PHOENIX — If Congress goes ahead with extending a fiduciary standard of care to all broker-dealers, that could lead to huge changes in the everyday lives of financial professionals who act as trustees.
Two speakers — Thomas Commito and Lawrence Brody — talked about that possibility here during the kick-off general session at the Society of Financial Service Professionals’ FSP Forum.
The broker-dealer fiduciary standard provision is part of the Investor Protection Act of 2009 bill.
Commito and Brody addressed the implications of the fiduciary standard in connection with a 2009 court case involving Key Bank, Cleveland.
The case centered on the financial institution’s role as trustee of an individual retirement account that owned a variable life policy on the insured, a 53-year-old man. Because of a steep decline in equity values, the policy collapsed and the bank hired two consultants to explore alternatives.
Their recommendation was to do a 1035 exchange of the VUL policy for a fixed universal life contract carrying a reduced death benefit ($3 million versus $8 million for the VUL policy). The trust’s beneficiaries–all family members of the insured–sued the bank, arguing that the bank did not fulfill its fiduciary duty because of the $5 million reduction in death benefits.
Key Bank “barely” won the case, for the speakers noted, the presiding judge ruled the bank could have done more (though he did not specify what) to fulfill its fiduciary obligations.
“This could be a brave new world,” said Commito, a director of sales concepts at Lincoln Financial Distributors, Hartford. “If we’re all held to be fiduciaries, then when proposing a 1035 exchange, we as advisors will have to do a lot more than most of us currently are in terms of deconstructing policies.”
Brody agreed, adding that advisors held to a fiduciary standard would likely also have to be more forthcoming in disclosing commissions and potential conflicts of interest. And, echoing Commito, he cautioned attendees to think hard before agreeing to become a trustee.
“If you’re a trustee, this is an instructive case,” said Brody, a partner at Bryan Cave L.L.P., St. Louis. “Do you really want to be a trustee of a client’s insurance trust? Unless you’re overseeing a whole life policy that has no moving parts, it may be wise not to take on this responsibility–or to resign if you already have.”
The speakers questioned, however, whether holding agents to a fiduciary duty would withstand legal scrutiny. They noted, as the Association for Advanced Life Underwriting, Falls Church, Va., recently argued in testimony before the House Financial Services Committee, that the standard could impose a conflict of interest.
“You can’t serve two masters,” said Brody. “If you’re an agent, then you’re a fiduciary of the insurer. If you’re also a fiduciary of the client, how can you serve both interests without having a conflict?”
Two Internal Revenue Service revenue rulings–2009-13 and 2009-14–also featured prominently during the Forum’s kick-off general session.
Revenue Ruling 2009-13 addresses the tax consequences of the surrender or sale of a policy to a person who lacks an insurable interest in the contract. The panelists talked about how 2009-13 applies to the surrender of a life insurance policy for its cash surrender value; the sale of a cash value policy to a life settlement company; and the sale of a term life policy to a life settlement company.
The ruling has proved “contentious,” the panelists said, because of the lack of guidance on how to calculate the cost of insurance when determining the amount of ordinary or capital gain resulting from one of the three transactions. When the transaction involves a sale to a life settlement company, for example, the COI is used to determine a policy’s “adjusted basis,” which in turn is subtracted from the policy’s sale price (or amount realized) to arrive at the gain. In this case, the gain is part ordinary income and part capital gain.
“With variable universal life, factoring out the cost of insurance is fairly easy,” said Commito. “But with other forms of insurance, particularly whole life, I have no idea how to calculate the cost.”
Added Brody: “If the cost of insurance is not easily ascertained, then do you ask the carrier what the cost of insurance has been over the last 40 years of the policy? Can you use Table 2002-08 to calculate COI? The ruling doesn’t tell us.”
A policy’s cost of insurance also factors into Revenue Ruling 2009-14, a ruling that addresses the tax implications involving a policy transferee. But in discussing the rule, the speakers directed much of their attention to a loophole that could be used to circumvent the IRS transfer-for-value rule. When invoked, the rule requires that life insurance death benefits be included in one’s gross income, thus making the death proceeds taxable.
The speakers discussed the 2009-14 tax treatment of a policy’s death benefit in the event that a life settlement company receives the proceeds upon the death of the insured by the settlement company; a life settlement company resells the policy while the insured is still alive; or a sale of the policy is effected by a foreign corporation.
Under the first scenario, said Commito, all gain resulting from a transfer for value would be taxed as ordinary income, except for the sum of premiums paid (or basis).
Under second scenario, any gain resulting from the resale of a term policy would be deemed a capital gain, because the policy is a capital asset in the hands of the life settlement company, and because the gain is realized on a sale or exchange. (In the case of a permanent policy, part of the resale, Brody noted, may be treated as ordinary income.)
When there is a sale carried out by a foreign corporation, the death proceeds are subject to U.S. income tax.
But Commito noted that, with some creative planning, clients could easily circumvent the transfer-for-value rule and, thus, avoid gain-related tax consequences.
“It is relatively easy to structure a transaction where there is no transfer for value,” he said. “Many life settlements programs use limited liability companies, where the LLC falls under a partnership exception [to the transfer for value rule].”
“Under President [Obama's] current tax proposals, no exception to the transfer for value would apply,” he added. “But it doesn’t appear Congress will take up tax legislation this year, given its other priorities.