Basis in a Life Insurance Policy

Life insurance contracts may be sold for many reasons, including among family members as circumstances change, between trusts when it is desired to move a policy out of an irrevocable trust to one that has more desirable terms (although oftentimes that is nontaxable if it is a sale between grantor trusts), or changes in business relationships and coverages.

Previously, the IRS had adopted the position that an owner’s basis in a life insurance policy was the total premiums paid, less the portion of premiums paid attributable to mortality, expense or other insurance coverage (except when the policy was not owned for purposes of insurance protection). This was based on its reading of Code §1016. Thus, persons selling an existing policy could not use a higher basis equal to gross premiums paid in calculating their gain or loss.

Many practitioners disagreed with this interpretation of the law. Happily, the 2017 tax act modified Code §1016(a) to specifically provide that the above basis reduction for mortality, expense, or other reason charges under the insurance contract does not occur. Further, the change was made retroactive to 2009.

There were still some Revenue Rulings in force that were contrary to the new law. So in Rev. Rul. 2020-05, the IRS revised Rev. Rul. 2009-13 and Rev. Rul. 2009-14 so that the examples included in them no longer have a basis reduction.

The old rulings were mooted by the new law, so this ruling is more in the nature of Treasury Dept. housekeeping. Nonetheless, it is a good reminder of the beneficial change enacted in 2017, and may educate some that missed picking up in the revision that occurred in 2017.

Rev. Rul. 2020-05

Proportionate Means Proportionate

If a taxpayer contributes a conservation easement in land to a qualified organization, to obtain an income tax deduction the contribution must be in perpetuity. However, the law recognizes that sometimes the easement must be unwound (for example, if the land is taken by the government under eminent domain). In that case, a portion of the value of the property must be given to the qualified organization for conservation purposes.

As to how much the qualified organization must receive, Treas. Regs. § 1.170A-14 (g)(6)(ii) says the property right given to the qualified organization at the time of the donation must have

“a fair market value that is at least equal to the proportionate value that the perpetual conservation restriction at the time of the gift bears to the value of the property as a whole at that time. * * * [T]hat proportionate value of the donee’s property rights shall remain constant. “

It goes on to provide 

“[T]he donee organization, on a subsequent sale, exchange, or involuntary conversion of the subject property, must be entitled to a portion of the proceeds at least equal to that proportionate value of the perpetual conservation restriction * * *”

In a recent Tax Court case, a contributor included this language in its instrument of conveyance:

In a recent Tax Court case, a contributor included this language in its instrument of conveyance: “(2) This Conservation Easement gives rise to a real property right and interest immediately vested in SERLC. For purposes of this conservation Easement, the fair market value of SERLC’s right and interest (which value shall remain constant) shall be equal to the difference between(a) the fair market value of the Conservation Area as if not burdened by this Conservation Easement and (b) the fair market value of the Conservation Area burdened by this Conservation easement, as such values are determined as of the date of this conservation Easement. If a change in conditions makes impossible or impractical any continued protection of the Conservation Area for conservation purposes, the restrictions contained herein may only be extinguished by judicial proceeding. Upon such proceeding, SERLC, upon a subsequent sale, exchange or involuntary conversion of the Conservation Area, shall be entitled to a portion of the proceeds at least equal to the fair market value of the Conservation easement as provided above. SERLC shall use its share of the proceeds in manner consistent with the conservation purposes set forth in the Recitals herein.(3) Whenever all or part of the Conservation Area is taken in exercise of eminent domain by public, corporate, or other authority so as to abrogate the restrictions imposed by this Conservation Easement, Owner and SERLC shall join in appropriate actions at the time of such taking to recover the full value of the taking and all incidental or direct damages resulting from the taking, which proceeds shall be divided in accordance with the proportionate value of SERLC’s and Owner’s interests as specified above. All expenses, including attorneys’ fees, incurred by Owner and SERLC in such action shall be paid out of the recovered proceeds to the extent not paid by the condemning authority. (emphasis added)

The instrument of conveyance does include some language and concepts required by the Regulation. Do you think it met the proportionality requirement of the Regulation? The Tax Court did not, and denied a $16 million deduction.

The Court interpreted the taxpayer’s instrument to require the computation of a fair market value of the easement at the time of contribution, and to require the donee to receive no less than that value at the termination of the easement. It also interpreted the Regulation as instead requiring that a proportion be determined at the time of the contribution with the numerator being the value of the easement and the denominator being the value of land as of the date of contribution – the donee must then receive on termination an amount equal to the current value on termination multiplied by that fraction – that is, a variable amount based on the original fraction/proportion. So if the value of the land went up over time, so would the amount that must pass to the donee on termination. Since the taxpayer’s instrument was not a variable amount based on value at the time of termination, no deduction was allowed.

The Regulation does talk about the “proportionate value” remaining constant. However, it appears in context of the language that this only means that the ratio must remain constant, not the result of the math computation that computes the minimum amount due to the donee.

Qualifying for charitable deductions for property contributions is a minefield, both as to substantive requirements such as these for easements, and more general appraisal requirements and reporting requirements. When material amounts are at issue, all efforts need to be made to comply with the statutory and regulatory requirements.

Query whether the original value of the easement sets a floor on what the donee must receive – that is, will the proportion formula be applied to reduce that amount if the value of the property declines since the contribution date? I haven’t researched the issue as to case law, rulings or other regulatory provisions, but the above regulatory language does not appear to me to rule out such a possible reduction.

Railroad Holdings, LLC v. Comm., T.C. Memo 2020-22 (February 5, 2020)

New “No Rule” Areas

Every year the IRS publishes a list of areas where the IRS will not issue a private letter ruling. Items on the list can provide a warning to taxpayers that the IRS may not agree with the conclusion that would be sought in the ‘no rule’ area.

For 2020, the IRS added to the ‘no rule’ list or the ‘will not ordinarily be issued’ list:

1. Whether any portion of the items of income, deduction, and credit against tax of the trust will be included in computing under § 671 the taxable income, deductions and credits of grantors when distributions of income or corpus are made – (A) at the direction of a committee, with or without the participation of the grantor, and (1) a majority or unanimous agreement of the committee over trust distributions is not required, (2) the committee consists of fewer than two persons other than a grantor and a grantor's spouse; or (3) all of the committee members are not beneficiaries (or guardians of beneficiaries) to whom all or a portion of the income and principal can be distributed at the direction of the committee or (B) at the direction of, or with the consent of, an adverse party or parties, whether named or unnamed under the trust document (unless distributions are at the direction of a committee that is not described in paragraph (A) of this section).

2, Whether a trust which is not exempt from tax under § 501(a) is described in § 4947(a)(2) where a grantor, trustee, executor, administrator, donor, or beneficiary has represented that the trust has no amounts in trust for which a deduction was allowed under § 170, 545(b)(2), 556(b)(2), 642(c), 2055, 2106(a)(2), or 2522, because no grantor, trust, estate, donor, or beneficiary has taken or plans to take any such deduction.

3. Whether a split-interest trust is described in § 4947(a)(2) because it has no amounts in trust for which a deduction was allowed under § 170, 545(b)(2), 642(c), 2055, 2106(a)(2), or 2522.

Rev.Proc. 2020-3