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AALU Hears Warnings Of Federal Action Against Insurance Tax Benefits

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Congressional action that might seriously undermine the tax benefits associated with life insurance consumed much of the debate among a panel of 4 experts during the 50th annual meeting of the Association of Advanced Life Underwriting, Falls Church, Va., held here last week.

Titled “The 110th Congress: The Good, The Bad, the Ugly Part 2,” the panel focused particular attention on legislative assaults against life insurance-funded nonqualified deferred compensation plans.

“We need to get our membership energized on this issue,” said Marc Cadin, AALU vice president of legislative affairs. “Otherwise, in the next several years, we may not have a tax-preferred product. It’s really that serious.”

Panelists voiced concern about proposed deferred compensation provisions that might be attached to a future bill needed to satisfy Congress’ pay-as-you-go (PAYGO) rules. Among them: a proposed rule cleared by the Senate Finance Committee that would cap nonqualified deferred compensation not subject to income tax to the lesser of $1 million or the average of the past 5 years of taxable compensation. The provision would also count earnings on nonqualified deferred compensation against the cap for any deferrals after Jan. 1, 2007. And the rule would apply to non-elective deferrals.

“If you violate the cap in any year [under this provision] it’s a nuclear event because all prior deferrals are immediately includable in income and there is a 20% penalty tax,” said Kenneth Kies, a managing director at the Federal Policy Group, Washington, D.C. “It’s pretty much a meltdown if you violate the rule.”

Bill Archer, a former chairman of the House Ways and Means Committee and a senior policy advisor to PricewaterhouseCoopers, New York, added that there is a “very great danger” the proposed law might be extended to cover executive compensation generally.

Panelists expressed satisfaction with the final regulations of Internal Revenue Code Section 409A, an outgrowth the 2004 American Jobs Creation Act that sets guidelines for deferred compensation plans. But they cautioned the regulations may come under renewed scrutiny as Congress seeks ways to fulfill PAYGO rules.

Kies observed the Democratic-controlled House might want to clamp down on deferred comp plans to help fund education, energy and health care initiatives that could cost between $70 billion and $80 billion, though he indicated that legislation reaching the president’s desk is unlikely to require more than $20 billion to $30 billion in funding. He speculated, too, that Congress will likely have to waive the PAYGO rules to reform the alternative minimum tax, or AMT, which he estimated would impose $50 billion in income tax liabilities on some 29 million taxpayers in 2008.

To guard against revenue-enhancing legislation that might adversely impact the tax-favored treatment of life insurance, Cadin said AALU has enlisted the support of its Issues Alliance Partners to participate in a coordinated lobbying campaign.

He added that AALU is also depending on its members–attendees to this year’s conference, as in prior years, took a bus trip to meet with Congressional members on Capitol Hill–to convey the message that that adverse legislation would, among other consequences, negatively affect savings rates, particularly those of middle income employees who depend on deferred comp plans to fund their retirement plans.

“There is an appetite among congressional members to do something about executive compensation,” said Cadin. “But there is a real dearth of understanding as to how these plans work and how they benefit both employers and employees. We’ve got a lot of educating to do.”

Archer agreed, adding: “Deferred compensation is important not just to the policy owner, but also to the aggregate savings of the country that is represented by permanent life insurance. You combine that with security and you have a heck of a message to sell, particularly at a time when the U.S. has a negative savings rate for the first time since the 1930s.”

On the question of the estate tax, Jeff Ricchetti, an attorney and principal at Ricchetti Inc., Washington, D.C., observed that repeal or legislation that is “tantamount to repeal” of the estate tax might still be in the offing for the remainder of the current congressional term. He said that pressure is growing on legislators to act in advance of 2010, when the estate tax sunsets for one year before reverting in 2011 to the tax structure that existed prior to the Economic Growth Tax Relief and Reconciliation Act of 2001. (EGTRAA changed the pre-2001 $1 million estate tax exemption and 55% top tax rate with progressively higher exemption levels and a lowering of top tax rates.)

Ricchetti estimated the chance of Congress tacking an estate tax reform measure onto a 2007 budgetary agreement under the current PAYGO rules at “less than 50%. But he speculated that reform backers might attempt to cut a deal with the current administration in 2008 on the assumption that a new Democratic president would be less disposed than a Republican one to okay a generous reform package. Kies observed that reform proponents would likely act in 2009 because a complete phase-out of the tax in 2010 and reversion to the pre-2001 framework in 2011 “can’t be allowed to happen.”

Invoking a football play analogy, Archer predicted that Congress would defer a final resolution of the issue by locking in, if only temporarily, the 2009 tax structure.

“I’ve noticed over many years that whenever Congress faces a difficult situation, they’ll punt–and there is a way to punt on this issue,” he said. “One thing they can do is extend from 2009 into 2010 and 2011 the $3.5 million exemption and 45% tax rate, buying Congress extra time in a way that’s revenue-neutral. I wouldn’t rule this out.”

When the session moderator, AALU CEO David Stertzer, questioned panelists about what Congress might agree to for a long-term solution, the speakers predicted exemption levels ranging between $2.5 million and $3.5 million and a top tax rate at about 40%. Two on the panel, Cadin and Archer, also anticipated a reunified gift and estate tax exemption.

Panelists were less optimistic about prospects for broad tax changes generally, in part because no one in the administration or in Congress is championing overall reform. Near-term, Ricchetti said, what energy exists for reform will be consumed by other issues, including education, energy and national security.

He ventured, however, that several developments–including EGTRRA tax provisions that are due to expire in 2010; a ballooning of entitlement expenses as boomers phase into retirement; and a large economic shock, such as a sharp rise in interest rates–could act as catalysts for reform.

Yet, what form the legislation might take remains a question mark. Kies said it is unlikely Congress would favor a flat tax, value-added tax or other national sales tax because such levies are not as progressive as the current income tax. Ricchetti agreed, noting also that the Democrats are interested in promoting tax-simplification, but not if the trade-off is a less progressive tax code.