Bank-owned life insurance—Time to rethink conventional wisdom?
INSIGHT ARTICLE |
Many banks have chosen to invest in bank-owned life insurance (BOLI) to fund a variety of obligations to their current and retired employees. BOLI’s status as a preferred funding vehicle is largely attributable to the inherent investment characteristics of cash value life insurance as well as to its often inter-related income tax and financial statement advantages.
The many advantages of BOLI notwithstanding, its purchase involves a rigorous due care process whereby the bank demonstrates to its regulators that it recognized and addressed the range of risks associated with owning such a long-term, potentially illiquid investment. One element of that risk analysis is the tax implications of owning BOLI, a topic that can have more bearing on other, seemingly unrelated risks than first meets the eye. That’s why any bank, whether buying BOLI for the first time or adding to its existing portfolio, should understand that the very tax characteristics of BOLI that can make it today’s solution can just as easily make it tomorrow’s problem.
Taxation of cash value life insurance and its subset, corporate or bank-owned life insurance, is an expansive topic, replete with its own acronyms and jargon. That said, there are actually just a few fundamentals that a bank needs to know to make informed decisions about whether to buy BOLI and, if so, how to design, fund and deploy it.
The Key Tax Fundamentals
The bank is the owner and beneficiary of the policy on the insured employee. The premiums paid by the bank, which is typically just one premium, are not deductible because the bank is the beneficiary of the policy that insures the life of an employee.1(section 264(a)(1)). Assuming the BOLI policy qualifies as life insurance under section 7702, something the carrier should represent, the build-up of the cash value is deferred for regular tax purposes as long as it stays in the policy. If the policy is surrendered, the excess of cash surrender value over premiums paid is ordinary income (not capital gain). So long as the bank complies with section 101(j), discussed below, the death benefit from the policy is received income tax free. The opportunity for long-term tax deferral on the “inside build-up” of the cash value and a tax-free death benefit are among BOLI’s strongest selling points versus competing and often lower yielding, taxable investment or funding vehicles.
Banks learn early on that a number of factors effectively limit the amount of money a given bank can invest in BOLI. Some of those limitations, found in the bank’s regulatory framework, speak in terms of the percentage of a bank’s capital that can be allocated to BOLI. State insurable interest laws can also come into play by perhaps by defining the level of employee that the bank can insure, the amount of insurance that the bank can place on a given employee, or both.
The tax law, of course, imposes its own limitations at time of purchase. Many banks (and other corporate purchasers) are familiar by now with section 101(j), which provides that, in the case of an employer-owned life insurance contract issued after Aug. 17, 2006, death benefit in excess of premiums paid will be taxable (ordinary) income to the bank. Fortunately, there are exemptions to this rule, meaning that the death benefits will be tax-free provided the bank meets two sets of requirements before the policy is issued. The first requirement involves notice to and consent from an employee; the second involves the status of the employee who the bank proposes to insure, that status generally limited to highly compensated employees. Notice 2009-48 provides helpful guidance concerning the treatment of these contracts in a question and answer format.
Another post-purchase focal point of the BOLI tax discussion is the section 1035 exchange. Generally, a policyholder can exchange one life insurance contract for another without recognizing gain or loss, so long as the owner and insured(s) are the same after the exchange. What’s more, a contract issued on or before Aug. 17, 2006 can be exchanged for a new policy without application of section101(j). Again, Notice 2009-48 provides helpful guidance here. The section 1035 exchange is often touted as way for a bank to remediate an unhappy situation with a BOLI carrier or product. In practice, that may not be quite true.
Section 264(f) denies a bank a deduction for interest on debt allocable to unborrowed cash values of policies issued after June 8, 1997. However, there is no pro-rata loss of interest deduction under section 264(f) as long as the policies are issued on active officers, directors and employees. While generally not an issue on an initial purchase, section 264(f) can come into play if the bank chooses to exchange its BOLI product for a new product and tries to cover the same insureds, some of whom are no longer active officers, directors or employees. Rev. Rul. 2009-11 provides that the new policies would have to be tested for compliance with section 264(f), which, of course, they could not pass with respect to retired or terminated insureds.
To MEC or not to MEC, that is the question
To a certain extent, part of the conventional wisdom about BOLI is that (1) a bank will want to “reposition” lower yielding taxable investments into the BOLI as quickly as possible and (2) BOLI is a true “buy and hold” asset that will provide liquidity upon the death of the insured employee and not before. That brings us to the topic of modified endowment contract (MEC) vs. non-MEC. First, some background.
