Merger and acquisitions: Tax treatments of bank-owned life insurance

Are you contemplating a merger or acquisition? If so, there are numerous items that you should consider as you structure, negotiate and consummate the transaction. 

Many of these items are complicated and require assistance from a professional advisor. To add to that complexity, the Tax Cuts and Jobs Act (TCJA) made significant changes to the tax treatment of life insurance policies that are transferred for value. These changes potentially impact mergers and acquisitions when a target bank owns life insurance policies. 

Background

The general rule for bank-owned life insurance (BOLI) is that proceeds received by reason of death are tax free; however, if the BOLI policy is transferred for value (i.e., the purchase of an existing policy, rather than a newly issued policy), the death benefit is no longer tax free, unless an exception applies to the transfer. 

Prior to the TCJA, several exceptions existed that caused most mergers and acquisitions to be exempt from the transfer for value rule. Thus, BOLI policies that were held by another bank that were acquired through a merger or acquisition generally maintained their tax-free treatment. All of that changed though with the passage of TCJA.

Changes from TCJA and impact on BOLI

The TCJA introduced numerous tax law changes — most of them favorable and several that were not. One of the unfavorable provisions relates to the acquisition of life insurance contracts. Under this new provision, the previously mentioned exceptions no longer apply if the acquisition of a life insurance policy constitutes a reportable policy sale (i.e., an acquisition of an interest in a life insurance policy where the acquirer has no substantial family, business, or financial relationship with the insured other than the acquirer’s interest in the contract).

If a life insurance policy was acquired through a reportable policy sale, future death benefits are no longer tax free. An exception to the reportable policy sale rule occurs when the BOLI policy covers a person who has a substantial family, business, or financial relationship with the insured. Unfortunately, the TCJA did not do a very good job of defining what that means.

The impact of these changes was to cause BOLI policies that were acquired through a merger or acquisition to potentially lose their tax-free treatment. Assuming that was true, banks that acquired another entity with BOLI were required to record a deferred tax liability at the closing date (assuming a C corporation) equal to the future taxable income related to the taxable death benefit from the BOLI policy. 

New guidance from the Treasury

There was significant uncertainty and controversy surrounding this topic. Many individuals believed that congress never intended this tax law change to apply to mergers and acquisitions. To help with that uncertainty, the Treasury published proposed regulations in March of 2019 and final regulations in October of 2019. 

Under the final regulations, some corporate acquisition scenarios are now exempt from this tax law change. Specifically, the final regulations preserve the tax-free treatment of BOLI policies acquired from another C corporation if two criteria are satisfied:

• First, the transfer results in the acquisition of a beneficial ownership interest in the C-corporation stock.
• Second, at the time of acquisition, not more than 50% of the fair market value of the acquired C corporation’s assets is comprised of BOLI.

These two criteria apply to many taxable acquisitions of C-corporation banks, thus preserving the tax-free treatment of BOLI policies; however, it does not apply to the acquisition of S-corporations banks. It also does not apply to certain tax-free mergers structured as asset deals. 

Thankfully, the final regulations also clarify what is meant by a “substantial family, business, or financial relationship with the insured.” The final regulations indicate that a substantial family, business, or financial relationship with the insured includes a policy on the life of an individual who was an officer, director, or highly compensated employee of the target immediately preceding the acquisition. Furthermore, this phrase includes a policy on the life of an individual who was an officer, director, or highly compensated employee of the target, if immediately after the acquisition, the acquirer has an ongoing financial obligation to the insured individual related to his or her employment with the target. An example of when this occurs is a BOLI policy held by a bank to fund various retirement obligations of the bank.

Now that the Treasury has clarified what is meant by a substantial family, business, or financial relationship with the insured, most BOLI policies acquired in the context of a banking merger or acquisition will likely meet these requirements and thus retain their tax-exempt status. That even holds true for S-corporation acquisitions or certain tax-free mergers, assuming the substantial family, business, or financial relationship test is satisfied. Acquirers of banks with BOLI policies should generally be pleased with these final regulations.

Any bank considering a merger or acquisition should consult with its professional advisors to determine the applicability of these final regulations to the bank’s specific fact pattern. Wipfli can help with that analysis.