damages could assign to a third party (a structured settlement company) the obligation to make the periodic payments. Under prior and present law, the portion of the amount received by the structured settlement company agreeing to a "qualified assignment" that is used to purchase qualified funding assets to fund the liability is not included in the company's income. The basis of a qualified funding asset is reduced by the amount excluded from gross income on account of the purchase of the asset. On disposition of a qualified funding asset, the gain recognized is treated as ordinary income. However, periodic payments made by the structured settlement company to the injured party are deductible. The net effect of the use of a structured settlement agreement is to permit a taxpayer liable for damages to an injured party to deduct the amount of the damages as if they are paid in a lump sum and to permit a structured settlement company to exclude from income the earnings on amounts used to fund its liability to make periodic payments to the injured party. Under prior law, a qualified assignment included all assignments requiring payments for personal injuries or sickness without regard to whether the payments involved physical injury or sickness. Reasons for Change The tax treatment of structured settlements has the overall effect of exempting from taxation investment income earned on assets used to fund the periodic payment of damages.3 Congress believed that this effect is inappropriate where the injury did not involve physical injury or physical sickness. In cases involving personal nonphysical injuries, Congress concluded that the investment income earned on assets used to fund the damage payment should be subject to taxation, whether or not the damages are paid by means of a structured settlement arrangement. Explanation of Provision The Act limits "qualified assignments" to those assignments requiring the payment of damages on account of a claim for personal injuries that involve physical injury or physical sickness of the claimant. Thus, the exclusion for structured settlements applies only to those qualifying structured settlement arrangements for payments of damages on account of a claim for personal injuries that involve physical injury or physical sickness of the claimant, including damages on account of a claim for wrongful death arising from physical injury or sickness, provided the arrangements meet all other applicable requirements. Claims which do not involve physical injury or physical sickness include, for example, defamation of a third party or invasion of privacy. Congress understood that multiple claims are alleged in many personal injury actions. Congress did not intend that allocation of 'By contrast, if a party liable for damage payments does not assign the liability in a structured settlement arrangement, then (1) income on amounts used to fund periodic payments of damages is subject to tax, and (2) investment income earned on lump-sum settlements is taxed to the recipient. damages is necessary among such multiple claims. Rather, if the action has its origin in a physical injury, then all damages that flow therefrom are treated as payments involving physical injury or physical sickness. Effective Date The provision is effective for assignments entered into after December 31, 1986, in taxable years beginning after December 31, 1986. 3. Life insurance policyholder loans (sec. 1003 of the Act and sec. 264 of the Code)4 Prior Law Under prior and present law, no deduction is allowed for any amount paid or accrued on indebtedness incurred or continued to purchase or carry certain life insurance, endowment or annuity contracts pursuant to a plan of purchase which contemplates the systematic direct or indirect borrowing of increases in the cash value of the contract, unless the requirements of certain exceptions to this disallowance rule are satisfied (sec. 264). The requirements of one of these exceptions (known as the four-out-of-seven rule) are that no part of four of the annual premiums due during the 7-year period (beginning with the date the first premium on the contract is paid) is paid by means of debt. If the requirements of the fourout-of-seven rule are satisfied, the deduction is not disallowed under section 264. In addition, no deduction is allowed for any amount paid or accrued on indebtedness incurred or continued to purchase or carry a single premium life insurance, endowment or annuity contract (sec. 264(a)(2)). Single premium contracts include contracts under which substantially all of the premiums are paid within 4 years from the date on which the contract is purchased, or contracts under which an amount is deposited with the insurer for payment of a substantial number of future premiums on the contract. Single premium contracts are not eligible for the four-out-of-seven rule. Interest deduction Reasons for Change Generally, when a policyholder borrows against a life insurance policy, the loan reduces the death benefit by the amount of the borrowing. Congress was concerned that, in the case of business-owned life insurance on the life of an employee, much of the death benefit promised to an employee is illusory if the employer borrows against the policy. The employee is merely depending upon the credit of his employer to the extent of the indebtedness. Congress was also concerned that, unlike most commercial loans, there is no set repayment period for these policy loans. The loan may remain outstanding until the employee's death many years in the future, For legislative background of the provision, see: Senate floor amendment, 132 Cong. Rec. S8051 (June 20, 1986), and H.Rep. 99-841, Vol. II (September 18, 1986), pp. 340-341 (Conference Report). and the employer may never have any obligation to repay the loan. Thus, in order to encourage businesses to provide effective death benefits to employees, the Act provides that the deduction for interest on business-owned life insurance is limited to interest on life insurance related to loans aggregating no more than $50,000 per officer, employee or person financially interested in a business of the taxpayer. This provision provides a cap on the deductibility of such interest, rather than phasing out deductibility. The provision was structured in this manner to allow small businesses to use loans on life insurance policies for their employees as a source of short-term capital when necessary. Congress did not intend to allow these loans to be an unlimited tax shelter as under prior law. Single premium policies It had also come to the attention of Congress that some practitioners may have been taking the position that some single premium life insurance contracts were eligible for the "four out of seven" exception to the disallowance rule, or that interest on borrowing with respect to a single premium contract was deductible under prior law. Further, the Congress was concerned that some practitioners may have been characterizing a universal