A MEC is not a kind of policy; it is a creature of tax statute. The MEC rules came about in 1988 and were intended to preclude the use of “single premium life insurance” as a tax-advantaged investment by minimizing the amount of death benefit relative to the premium paid so as to generate maximum growth of cash value. Both the MEC and the non-MEC allow the same tax-deferred inside build-up and tax-free death benefit. However, if the policy is a non-MEC, proceeds of policy loans are not taxable income and partial withdrawals of cash value are tax-free to the extent of the policy owner’s basis; i.e.; the premiums it has paid. On the other hand, loans and withdrawals from MECs are taxed to the extent of income in the contract, meaning any excess of cash value over premiums paid. In addition, there is a 10 percent tax on the amount of income borrowed or withdrawn from a MEC if the taxpayer is below age 59 ½ . The 10 percent tax is also imposed upon the gain on full surrender of the policy. The age 59 ½ refers to the taxpayer or policy owner, not the insured. A bank is always considered to be “younger” than 59 ½ , so the 10 percent penalty will always apply.
The downside of the MEC story would not be complete without mentioning the MEC aggregation rule of section 72(e)(11)(A)(i). Simply put, all MECs purchased in the same year from the same carrier are considered to be one policy. This rule won’t come into play if all policies are held until the insureds pass away. But if the bank decides to surrender a portion of its BOLI portfolio, perhaps to generate cash, then the MEC aggregation rule could very well cause the bank to more taxable gain (and penalty tax) then it had initially reckoned with.
The flexibility of the non-MEC from a tax perspective is not without some cost. The non-MEC has to carry an initial death benefit that is considerably higher at a given premium than the MEC, which only has to qualify as life insurance under section 7702. This incremental death benefit can be a drag on the policy’s performance, especially in those critical early years of the policy when the impact of the policy on the bank’s earnings can be most clearly felt. To be sure, there are ways to mitigate the impact of the incremental death benefit of the non-MEC. For example, the bank can select a death benefit that is high enough for the policy to qualify as life insurance under section 7702 and just high enough to avoid MEC status. Also, the bank can spread its premiums over perhaps three years so as to have a lower death benefit than would be required with a single payment on a non-MEC. Finally, it can reduce the death benefit after the seventh year. But, harkening back to the conventional wisdom, a bank that is interested in truly maximizing the tax and financial statement benefits of BOLI and has no intention of ever tapping the policy for cash will find the MEC almost irresistible. Indeed, that conventional wisdom is a cornerstone of BOLI policy design, i.e., most BOLI policies on the market are available only as single premium MECs.
But banks can also consider more traditional COLI products, designed for utmost efficiency, high early cash value, and enough initial death benefit to accept additional premiums within guidelines imposed by the carrier and the tax law, respectively. While the non-MEC COLI policies may not offer the very early benefits of their MEC BOLI brethren, on a comprehensive, risk-adjusted basis, they may be a better choice for the long run.
For example, consider the bank that purchased a MEC some years ago, still likes BOLI as an investment but is quite disenchanted with (or concerned about) the BOLI carrier. What are the bank’s options? Surrender and redeployment into a new policy with a new carrier is certainly not attractive because it would trigger ordinary income and the 10 percent penalty. The bank can’t take cash out of the policy and perhaps out of harm’s way without triggering income and the penalty tax. What about a section 1035 exchange? As noted, even if the new policy would be grandfathered for purposes of section 101(j), it would not be grandfathered for purposes of section 264(f). In any event, the new insurer is not going to issue policies on individuals who no longer work for the bank. A non-MEC would not offer any relief on the section 264 issue. It would, however, allow the bank to take out a considerable amount of cash without tax or penalty, thereby at least moving some of its asset to higher ground away from a worrisome carrier.
Next, consider the bank that, contrary to its initial assumptions, actually needs to tap the BOLI policies for cash. The MEC effectively keeps those policies off limits for that purpose. The non-MEC gives tremendous flexibility to access cash value on a tax-favored basis.
On the other (more positive) hand, assume that the bank likes BOLI, likes the carrier and the product. In fact, the bank would like to increase its investment in the policy. That’s not possible with a single premium product (let alone a MEC). If the bank wants to increase its investment, then it has to buy new policies (and deal with the increased administrative burden associated with more policies and more insureds). Had the bank purchased a more traditional COLI policy designed as described above, then it could just increase its investment in the same product, again to the extent permitted by the carrier and tax law.
The bottom line is that if, at the end of the day, a bank chooses to buy a MEC, then it had better be sure that the carrier issuing the product will stand the test of time and continue to treat its policyholders well. Those policies could be in force for 40 year or more, which is a long time to hold an asset that’s basically frozen in place by its tax characteristics.
BOLI’s economic, accounting and tax advantages have long been recognized by the banking community, and many banks continue to add to their already considerable holdings. That said, the financial crisis has altered the terrain on which much of the conventional thinking about BOLI product selection and design was founded. So, in addition to asking the “what”, new buyers of BOLI should be sure to ask the “what if’s” and be equally sure to see alternative proposals that might address the latter set of questions more satisfactorily. Maybe, just maybe, some buyers will decide to attend a different convention.