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Abusive life insurance in retirement plans.

The IRS and Treasury have released extensive guidance aimed at shutting down abusive transactions that involve specially designed life insurance policies in Sec. 412(i) retirement plans. These tax-qualified plans are funded entirely by life insurance contracts or annuities. The guidelines designate certain arrangements as "listed transactions" for tax shelter reporting purposes.

The arrangements involve an employer's establishment of a plan and deduction of plan contributions used to purchase specially designed life insurance contracts for highly compensated employees (HCEs). The contract's cash surrender value (CSV) is temporarily depressed to an amount significantly less than the premiums paid. The contract is distributed or sold to the employee for the depressed CSV; however, it is structured so that the CSV increases significantly following the transfer. Use of the springing cash value life insurance enables employers to claim deductions for amounts far in excess of those the employees recognize in income.

Prop. regs.: New proposed regulations (NPRM REG-126967-03) provide that any life insurance contract transferred from an employer or a tax-qualified plan to an employee is taxable at fair market value (FMV). Under the proposals, that requirement is controlling in situations in which the existing regulations provide for the inclusion of the entire CSV. Thus, when a qualified plan distributes a life insurance contract, retirement income contract, endowment contract or other contract providing life insurance protection, the FMV of such a contract would generally be included in the distributee's income, not just the contract's CSV.

If a qualified plan transfers property to a plan participant or beneficiary for consideration less than the property's FMV, the transfer would be treated as a plan distribution to the recipient to the extent that the FMV exceeds the amount received in exchange. Consequently, any bargain element in the sale would be a distribution under Sec. 402(a) and deemed a distribution for other Code purposes, including the limits on in-service distributions from certain qualified retirement plans and the Sec. 415 limits.

The proposed regulations also amend the rules implementing Secs. 79 and 83, to clarify that FMV is also controlling as to life insurance contracts under those provisions. Accordingly, all contract rights would have to be considered in determining FMV. Unless specifically excepted from the definition of permanent benefits or FMV, the value of all features of a life insurance policy providing an economic benefit to a service provider would have to be included in determining the employee's income.

Rev. Rul. 2004-20: The IRS has ruled that a qualified pension plan will not satisfy the requirements for a Sec. 412(i) plan if it holds life insurance 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 plan terms. Further, employer contributions under a qualified defined benefit plan that are used to purchase life insurance coverage for a participant in excess of that party's death benefit under the plan arm not fully deductible when contributed; instead, they are carried over as contributions in future years and deductible in future years when other plan contributions taken into account for the tax year are less than the maximum amount deductible for the year under the Sec. 404 limits.

Such transactions have been identified as listed transactions effective Feb. 13, 2004, if the employer deducted premiums paid on a contract for a participant with a death benefit that exceeds the participant's plan death benefit by more than $100,000. Rev. Rul. 2004-20 modifies and supersedes Rev. Rul. 55-748.

Rev. Rul. 2004-21: The IRS has made it clear that a Sec. 412(i) plan cannot use differences in life insurance contracts to discriminate in favor of HCEs. A plan funded, in whole or part, with life insurance contracts will not satisfy the Sec. 401 (a)(4) nondiscrimination rules if:

1. The plan permits HCEs to purchase those life insurance contracts at CSV before the distribution of retirement benefits.

2. Any rights under the plan for non-HCEs to purchase life insurance contracts from the plan prior to distribution of retirement benefits are not of inherently equal or greater value than the HCEs' purchase rights.

Rev. Proc. 2004-16: In conjunction with the proposed regulations, Rev. Proc. 2004-16 provides a temporary safe harbor for determining FMV. Under these interim rules, the CSV of a life insurance contract distributed from a qualified plan may he treated as that contract's FMV. Effective Feb. 13, 2004, the rules permit the use of values that should be readily available from insurance companies, because the cash value is an amount that, in the case of a flexible insurance contract, is generally reported in policyholder annual statements and, in the case of traditional insurance contracts, is fixed at issue and provided in the insurance contract.

A plan may treat the CSV as the contract's FMV at the time of distribution if it is at least as large as the aggregate of (1) the premiums paid from the issue date through the distribution date, plus (2) any amounts credited to the policyholder as to those premiums, minus (3) reasonable mortality charges and reasonable charges, but only if actually charged on or before the distribution date and are expected to be paid. When the contract is a variable contract, a plan may treat the CSV as its FMV at the time of distribution, if the CSV is at least as large as the aggregate of (1) the premiums paid from the issue date through the distribution date, plus (2) all adjustments made as to those premiums during the period that reflect investment return and the current market value of segregated asset accounts, minus (3) reasonable mortality charges and reasonable charges, but only if actually charged on or before the distribution date and are expected to be paid.
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Title Annotation:From The IRS
Author:Laffie, Lesli S.
Publication:The Tax Adviser
Date:Apr 1, 2004
Previous Article:Partnership retirement payments satisfy SE tax exemption.
Next Article:Business purpose requirement.

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