- Through transactions sometimes known as “pension rescue” or “IRA rescue,” taxpayers long attempted to shield their qualified plan assets from income and estate taxation by using plan assets to purchase a life insurance policy and later having the insured’s irrevocable trust purchase the policy at a discounted value.
- IRS guidance on policy valuation, issued in 2004, effectively voided the version of the technique then in use.
- Subsequently, unrelated to pension rescue, the life insurance industry developed a new life insurance variation that appeared to revive the technique.
- It is often assumed that the cash surrender value of a life insurance policy equals its fair market value when selling or distributing the policy from a qualified plan; this may be an erroneous assumption, leading to disastrous results when the transaction is audited.
“Pension rescue”1 is a sales concept used to help sell life insurance to certain participants in profit sharing plans. In general, it purports to be a way of getting a very large life insurance policy out of a qualified retirement plan for a significantly discounted price.
The common fact pattern for a pension rescue sale involves a client who is the owner of a closely held business, who has built up a sizable balance in his or her profit sharing plan, who now has other retirement resources but is facing a large estate tax liability, and who wants to find a way to get the money out of the plan at a significantly discounted value. As described in more detail below, the discount is achieved by purchasing a special kind of life insurance policy. The transfer for that significantly discounted value “rescues” the discount in value from taxation—thus the name. The problem with pension rescue is that it is based on a valuation of the life insurance policy that may not hold up to IRS scrutiny.
The following case study is hypothetical and does not portray a particular person or situation. All references to premiums, cash values, interpolated terminal reserves, and other values are not based on a particular life insurance policy. They are provided only to illustrate the pension rescue concept.
Henry had been a successful real estate sales representative for many years. When he was 55, he was approached by a life insurance producer who explained the pension rescue concept. At the time, Henry had $3 million in his profit sharing plan. Pension rescue sounded like a wonderful idea. Henry used $2 million from his profit sharing plan to purchase a special kind of life insurance contract that had a disappearing cash value. The policy had a death benefit of $4 million.
Ten years after the policy was issued, when Henry was 65, the cash surrender value had dropped to $700,000. Believing that the cash surrender value was the policy’s fair market value (FMV), Henry had his profit sharing plan sell the policy to his irrevocable life insurance trust (ILIT) for $700,000. Henry was thrilled. He had to use $700,000 of his lifetime gifting exclusion to fund the ILIT for the sale,2 but he avoided having to pay income tax on the $1.3 million discount from the premium to the cash surrender value and had removed the entire $4 million death benefit from his estate. But as this article will show, that may not have been the correct outcome.
The Popularity of Pension Rescue
There has been a resurgence in the popularity of pension rescue.3 Three developments have contributed to it:
- The Department of Labor amended Prohibited Transaction Exemption 92-6 (PTE 92-6) to allow a plan that owns a life insurance policy on a participant’s life to sell the policy to the participant’s trust.4
- Producers and clients believe that the cash surrender value of a life insurance policy is approximately equal to its interpolated terminal reserve (ITR, explained later), and that the ITR is the policy’s FMV.
- The insurance industry introduced no-lapse guarantee universal life insurance (NLG UL). As alluded to in Henry’s example, the characteristic of those policies critical to the pension rescue concept is that the cash value decreases and eventually disappears altogether.
This article examines the interrelationship of several areas associated with pension rescue and NLG UL insurance:
- A basic description of NLG UL insurance;
- The mechanics of pension rescue or IRA rescue;
- The determination of the FMV of a life insurance policy;
- The role of the life insurance company in determining a policy’s FMV; and
- The situation in which the pension rescue concept might leave the client.
In the process, this article examines the fundamental weakness in the pension rescue concept.
No-Lapse Guarantee Universal Life Insurance
Stock market declines since the beginning of this century have made variable life insurance unattractive to many investors. In addition, low interest rates have decreased the appeal of traditional universal life insurance. Real estate values are down. Having been battered by those unfavorable conditions, many life insurance buyers have developed an appetite for death benefit guarantees. The life insurance industry responded with NLG UL insurance.
