Understanding Stranger-Originated Life Insurance (STOLI) Schemes

What Is a Stranger‑Originated Life Insurance (STOLI) Policy?

A STOLI arrangement occurs when an individual, often a business or high‑net‑worth client, purchases a life insurance policy on a third party (the insured) and names a separate beneficiary. The purchaser typically receives the policy proceeds, while the insured's estate remains the legal owner of the policy. The purpose is usually to transfer wealth outside the insured's estate for tax or asset‑protection reasons.

Key Components of a STOLI Deal

• Insured: The person whose life is insured.
• Purchaser: The party buying the policy and often receiving the death benefit.
• Beneficiary: Usually the purchaser or a related entity.
• Policy Ownership: The insured's estate retains ownership, which can trigger gift and estate tax issues.

Legal Landscape and IRS Scrutiny

The Internal Revenue Service treats STOLI arrangements as potential tax shelters. The IRS applies the "gift" and "estate" tax rules to the transfer of policy ownership, meaning the insured's estate may owe taxes on the policy's value. In 2017, the IRS issued a Notice of Proposed Rulemaking (NPRM) to tighten enforcement, and in 2021 the Treasury finalized regulations that explicitly define and disallow STOLI structures for tax avoidance.

Risks for Insureds and Purchasers

For the insured, a STOLI can lead to:

• Unexpected estate taxes.
• Loss of control over policy proceeds.
• Potential loss of policy if the insured dies before the policy matures.

Purchasers face:

• Legal challenges from the IRS.
• Potential penalties and interest on unpaid taxes.
• Reputational damage if the arrangement is viewed as a tax avoidance scheme.

Alternatives to STOLI for Wealth Transfer

Instead of a STOLI, consider:

• Family Trusts with life insurance policies owned by the trust.
• Irrevocable life insurance trusts (ILITs) that separate ownership and control.
• Gifting strategies that comply with annual gift tax exclusions.

Conclusion

STOLI arrangements can offer short‑term financial flexibility but carry significant legal and tax risks. Consulting with estate and tax attorneys before engaging in such structures is essential to avoid unintended consequences.