Policymakers should take steps to curb the tax benefits of cash value life insurance, which has morphed into a tax avoidance tool for wealthy taxpayers, scholars say.
In a draft paper released August 23, Ari Glogower of Northwestern University Pritzker School of Law and Andrew Granato of Yale Law School and Yale School of Management say that while the “purpose of life insurance was once to provide financial protection to ‘widows and orphans’ upon an untimely death,” it is now mostly used by investors to avoid paying taxes.
The market for cash value life insurance has shifted over the past 30 years “from the middle class to the very rich,” and “the policies that are being issued are now larger in size and more concentrated among the wealthiest 1 percent of households,” the authors wrote. “As a result of these trends, the tax preferences for cash value life insurance increasingly operate as a tax avoidance strategy for the rich, and thereby undermine the progressivity of the tax system.”
The report comes amid an investigation by the Senate Finance Committee’s Democratic staff into private placement life insurance (PPLI) — a specialized type of cash value life insurance that is available only to investors with a certain net worth — and after the committee released a report that estimates at least $40 billion is being held in domestic policies issued by seven of the largest PPLI carriers.
Glogower told Tax Notes that “for decades, there’s been this opportunity to use the life insurance form as a tax preferred savings vehicle, and what we’re seeing now is a lot of policies that are explicitly marketed to provide the minimal . . . amount of real insurance protection required under current law, and instead to explicitly be marketed on the basis of their tax benefits.”
The draft paper notes that proceeds from life insurance contracts have benefited from favorable tax treatment “since the beginning of the modern federal income tax.”
“Policyholders and beneficiaries are not taxed on the ‘death benefit’ nor on the ‘inside buildup’ of the cash value reserve’s investment returns and tax-advantaged withdrawals from the policy or loans against the policy,” according to the paper. Trusts can also be used to set up arrangements that avoid estate and gift taxes.
Senate Finance Committee Chair Ron Wyden, D-Ore., and President Biden have released proposals to curb the use of PPLI, which Glogower and Granato said “offer promising directions to rein in abusive strategies that take undue advantage of the tax preferences for life insurance, and that deliver their biggest benefits to the richest taxpayers.”
Menu of Options
Glogower and Granato argue that policymakers should take steps to curb the tax benefits of cash value life insurance. They provide a menu of options for reform.
The paper suggests taxing the inside buildup within cash value life insurance policies. In the early 1980s President Reagan introduced a proposal to tax inside buildup that would have required policyholders to “include in their interest income each year the excess of any increases in the cash value reserve balance over any investments in the contract made during the taxable year,” the report says.
Granato acknowledged that this could be a difficult political lift and said another option for reform would be to cap the level of inside buildup that can go untaxed.
Ultimately, the report says, “capping the life insurance tax exclusion for all policies could comprehensively address the various abuses of the tax preferences for life insurance as well as their distributional consequences.”
Glogower and Granato explain that such a cap could be designed “in a manner that would be administrable and difficult for taxpayers to avoid.”
The report also suggests reforms that could be implemented by the IRS and the courts, including more aggressive enforcement of the investor control rules for life insurance, which the Finance Committee says are extremely difficult for the IRS to enforce because of a lack of reporting requirements.
Changing the structure of current rules “could rein in certain egregious abuses while preserving the basic tax advantages of life insurance under current law,” the authors wrote.
Granato said more meaningful information requirements are also important to the enforcement side of addressing these issues.
“When information is reported, especially through third-party information reporting and even through first-party information reporting by taxpayers themselves, compliance rates increase dramatically,” Glogower said.
‘Slippery Slope’
According to Josh O. Ungerman of Meadows, Collier, Reed, Cousins, Crouch & Ungerman LLP, adjusting the rules for PPLI “prospectively, when wealthy taxpayers are following the advice of skilled tax practitioners, starts down a slippery slope of increasing tax rates on the highest earners while not increasing the tax rates themselves.”
“Taxpayers should be allowed to rely on the existing PPLI rules without any retroactive adjustments. Many families engaged in significant planning based on the rules as they stand today,” said Ungerman, who advises clients on IRS exposure in their estate plans.
Jack Dolan, a spokesperson for the American Council of Life Insurers, said the council hasn’t had the opportunity to review the new study but that the “life insurance industry remains steadfast in ensuring the financial security of American families.”
“Life insurance is a fundamental component to this goal, and the industry remains committed to ensuring the availability and access to it,” Dolan said.