In preparation for the coming debate on tax reform, the industry is now marshaling arguments to defend the long-standing tax-favored treatment of its products. High among its talking points is this one: that life insurance does not belong on Congress' list of tax expenditures because the product does not meet the definition of one.
This position, which is to figure prominently in industry lobbying on tax reform this year – including visits to Capitol Hill this week by members of the Association for Advanced Life Underwriting – was revealed during a general session on Tuesday at the AALU's annual meeting. A highlight of the conference, the "AALU Washington Report" brought together members of the organization's Government Affairs team and affiliated attorneys to outline the legislative challenges ahead for the industry.
See also: The road to comprehensive tax reform
"If we can persuasively argue, as I believe we can, that the inside build-up of life insurance is not a tax expenditure, then we set ourselves apart from other exposed industries," said Kenneth Kies, managing director of the Federal Policy Group LLC and an outside counsel to the AALU. "Because present law relating to the tax treatment of insurance policies' inside build-up is consistent with generally applicable tax law, it's not a tax expenditure."
Marc Cadin, AALU's senior vice president of government affairs, agreed, adding: "Your message on Capitol Hill needs to be that life insurance and annuities are now taxed appropriately and deliver strong public policy benefits. This message is not merely self-serving; it also advances our common vision: that the promises you make to your clients today will still be good tomorrow."
The Congressional Budget Act of 1974 defined a tax expenditure as "a revenue loss attributable to provisions of the federal tax laws, which allow a special exclusion, exemption or deduction for gross income, or which provide a special credit for a preferential rate of tax." Kies said that life insurance falls outside the definition because not taxing permanent policies inside build-up – the cash value or savings component – is consistent with "generally applicable tax law" pertaining to investment income.
Translation: The IRS doesn't tax investment earnings until income is "recognized" or received as cash. This policy, Kies noted, makes sense, because without the investment income, taxpayers might have difficulty paying the tax. He added that, unlike other recognized tax expenditures, the Internal Revenue Code has no provision establishing an exception to the tax rules for life insurance.
Indeed, life insurance has never been classified as a tax expenditure meriting special treatment since Congress enacted the federal income tax in 1913. Nor has the inside build-up ever been taxed.
Over the decades, tax courts have also upheld the long-standing tax treatment of life insurance. Kies cited two cases, the first from 1961 and the second from 1963, in which the courts ruled that, because of substantial restrictions on policyholders' access to the inside build-up, constructive receipt does not apply under the IRC definition.
Yet life insurance remains in Congress' crosshairs: First eyed as a tax expenditure by Congress' Joint Committee on Taxation in 1972, the tax-favored treatment of life insurance would yield an estimated $157.6 billion in revenue for the U.S. Treasury if policyholders no longer enjoyed income tax-deferral of policy earnings. Given still large federal budget deficits, many tax reform proponents are tempted to secure the revenue windfall.
To ward off the threat, the AALU has been beefing up its political advocacy campaign – and not just during the annual meeting. Cadin said that during the 2012 election year, 700 AALU members supported more than 110 events with 86 members of Congress. Member contributions have made the AALU the nation's fourth largest organization in terms of campaign donations.
The political giving is complemented by wing-tipped shoes on the ground; Cadin said the AALU has appointed its members to serve as industry "ambassadors" to 65 percent of Congress' most influential lawmakers. And the organization is looking to boost that number to 100 percent.
The additional manpower may be needed. Kies said that Congress is making progress toward tax reform, in part because of a good working relationship between the two principals spearheading the effort: Sen. Max Baucus, D-Mont., who serves as chair of the Senate Finance Committee; and David Camp, R-Mich., who heads up the House Committee on Ways and Means.
Both men, noted Kies, are keen to add tax reform to their political legacies, in part because they're working against the same timetable: Baucus has announced that he will retire when his term ends in 2015; and Camp's chairmanship of the Ways and Means Committee is due to terminate at the same time.
The AALU has participated in tax reform working groups established by the committees. And the expectation is that a bill can be produced before the end of 2014. Though coinciding with the next mid-term elections, Kies observed that the last major tax reform bill – that of 1986 – also passed during an election year.
AALU Vice President of Legislative Affairs Chris Morton noted, however, that the committee chairs will have to reconcile the opposing positions of their respective parties. In the House, Camp is facing pressure from fellow Republicans to reform the federal tax code in a revenue-neutral manner. However, Senate Democrats want Baucus to produce additional revenue to help cut the federal government's red ink.
Baucus may have little room to maneuver, given his recent votes on legislation that have run counter to positions taken by his party's leadership.
"Baucus' relationship with the Democrats' leadership is frayed, given his recent votes on the budget, gun control and the proposed Internet sales tax," said Morton. "But factoring in also his pending retirement, he's insulated from political pressures to some degree."
Ricchetti Inc. Founder and President Jeff Ricchetti, an outside to counsel to the AALU, added that if and when a tax reform bill is produced, life insurance is likely to preserve its tax-favored status if the Senate and House committees stick to the current goals of realizing $500 billion in debt reduction and maintaining current tax rates on individuals and businesses.
"Half a trillion dollars in savings can be found without targeting life insurance products," he said. "It would get dicey for our industry, however, if Congress tries to finance a more dramatic, multitrillion dollar debt reduction and lower top marginal tax rates. It's very hard to see how this can happen without hitting more tax expenditures."