelson & Robert Whitmire, Federal Taxation of Partnerships and Partners 1.02 (4th ed. 2007). 12 See, e.g., Holiday Village Shopping Center v. United States, 773 F.2d 276 (Fed. Cir. 1985). 13 PLR (Dec. 20, 2007). Page 6 of 14