The primary guarantees in a traditional universal life policy are the guaranteed minimum interest crediting rate and the guaranteed maximum mortality costs and administrative costs. In NLG UL, the life insurance company makes a secondary guarantee to the policy owner: If the policy owner pays the premiums as designed in the policy illustration, the insurance company will pay the death benefit even if the crediting rate drops below the guaranteed rate and even if the cash value disappears. In fact, in an NLG UL policy the cash value does disappear; it is taken up by the additional policy reserves NLG UL requires. In the end, the insured gets what is wanted—death benefit coverage until policy maturity.5 NLG UL is essentially pure death benefit coverage for life.6 It is stripped down, bare-bones death benefit coverage. Cash-value accumulation is not a factor. It is very attractive to people who need the coverage and who have been battered by the declining economy. As stated above, for pension and IRA rescue, the critical trait of NLG UL is its disappearing cash value.
The pension rescue concept may work with other products, but it works best with a single premium paid into an NLG UL policy, which is the only product that combines a guaranteed limited payment stream, a guaranteed death benefit—subject to the claims-paying ability of the insurer—and the all-important decreasing cash value. A qualified plan could use a regular universal life policy and not pay the premiums, which would create the desired decreasing cash value. However, that would put the policy in jeopardy of lapsing. Therefore, after the sale to the ILIT at the discounted price, the insured would have to gift money into the ILIT to revive the policy. In the context of using qualified plan money, the insured would be forced to fund the gift with a taxable distribution from the qualified plan, defeating the purpose of the pension rescue concept.
Basic Mechanics of Pension or IRA Rescue
As previously mentioned, in the pension rescue strategy, the client has a qualified profit sharing plan with a large balance in his or her account. The balance qualifies as seasoned money,7 so all of it is available to buy life insurance. Alternately, in IRA rescue, the client rolls the IRA into a profit sharing plan that accepts rollovers from an IRA. In either case, the client is the sole participant. The client has developed other sources of retirement income and now does not need the money in the qualified plan. The client has a potential estate tax liability and wants to provide the liquidity to pay it. The client wants to make better use of the qualified plan funds because he or she faces potential taxes of 75% or more in state and federal income tax on income in respect of a decedent and state and federal estate tax on the value of the account at the client’s death. Using the seasoned-money exception, the plan purchases an NLG UL contract on the client’s life.8 Typically, it will be a large, single-premium policy that will consume the bulk of the client’s account balance.
Time passes. The cash surrender value of the policy decreases. The client creates an ILIT that qualifies as a grantor trust.9 The qualified plan sells the policy to the ILIT for the cash surrender value.10 Since the ILIT is a grantor trust, the sale to the ILIT qualifies as a transfer to the grantor, qualifying for the transfer-for-value exception under Sec. 101(a)(2)(B).11 The client has removed the potential life insurance death benefit from his estate at a significantly discounted value. The sale of the policy for its cash surrender value exposes the issue and the potential problem dealt with in this article; the policy has to be sold for its FMV, but that value may exceed the cash surrender value.
Life insurance policies are difficult to value. In Henry’s case, what might the FMV of the policy be 10 years after issue? Of course, Henry thinks it is the $700,000 cash surrender value.
Does the life settlement market offer any guidance? In the 1980s, the advent of AIDS and the associated need for viatical settlements gave impetus to the life settlement market. Certainly, the amount paid by a life settlement brokerage firm would be the policy’s FMV. The Internal Revenue Code, however, does not yet refer to an FMV established by the life settlement market, and there is no case law on it to date. Further, even in that market there is uncertainty. Because each valuation is tied to the insured’s health, different medical underwriters will disagree on an insured’s life expectancy and, consequently, on the price to be paid for the policy.
