Premium Financed Surprises: Cancellation of Indebtedness Income and Financed Life Insurance

Abstract

The last decade saw a tremendous expansion in the use of premium financed life insurance for high net worth individuals. Billions of dollars in premium finance loans were sold as low risk options for purchasing high-value life insurance. But the collapse of the secondary market for life insurance policies eliminated the primary exit strategy for insureds who purchased policies utilizing premium finance loans. When the option of selling the policies on the secondary market evaporated, most viewed the best course of action as surrendering the policies in satisfaction of the loan or allowing the policy to lapse.

But while handing back an underwater policy will eliminate all, or at least most, of the debt on the policy, this cancellation of debt (COD) has potentially dire income tax consequences that must be examined by insureds and their advisers. A taxpayer will usually realize income from COD when a premium finance loan is forgiven. But a number of factors may reduce or eliminate the insured's exposure: the identity of the taxpayer, the structure of the trust holding the policy, the structure of the loan, and the applicability of exceptions to the inclusion of COD income in gross income. Each of these factors must be analyzed to determine whether the insured should be prepared for a doomsday tax scenario or whether the insured will walk away from the deal relatively unscathed.

Keywords: life insurance, stranger-originated life insurance, STOLI, cancellation of debt, COD, income from discharge of indebtedness, insolvency exception, taxation

JEL Classification: K34