life insurance policy as a contract that provides for annual premiums due for purposes of the four out of seven rule. Congress believed it was appropriate to restate and clarify the provision of prior and present law disallowing interest deductions with respect to borrowings incurred or continued in connection with single premium life, endowment or annuity contracts. Interest deduction Explanation of Provision In general, the provision limits the deductibility of interest paid or accrued on debt with respect to life insurance policies covering the life of an officer, employee or individual financially interested in any trade or business carried on by the taxpayer. The limitation applies to the extent the aggregate amount of such debt exceeds $50,000 per officer, employee or financially interested individual. In the case of a taxpayer carrying on more than one trade or business, the $50,000 amount per officer, employee or person who is financially interested in any trade or business of the taxpayer is determined on an aggregate basis for each such person in all trades or businesses of the taxpayer. For example, if an employee of a business of the taxpayer is also an officer in two other businesses of the taxpayer, the $50,000 of permitted borrowings by the taxpayer with respect to life insurance covering the person is determined by aggregating all policies covering his life subject to this provision and with respect to which the taxpayer has borrowed. In the case of a controlled group of corporations, it is intended that the controlled group is considered to be one taxpayer for this purpose, and all loans with respect to policies covering the life of an officer or employee or person financially interested in, a business of any member of the group are aggregated. Similar principles are intend ed to apply in the event of common ownership of unincorporated trades or businesses. Under the Act, the fact that the proceeds of a loan under a life insurance contract are used in a trade or business does not affect the deductibility of interest paid on the loan. Therefore, for example, if a sole proprietor borrows under a life insurance policy on the sole proprietor's life, the interest paid on the loan (to the extent the loan exceeds $50,000) is not deductible even though the proceeds of the loan are used in the sole proprietor's trade or business. Single premium contracts The Act restates the prior-law rule that no deduction is allowed for any amount paid or accrued on indebtedness incurred or continued to purchase or carry a single premium life insurance, endowment, or annuity contract (sec. 264(a)(2)). Single premium contracts include contracts where substantially all of the premiums are paid within four years from the date on which the contract is purchased, or contracts where an amount is deposited with the insurer for payment of a substantial number of future premiums on the contract. Generally, section 264(a)(2) also applies to contracts other than those under which the nonpayment of premiums would cause the policy to lapse, but no inference is intended that universal life insurance policies are always treated as single premium contracts. Effective Date The provision is effective for interest on loans under policies purchased after June 20, 1986, in taxable years ending after that date. Applications for a policy of this sort are often sent after consideration of competing bids, and an application is usually considered to be acceptance of the insurance company's bid; under this provision, therefore, policies are considered purchased for purposes of the ef fective date once the policy has been applied for. Factual determinations under this provision will be made by the Internal Revenue Service and the courts. A life insurance contract, other than one received in exchange for a life insurance contract issued by the same insurer, received after June 20, 1986, in exchange for an existing contract is considered to have been purchased after June 20, 1986. In the case of a policy purchased before June 21, 1986, minor administrative changes in the policy after June 20, 1986, such as changes in the address of the insurer, the officers of the insurer, or the address of the insured, do not cause the policy to be treated as purchased after June 20, 1986. 4. Deduction for nonbusiness casualty losses (sec. 1004 of the Act and sec. 165(h) of the Code)5 Prior Law Under prior and present law, for property not connected with a trade or business or a transaction entered into for profit, casualty 5 For legislative background of the provision, see: H.R. 3838, as reported by the House Committee on Ways and Means on December 7, 1985, sec. 1002; H.Rep. 99-426, p. 658; and H.Rep. 99841, Vol. II (September 18, 1986), pp. 342-343 (Conference Report). losses are deductible only if they arise from "fire, storm, shipwreck, or other casualty or theft." These personal casualty losses were deductible under prior law only to the extent that each casualty loss exceeded $100, and to the extent that all casualty losses for the year exceeded 10 percent of the taxpayer's adjusted gross income (sec. 165(h)). Certain courts have ruled that a taxpayer whose loss was covered by an insurance policy could nevertheless deduct the loss if the taxpayer decided not to file a claim under the terms of the insurance policy. See Hills v. Commissioner, 691 F.2d 997 (11th Cir. 1982); Miller v. Commissioner, 733 F.2d 399 (6th Cir. 1984). Reasons for Change The deduction for personal casualty losses should be allowed only when a loss is attributable to damage to property that is caused by one of the specified types of casualties. If the taxpayer has the right to receive insurance proceeds that would compensate for the loss, the loss suffered by the taxpayer is not damage to property caused by the casualty. Rather, the loss results from the taxpayer's personal decision to forego making a claim against the insurance company. Congress concluded that losses resulting from a personal decision of the taxpayer should not be deductible as a casualty loss. Explanation of Provision Under the Act, a taxpayer is not permitted to deduct a casualty loss for damages to property not used in a trade or business or in a transaction entered into for profit unless the taxpayer files a timely insurance claim with respect to damage to that property. This requirement applies only to the extent any insurance policy would provide reimbursement for the loss. If a policy would provide compensation for the loss, it is immaterial whether the taxpayer is the primary beneficiary of the policy so long as it is within the control of the taxpayer whether to file a claim. Effective Date The provision applies to losses sustained in taxable years beginning after December 31, 1986. Revenue Effect of Part A (Insurance Policyholders) These provisions are estimated to increase fiscal year budget receipts by $2 million in 1987, $5 million in 1988, $6 million in 1989, $7 million in 1990, and $8 million in 1991. |