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IRS Issues Guidance on Life Insurance Valuation
by Jefferson Pilot
The IRS has released guidance on the use of life insurance in Sec. 412(i) plans, and how it must be valued. According to the IRS and Treasury, this guidance was intended to “shut down abusive transactions involving specially designed life insurance policies in retirement plans”. Caught up in this web are similar programs such as pension rescue, Sec.79 permanent, and situations where an employer transfers a life insurance contract to an employee in connection with the performance of services.
Included in the February 13 release were a set of proposed regulations, two revenue rulings and one revenue procedure.
Proposed Regulations
The proposed regulations provide that any transfer of a life insurance contract from an employer or qualified plan to an employee must be taxed at its full fair market value. The regulations prohibit the use of springing cash value policies or any other structure by which the value of the contract is “understated” to be used to determine the fair market value for transfers occurring after February 13, 2004. According to the Service and Treasury press release, the regulations are aimed at situations under which the employer receives a tax deduction far in excess of the amount recognized by the employee into income.
The proposed regulations also provide that if a qualified plan transfers property to a plan participant or beneficiary for consideration that is less than the fair market value of the property, the transfer will be treated as a distribution by the plan to the participant or beneficiary to the extent the fair market value of the distributed property exceeds the amount received in exchange. Thus, any bargain element in the sale would be treated as a distribution.
These proposed regulations also amend the current regulations under section 79 and 83 to clarify that fair market value is also controlling with respect to life insurance contracts under those sections and, thus, that all of the rights under the contract (including any supplemental agreements thereto and whether or not guaranteed) must be considered in determining that fair market value.
With respect to section 79, these proposed regulations would amend Sec.1.79-1(d) to remove the term cash value from the formula for determining the cost of permanent benefits and substitute the term fair market value.
With respect to section 83, these proposed regulations would amend Sec.1-83-3(e) generally to apply the definition of property for new split dollar life insurance arrangements to all situations involving the transfer of life insurance contracts. While these regulations do not effect “grandfathered” split dollar arrangements, taxpayers are reminded that, in determining the fair market value of property transferred under Sec. 83, lapse restrictions (such as life insurance contract surrender charges) are ignored.
http://www.treas.gov/press/releases/reports/402reg.pdf
Revenue Procedure
Recognizing that taxpayers could have difficulty determining the fair market value of a life insurance contract after the comments in the proposed regulations, in connection with this guidance, the IRS has issued Rev. Proc. 2004-16 which provides interim rules under which the cash value (without reduction for surrender charges) of a life insurance contract distributed from a qualified plan may be treated as the fair market value of that contract.
The interim rules permit the use of values that should be readily available from insurance companies, because the cash value (without reduction for surrender charges) is an amount that, in the case of a flexible insurance contract (including a variable contract), is generally reported in policyholder annual statements (accumulated value), and in the case of traditional insurance contracts, is fixed at issue and provided for in the insurance contract.
Under those interim rules, a plan may treat the cash value (without reduction for surrender charges) as the fair market value of a contract at the time of distribution provided such cash value is at least as large as the aggregate of: (1) the premiums paid from the date of issue through the date of distribution, plus (2) any amounts credited (or otherwise made available) to the policyholder with respect to those premiums, including interest, dividends, and similar income items (whether under the contract or otherwise), minus (3) reasonable mortality charges and reasonable charges (other than mortality charges), but only if those charges are actually charged on or before the date of the distribution and are expected to be paid.
For variable contracts, a plan may treat the cash value (without reduction for surrender charges) as the fair market value of the contract at the time of distribution provided such cash value is at least as large as the aggregate of: (1) the premiums paid from the date of issue through the date of distribution, plus (2) all adjustments made with respect to those premiums during that period (whether under the contract or otherwise) that reflect investment return and the current market value of segregated asset accounts, minus (3) reasonable mortality charges and reasonable charges (other than mortality charges), but only if those charges are actually charged on or before the date of distribution and are expected to be paid.
A public hearing on the proposed regulations has been schedule for June 9, 2004 in Washington, DC.
http://www.irs.gov/pub/irs-drop/rp-04-16.pdf
Revenue Ruling 2004
Issue 1: Can a qualified pension plan be a plan described in Sec. 412(i) of the Code if the plan holds life insurance contracts and annuity contracts for the benefit of a participant that provide for benefits at normal retirement age in excess of the participant’s benefits at normal retirement age under the terms of the plan?
Issue 2: If a qualified pension plan holds life insurance contracts providing for life insurance on the participant’s life in excess of the participant’s death benefit under the terms of the plan, are contributions for premiums for such excess life insurance coverage currently deductible by the employer?
Holding:
A qualified pension plan cannot be a Sec. 412(i) plan if the plan holds life insurance contracts and annuity contracts for the benefit of a participant that provide for benefits at normal retirement age in excess of the participants benefits at normal retirement age under the terms of the plan.
Employer contributions under a qualified defined benefit plan that are used to purchase life insurance coverage for a participant in excess of the participant’s death benefit provided under the plan are not fully deductible when contributed, but are carried over to be treated as contributions in future years and deductible in future years when other contributions to the plan that are taken into account for the taxable year are less than the maximum amount deductible for the year pursuant to the limits of Sec. 404.
Listed Transactions
Transactions that are the same as, or substantially similar to, the transaction described in Situation 2 of this revenue ruling are identified as “listed transactions”, provided that the employer has deducted amounts used to pay premiums on a life insurance contract for a participant with a death benefit under the contract that that exceeds the participant’s death benefit under the plan by more than $100,000.
http://www.irs.gov/pub/irs-drop/rr-04-20.pdf
Revenue Ruling 2004-21
Issue:
Does a plan that is funded, in whole or in part, with life insurance contracts satisfy the requirements of Sec. 401(a)(4) of the Internal Revenue Code prohibiting discrimination in favor of highly compensated employees where: (1) highly compensated employees are permitted, prior to distribution of retirement benefits, to purchase life insurance contracts from the plan at cash surrender value; and (2) any rights under the plan for non – highly compensated employees to purchase life insurance contracts from the plan prior to distribution of retirement benefits are not of inherently equal or greater value than the purchase rights of highly compensated employees?
Holding:
A plan that is funded, in whole or in part, with life insurance contracts does not satisfy the requirements of Sec. 404(a)(4) prohibiting discrimination in favor of highly compensated employees where: (1) the plan permits highly compensated employees, prior to distribution of retirement benefits, to purchase those life insurance prior to distribution; and (2) any rights under the plan for non – highly compensated employees to purchase life insurance contracts from the plan prior to distribution of retirement benefits are not of inherently equal or greater value than the purchase rights of highly compensated employees.
http://www.irs.gov/pub/irs-drop/rr-04-21.pdf
Summary
We have included only the essential elements of these rulings in this document in the interest of an early release. Additional details may be found in the full texts of the items in question by clicking on the links at the end of each section of text. We will follow-up with further analysis as additional issues are identified.
[PRINTER FRIENDLY VERSION]
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