The growing chorus among the nation’s political elite for closing so-called “tax expenditures” or loopholes as part of a bipartisan tax-reform package have placed the tax-favored status of life insurance squarely within Congress’ cross-hairs. Not surprisingly, Congressional-watchers within our industry are sounding the alarm, warning of the threat that eliminating or restricting such preferential treatment would pose.
Impact on the industry
Clearly, if life insurance policyholders could no longer claim the tax benefits they now enjoy—income tax-free death benefits and tax-deferral of the cash value component of permanent life insurance policies—the products would be less attractive from a tax perspective. Lest you doubt this assertion, consider the negative impact of past changes to the tax code.
Time and again, IRC restrictions on one or another life insurance-funded advanced planning technique has forced advisors and their clients to consider alternative solutions for achieving financial goals. Example: IRS regulations finalized in 2003, which dampened enthusiasm for a once popular strategy, equity collateral assignment split-dollar plans, as a vehicle for funding non-qualified executive compensation.
Employer-funded premium payments into these executive comp plans are now treated as a series of “loans” to the employee. Assuming (as is usually the case) the loan is governed by below market loan rules, then the loan is characterized as one bearing interest, subject to the applicable federal rate (AFR). And this “foregone interest” is taxable.
Key employees thus now must pay a tax on a previously tax-free fringe benefit: their share (or equity) of a policy’s cash value. For this reason, sources say, the 2003 regs chilled businesses’ interest in loan regime plans used in executive comp planning.
The chilling effect would undoubtedly be all the greater if Congress were to water down or eliminate the tax-favored treatment of the inside build-up in employer-owned life insurance—a much discussed item in Congress’ target list of tax expenditures. And if all cash value policies—EOLI or otherwise—were no longer accorded tax-preferential status, then the chilling could lead to a deep freeze in permanent life insurance sales.
To be more precise, the drop off in sales would extend to a sector of a market most coveted by life insurance and financial service professionals: high net worth individuals and businesses owners who value the products as a tax play in investment planning, business planning and estate/wealth transfer planning. For the affluent, life insurance is simply one asset class among many—mutual funds, ETFs, emerging market stocks, commodities, real estate investment trusts, among others—to be considered when designing a portfolio. Take away the tax-preferential treatment on the inside build-up, and affluent investors might decide to reallocate the insurance component of the portfolio to other asset classes.
How changes to tax policies enter into the calculus of high net worth individuals when deciding whether to buy life insurance was explored in a June 2011 paper, “Who Responds to Tax Reforms? Evidence from the Life Insurance Market.” The report, based on an earlier German (SAVE) study, discussed the impact on the life insurance market of a 2005 income tax reform in Germany. For decades, the report notes, endowment life insurance—contracts payable to insured individuals if they are still living on a policy’s maturity date; or otherwise payable to the beneficiary—was a best seller in Germany. Between 1975 and 1990, the policies accounted for about 60% of newly written individual life insurance contracts.