Biden Hopes to Tax 'Frozen Cash Value' Life Contracts

The administration of President Joe Biden hopes to impose federal income, estate and gift taxes on the “frozen cash value” inside some wealthy families’ life insurance arrangements.

The U.S. Treasury Department described the new proposal Thursday in its “Greenbook,” or description, of the tax provisions in the administration’s 2024 budget proposal.

The proposal could increase taxes on the assets in arrangements that qualify as life insurance policies outside the United States but count only as “failed contracts” under the Internal Revenue Code section 7702(g) definition of life insurance.

If adopted and implemented as described in the Greenbook, the proposal could have a retroactive effect on the net investment value of policies that “failed” IRC 7702 life insurance policy tests after the effective date.

What It Means

Any clients who have frozen cash value life insurance policies need to talk to their tax advisors and other legal and financial advisors.

Frozen Cash Value Life Arrangements

Designers of frozen cash value life insurance arrangements, or “restricted cash value life insurance policies,” base the arrangements on IRS rules for handling contracts that meet the definition of “life insurance” in a non-U.S. jurisdiction but fail to qualify as life insurance policies in the United States.

In the eyes of the IRS, the failed contract has no “net surrender value” because it’s not a life insurance policy.

The arrangement designer sets up a flexible-premium variable universal life insurance policy that’s issued by a company in a jurisdiction such as Bermuda.

Advocates of the strategy have said that U.S. clients can accumulate income and capital gains free of U.S. federal assets inside a failed contract, and then get cash out, free of U.S. federal taxes, using policy loans and policy surrenders.

Frozen cash value arrangements came up when the U.S. Justice Department was investigating offshore private placement life insurance policies arranged by affiliates of Swiss Life Holding. The Justice Department investigation led to a deferred prosecution agreement in April 2021.

Federal investigators found that the frozen cash value life policies were designed to comply with U.S. tax rules but sometimes were used by U.S. clients who were trying to hide assets from the IRS.

The New Proposal

The Treasury Department has proposed that the government close any frozen cash value life policy asset taxation gaps by making three changes:

1. The government would eliminate terminology problems by replacing the term “net surrender value” with the term “net investment value” in the rules for failed contracts.
2. The government would apply the rules for “modified endowment contracts” — arrangements that pass some IRS tests for life insurance policy status, but not others — to the cash coming out of frozen cash value policies.
3. If a frozen cash value life policy paid a death benefit bigger than the policy’s net investment value, the IRS would treat the difference as a death benefit payment when calculating tax bills.

These changes would mean that all future earnings credited to a frozen cash value contract “owned by U.S. persons would be included in the U.S. policyholder’s ‘income on the contract’ for the taxable year,” according to the Greenbook.

Treasury officials also addressed briefly what would happen to contracts that became failed contracts after the change took effect.

If a policy failed after the effective date for the changes, “any prior amounts of untaxed investment value would become taxable,” officials note. “Therefore, any distributions and policy loans from such contracts would come from amounts attributed to investment in the contract and would not be taxable.”

Other Greenbook Provisions

The Greenbook also includes some life insurance and annuity provisions that appeared in the 2023 Greenbook.

The returning proposals could change the rules governing:

• The duration of the generation-skipping tax, which helps reduce the taxes when taxpayers who die pass assets on to members of younger generations.
• The tax rules for business-owned life insurance policies covering employees, officers and directors.
• How insurers handle policy acquisition costs, or distribution costs, for products other than annuities.

The Process

The Biden administration unveiled its budget proposal for federal fiscal year 2024 on Thursday.

The federal fiscal year starts Oct. 1.

Because the administration will have to work with a Republican-controlled House and a Senate with only a narrow Democratic majority to keep the government running, observers are assuming that the budget proposal has little chance of getting through Congress.

But some budget and tax proposals become law after showing up in Greenbooks and congressional bills for years, and even the possibility that the Internal Revenue Service could change how it handles frozen cash value life insurance policies could affect wealthy clients’ tax planning strategies.

One challenge for financial professionals and clients is the general nature of the description of the frozen cash value life proposal and other proposals in the Greenbook.

House Ways and Means Committee Chairman Jason Smith, R-Mo., today expressed frustration about the general nature of the Greenbook provision summaries during a hearing on the budget proposal.

“The American people deserve to know exactly how the Biden administration plans to raise their taxes,” Smith told the only hearing witness, Treasury Secretary Janet Yellen.

Smith asked Yellen to provide the legislative language for the Greenbook proposals within 30 days.

“I don’t believe that has ever been done,” Yellen said.

She said Treasury Department staffers would work with the House Ways and Means members and staffers on any specific provisions and provide feedback on any proposed legislative language.

Pictured: Treasury Secretary Janet Yellen holds up the “Greenbook,” or detailed description of Biden administration tax proposals, for the federal fiscal year that starts Oct. 1, at a House Ways and Means Committee hearing held March 10. (Photo: House Ways and Means Committee)