Reform Treatment of Insurance Companies and Products
The budget contains four proposals that would change the tax treatment of insurance companies and their products. We evaluate three of them here.
Expand Pro Rata Interest Expense Disallowance for Corporate-Owned Life Insurance (COLI). An insurance company will credit interest on life insurance policies, which generally increases the policies’ cash surrender value. This interest is not currently taxable. If a company could borrow to purchase such a policy and deduct the interest, they would be matching currently deductible interest against deferred income. Accordingly interest on borrowing to purchase or carry life insurance is generally not deductible. Further, since it would often be difficult to trace borrowing used to fund the purchase of insurance, a pro rata portion of the corporation’s interest expense is disallowed to the extent it has “unborrowed” cash value under life insurance policies (Section 264(f)). However, this rule does not apply if the policy covers the life of an individual who is an employee, officer or director of the corporation. This proposal would repeal that exception for policies issued after December 31, 2010. The exception for policies covering the life of a 20-percent owner of the business would remain.
Modify Dividends Received Deduction for Life Insurance Company Special Accounts. Corporations may deduct from 70 percent to 100 percent of dividends received from other corporations in order to avoid taxing that income twice at the corporate level. The dividend has already been taxed to the distributing corporation and the deduction avoids a second full corporate tax levied on the recipient. Under current law, an allocation rule for life insurance companies disallows the deduction with respect to the portion of the dividend that is allocated to policyholders and not the company. This proposal would limit the share of the dividend to which the deduction applies to no more than the company's economic interest in the dividend.
Modify Rules that Apply to Sales of Life Insurance Contracts. Investors sometimes purchase existing life insurance contracts, thus providing the sellers of those contracts with immediate payment in return for the buyers getting insurance payments when insured individuals die. Death benefits received by a decedent’s family are not taxed, even if the insurance amount exceeds the premiums paid. In general, however, an investor with no financial interest in the insured must pay tax on the amount of insurance collected less the amount paid for the policy and premiums paid by the investor. But various exceptions may give investors an incentive to structure the purchase of insurance contracts to avoid subsequent tax liability. This proposal would modify transfer rules to make those exceptions inapplicable for investors, thus ensuring that investors pay tax on their gains. It would also impose reporting rules on the transfer of policies with a death benefit of $500,000 or more. The new rules would apply to transfers of policies and payments of death benefits for taxable years beginning after December 31, 2010.
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