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Reform Treatment of Insurance Companies and Products

The budget contains three proposals that would change the tax treatment of insurance companies and their products. In combination, the proposals would raise about $16 billion through 2022.

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 and increase revenues by $811 million over 10 years. 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, 2012.

Modify proration rules for life insurance company general and seperate accounts

In general, corporations may deduct between 70 percent and 100 percent of dividends received from other corporations in order to avoid taxing that income twice at the corporate level. 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 aims to limit the share of the dividend to which the deduction applies to no more than the company’s economic interest in the dividend, all while making the allocation system less complex and more consistent with the treatment of other corporations. This proposal would be effective for taxable years beginning after December 31, 2012, and would raise about $7.7 billion through 2022.

Expand pro rata interest expense disallowance for corporate-owned life insurance

An insurance company will accrue interest on life insurance policies, which generally increases the policies’ cash surrender value. This interest is not taxable under current law. If a company could borrow to purchase such a policy and deduct the interest, it would be matching currently deductible interest against tax-free 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, 2012, increasing revenues by $7.3 billion over 10 years. The exception for policies covering the life of a 20 percent owner of the business would remain.