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COLI Changes In PPA A Mixed Bag, Says AALU Speaker

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Key provisions of the Pension Protection Act of 2006 received an unfavorable reception during a session of the Association for Advanced Life Underwriting’s annual conference here last month. John Adney, an attorney at Davis & Harman, Washington, D.C., took direct aim at the new Internal Revenue Code section 101(j), which he characterized as excessive in its reach and in need of clarification on several points.

“Some of the [code] provisions are not very useful," said Adney. "There are a lot of quirks and traps for the unwary."

Under IRC Section 101(j), death benefit proceeds of employer-owned life insurance covering an employee are taxable to the employer for distributions exceeding premiums paid unless the employer gives notice to, and secures consent from, the covered employee(s). Section 101(j)(2) provides for several exceptions to the rule.

Proceeds are tax-free, Adney noted, if distributed within the 12 months following the death of a covered key employee. Death benefits are also tax-exempt if the face amount is payable to a trust, the key employee's family member or a designated beneficiary other than the employer.

The exceptions notwithstanding, Adney said he was concerned that 101(j)(1) defines employer-owned life insurance so broadly: The rule applies to any policy covering an insured employee of any entity that is directly or indirectly engaged in trade or business. The code might thus invoke affiliate aggregation rules that could impose notice-and-consent provisions on life insurance-funded buy-sell agreements, related persons transactions and voluntary employee benefits associations.

Of as much concern as what rule 101(j) stipulates is what it doesn't. It's not clear, Adney noted, who, apart from the employer (such as the agent or insurer), must satisfy the notice and consent requirement. Also in need of explanation, he said, is whether the requirement that maximum face amounts on contracts be disclosed applies to post-policy issue increases of these amounts, and whether a new or "refreshed" notice and consent is mandated after a coverage increase or other "material change" in the contract, such as a 1035 exchange.

The lack of clarity, Adney said, has prompted the American Council of Life Insurers to seek guidance from the U.S. Treasury Department. In the interim, he has counseled attendees to secure a private letter ruling from the IRS.

In counterpoint to the 101(j) changes, Adney characterized amendments of tax rules governing qualified long-term care insurance enacted by IRS Section 844 of the Pension Protection Act as "good news" for advisors. One reason: The LTC pieces of hybrid LTC/annuity solutions are considered tax-qualified products, thus entitling users to receive benefits income tax-free and to treat premiums paid as medical expenses that may be listed as itemized deductions on the insured's income tax return.

"The treatment applies whether or not the LTC benefit is paid out of the annuity's cash value," said Adney. "This is a great rule and [will help spur sales of] deferred annuities."

He cautioned, however, that the pension legislation does not benefit combo products offered in qualified retirement plans. The new law additionally leaves open to interpretation whether immediate annuities will enjoy the tax-preferred treatment.

Also a question mark is the tax treatment of hybrid products issued before 2010, when section 844 of the PPA takes effect. Still to be determined, said Adney, is whether the substituting of one qualified combo product for another in 2010 constitutes a taxable exchange, and whether the replacement product will enjoy a lower deferred acquisition cost (DAC) tax.

Impacting exchanges of bank-owned life insurance, said Adney, are 2 IRS private letter rulings issued during the past year. In PLR 2006627021, the IRS stated the pro rata disallowance rule of IRC Section 264(f)(1) applies to a 1035 exchange. (The IRC section precludes companies from deducting that portion of its interest expense that can be allocated to non-borrowed cash values, but provides an exception under Section 264(f)(4)(A) for contracts covering an individual who is a 20% owner, officer, director or employee of the business owning COLI "at the time first covered.) Upshot: The rule disallows interest deductions on 1035 exchanges involving former bank employees based on the ratio of the cash value of the BOLI contracts to the total assets in the bank.

In PLR 200711014, issued on March 12, 2007, the IRS ruled that the exchange of old contracts covering active employees for new policies with different terms will qualify for Section 1035 tax-free treatment. The ruling further noted that section 264(f) doesn't apply to the exchange.

"The bottom line of all this is that one needs to be sensitive to changes in contracts--not just exchanges, but the addition of endorsements, riders or death benefits," said Adney. "All of these things can be material changes under the tax law. And if you have a material change, then you lose the exclusion under Section 264(f)."

In yet another private letter ruling cited by Adney (PLR 200651023), the IRS held the division of group contracts involving employees of merged banks to be tax-free. In reaching its conclusion, the service was guided not by IRC Section 1035, but rather by division of property rules, specifically Revenue Ruling 56-437.

Adney questioned the ruling of the U.S. 6th Circuit Court of Appeal in a case involving Dow Chemical. The court, he said, left unclear whether the "mortality neutrality" standard is relevant to COLI/BOLI contracts and whether experience ratings in large contracts nullify risk-shifting--a key requirement of all insurance policies under federal tax law.

Turning to the aggregation of modified endowment contracts and annuities, Adney observed that additional tax law should be forthcoming by the close of 2007.

"There will be a blockbuster set of rules from the federal government, probably by year-end," said Adney. "We'll see guidance on the treatment of annuity distributions after a partial exchange and exchanges of portions of contracts aggregated under IRC Section 72."


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