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New COLI Rules: Good Intentions, 'Disastrous' Reporting Requirements

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Best practices governing the issuance of corporate-owned life insurance, which have garnered industrywide support and which President Bush signed into law on August 17 as part of the Pension Protection Act of 2006, may not be such a good thing after all, according to speakers at LIMRA International’s Advanced Sales Forum, held here last week.

COLI notice and consent provisions, plus a host of recent court cases, IRS rulings and other legislation, drew much criticism from presenters during the first general session.

Thomas Commito, vice president and senior tax advisor for Lincoln Financial Distributors, Philadelphia, Pa., lauded the COLI provisions’ intent but described the legislation’s reporting requirements as “a disaster.” He noted that IRS attribution rules require individuals owning more than 50% of a company’s stock–be they an owner-employer, family member in a family-limited partnership or other majority shareholder–to file all prior notice and consent forms, in addition to an annual report, respecting ownership of life insurance policies on the lives of employees.

To ensure that death benefit proceeds from COLI policies remain exempt from income tax, Stephan Leimberg, president and CEO of Leimberg Information Services, Bryn Mawr, Pa., said companies will have to thoroughly document notice and consent forms for each insured employee, and specify the maximum amount of insurance to be purchased, before policies are issued. The reporting requirements will apply, too, to policies covering key person insurance, stock redemption plans and non-qualified deferred compensation plans, among other life insurance-funded vehicles used for business planning purposes.

“Somebody was asleep at the switch when they shepherded these provisions through Congress because they’re an absolute nightmare,” said Leimberg. “You’ve got to alert everyone to be careful about COLI–period.”

Among the landmark cases focusing on insurable interest during the year past–Ecel Energy vs. United States, Mayo vs. Hartford Life, Betina Tillman vs. Camelot Music, and Chawla vs. Transamerica Occidental Life–the last especially concerned the presenters because of the inconclusive result of an appeals court ruling.

In Chawla, the U.S. District Court for the Eastern District of Virginia held that an irrevocable life insurance trust lacked an insurable interest in the grantor, who was also the sole lifetime beneficiary and a co-trustee. The 4th Circuit Court of Appeals held the trust was not entitled to death benefit proceeds because of misrepresentations by the insured. But the court vacated the insurable interest holding.

Commito said the fact the appeals court did not reverse the lower court’s insurable interest holding “leaves the worst impression.” If left in force, irrevocable life insurance trusts could never become the first owners of life insurance policies. Rather, an insured would have to buy a policy, hold it for a period of time, then assign it to a trust.

To circumvent the lower court’s restrictive interpretation of Maryland statutory law respecting ILITs, Leimberg recommended that clients buy a policy and establish a trust in a “friendly state” (i.e., one that offers a statutory grant of insurable interest to a trust created by the insured). Among the trust-friendly states, he said, are Maine, Virginia and South Dakota.

Respecting the drafting of buy-sell agreements, Leimberg counseled caution in the wake of a holding by the 11th Circuit Court of Appeals. The court reversed a lower tax court on the treatment of life insurance proceeds funding a buy-sell, noting that insurance proceeds are not an ordinary non-operating asset that should be included in the value of the business under Treasury Department regulations.

The lesson of the case, said Leimberg, is that “life insurance proceeds should cover both the economic and tax implications of a stock redemption agreement because if they don’t, the surviving shareholders will get a windfall.

“When you do a buy-sell, it’s extraordinarily important that you review the wording, particularly as regards how life insurance is being treated in the valuation of the business,” he added.

Clients also need to tread carefully on transactions involving transfer for value. An IRS private letter ruling issued during the year past, PLR 200518061, held the transfer of a life insurance policy from one grantor trust to another may be disregarded for federal income tax purposes because the transaction will not be considered a transfer for value.

Leimberg observed, however, that a transfer could encounter resistance from a policy beneficiary if the transaction were executed through a sale that yielded less than fair market value for the life policy. That might happen, for example, if the sale were based on interpolated terminal reserve, a formula used for valuing life insurance contracts for gift tax purposes.

“In this case, we have a V8 problem–I could have had a V8!” said Leimberg. “Once the policy is sold for its interpolated terminal reserve, a beneficiary could argue that he would have gotten more for the policy via a life settlement. My point is this: [Policy] transfers from one grantor trust to another are nowhere near as simple or clean cut as we might think at first glance.”


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