Note: The following is an excerpt from the introduction to the article as published in The Tax Lawyer. Author citations have been omitted for brevity. Tax Section members may read the article in its entirety in Adobe Acrobat format.
Premium Financed Surprises: Cancellation of Indebtedness Income and Financed Life Insurance
Robert S. Bloink*
In today’s dismal credit markets, concerns regarding cancellation of indebtedness (COD) income are being raised as billions of dollars worth of life insurance premiums financed over the past five years are coming home to roost. This recent dramatic increase in premium financing was driven by a new economic paradigm that bears little resemblance to traditional premium financing planning scenarios.
. . . .
The last decade saw the development of new kinds of premium financing arrangements—nonrecourse and hybrid premium finance—that loosen or eliminate the collateral requirements of traditional premium finance. This new generation of premium finance was not typically used to purchase life insurance as part of an estate planning objective. Rather, nonrecourse loans were typically sold to individuals who intended to exit the premium financing arrangement by selling the life insurance policy on the secondary market after holding the policy for a two to three year period.
While insureds had the putative option of continuing coverage under the policy after that period, doing so would require the insured to pay off the premium finance loan, including interest and fees, and make the remaining premium payments. Because the insureds who participated in these programs often were not in the market for life insurance, the high cost associated with retaining the policy made it very unlikely that insureds would elect to maintain
Instead, insureds hoped to sell the policies on the secondary market, reaping enough on the sale to pay off the premium finance loan and take a profit or, at worst, break even on the transaction. This nonrecourse premium financing was often sold to seniors as “free life insurance,” with all fees and premium payments made by the premium finance company. If for any reason the insured decided to walk away from the policy, the insured could not be held liable by the lender for the loan balance. In contrast, subsequently developed hybrid premium financing programs required the insured and his family to provide a personal guarantee of part (often 25%) of the loan balance to the lender.
Part B examines the development of these variations on the traditional premium financing arrangement and the issues created by that development.
*Robert S. Bloink, Principal, HBC Ferguson, PLLC, et al.; Adjunct Professor of Law, Thomas Jefferson School of Law; University of Illinois, N.S.; Wayne State University Law School, J.D.; University of Florida Levin College of Law, LL.M.