Sales agents collected fat commissions by convincing seniors there was no risk. Household names in financial services were raising money to buy these policies, betting they would pay premiums for a few years and then collect on death. Among them were LaSalle Bank (now part of
Bank of America
(BAC - Get Report)
Credit Suisse Group
(CS - Get Report)
and funds managed by
(BRK.A - Get Report)
(GS - Get Report)
Death bet gone wrong:
Then came the credit crunch. Demand for the policies dropped as investors struggled to borrow. When the two-year premium period expired, the insured expected brokers to sell the policies, allowing them to collect their bonuses. But there was no money to complete deals.
Suddenly, seniors faced premiums on insurance they didn't need and couldn't afford. It wasn't unusual for a senior to take out a $5 million policy, citing estate tax purposes. The premium on that policy could be $200,000 a year.
Sure, they could stop paying premiums and drop the policies, but most had signed documents agreeing to repay at least 25% of the first two years of premiums, plus interest. At the end of two years, the senior would owe $100,000 plus interest, adding another $6,000 to the tab.
Forgiven loans taxed:
If the senior manages to pay off the guaranteed amount, plus interest, the lender will "forgive" the balance and additional interest. However, the policy holders will owe taxes on the forgiven debt.
If $300,000 plus $18,000 in interest was forgiven, a senior in the 35% tax bracket would owe an additional $100,000 in taxes on this phantom income.