The Obama Administration’s 2012 federal budget proposal has revived two budget proposals that will touch the life insurance business – one affecting Corporate-Owned Life Insurance (COLI) and the other affecting carriers’ Dividends-Received Deduction (DRD).
In response to alarm that the proposals tamper with the tax preferred status of life insurance, the Treasury recently issued a letter clarifying that these proposals center around tax arbitrage issues, not the tax treatment of death benefits.
Corporate-Owned Life Insurance Proposal
If passed, the COLI proposal would repeal the pro rata interest expense disallowance rule, which enables business taxpayers to deduct certain interest expenses related to corporate-owned policies.
COLIis life insurance that a corporation takes out on its employees’ lives. COLI policies were originally designed to reduce the risk of unexpected death of important corporate employees, so-called ‘key man’ insurance. COLI cushions corporations from some of the costs of re-recruiting and retraining replacements for employees who serve integral employment roles.
Congress has already implemented rules applying to corporations that are perceived to abuse the COLI option, usually by taking out insurance on an overbroad range of employees – sometimes without the employees’ knowledge. The new changes would further restrict COLI by allowing deductions for premium payments only if the employee, officer, or director has a 20% minimum interest in the corporation – helping ensure the COLI option is not abused.
Dividends-Received Deduction Proposal
If passed, the DRD proposal would change the way DRDs are currently calculated by imposing limitations similar to other corporate tax-related dividend payments. Life insurance companies are currently allowed to claim DRDs, but are subject to industry specific rules. To be eligible for the DRD, a portion of the company’s dividend income must be used to fund policyholders’ tax-deductible reserves.
“Life insurance companies get a tax deduction for their increase in reserves,” explains an IRS memorandum. “Correct determination of the amount of dividends subject to the DRD ensures that a life insurance company does not realize an excess benefit by deducting part of investment earnings credited to policyholders that have already been deducted through increases in reserves.”