Another possibility might be the discounted present value of the policy benefit. With a $4 million policy benefit, Henry’s remaining life expectancy of 15 years, and a 4% discount rate, the discounted present value of the policy benefit would be approximately $2.2 million. That is a perfectly logical method that is codified in another context in Secs. 1271–75. Unfortunately, however, there is nothing authoritative on that valuation method, either.
Another possibility is replacement cost. In Henry’s case, the replacement cost of the policy would be the single premium needed to replace it at the insured’s current age. Given the extra reserving requirements of NLG UL, 10 years after issue, the single premium might be $3.5 million or more.
All of those values are substantially greater than Henry’s choice, the $700,000 cash surrender value.
There is some guidance from the IRS. If a policy is being distributed or otherwise transferred from a qualified plan, Rev. Proc. 2005-2512 gives a safe-harbor valuation as the greater of:
- The policy’s ITR (defined below) plus unearned premiums,13 plus estimated dividends,14 or
- The PERC amount (premiums plus earnings, minus reasonable costs), adjusted for an average surrender value factor.15
For estate tax purposes, Sec. 2031(a) says the gross estate includes all the decedent’s property at its value at the date of death. Regs. Sec. 20.2031-1(b) specifies this value as its FMV. Regs. Sec. 20.2031-8 specifically covers valuation of life insurance contracts. Paraphrased, it defines FMV as:
- The cost of comparable contracts (Regs. Sec. 20.2031-8(a)(1)), or
- ITR plus unearned premium for policies that have been in force some time and on which future premiums will be due. However, if because of the contract’s “unusual nature” that “approximation” is not reasonable, then the ITR-plus-unearned-premium method may not be used (Regs. Sec. 20.2031-8(a)(2)).
For gift tax purposes, Sec. 2512 refers simply to “value.” Regs. Sec. 25.2512-6(a) specifically covers valuation of life insurance contracts. Paraphrased, it:
- Looks to the premium for a similar contract, again, to determine FMV, and
- Suggests that ITR plus unearned premium might determine FMV for policies that have been in force some time and on which future premiums are due, with the same caveat regarding a contract with an unusual nature.
Example (1) in the regulation suggests that in the year of issue the FMV is the premium paid for that year. Example (3) in the regulation suggests that for a policy on which no further premiums are to be paid, the FMV could be a single-premium replacement policy.16
Obviously, there is significant flexibility in determining the FMV, but, if nothing else, ITR17 plus unearned premiums is a recurring theme in IRS guidance. Therefore, ITR is often seen as a strong indicator of FMV.
What Is the Interpolated Terminal Reserve?
To define ITR, one must first define “terminal reserve” and “interpolated.”
The terminal reserve is the money the insurance company is putting aside—reserving—to pay the death claim. Under normal circumstances the terminal reserve grows each year until at policy maturity it equals the death benefit.
Where does “interpolated” fit in? In the context of whole life insurance with its guaranteed values, the terminal reserve is set annually on the policy anniversary date and is predictable, based on guaranteed premiums and guaranteed cash value. If the policy is transferred on any date other than the anniversary date, the prior year’s terminal reserve has to be adjusted—interpolated—to allow for the growth in the reserve between the past anniversary date and the date of transfer. That remains true for whole life insurance. For universal life insurance—and with the advent of computers—the terminal reserve can be determined each month.
Why do so many think that the ITR is roughly equivalent to cash surrender value and, therefore, roughly equivalent to FMV? People believe ITR is roughly equivalent to cash surrender value because it was, and often still is, true. When whole life insurance was the most common permanent life policy (before universal life was introduced), the whole life policy was designed so the growth of the cash value and terminal reserve were roughly parallel and very close in amount, both equaling the death benefit at policy maturity.18
The assumption that ITR equals FMV is based on IRS guidance that says ITR does equal FMV. That guidance is primarily in the estate and gift tax regulations and was buttressed by Rev. Proc. 2005-25.
Logically, if A = B and B = C, then A = C. Therefore, if cash surrender value equals ITR, and ITR equals FMV, then cash surrender value equals FMV. Roughly speaking, that is still true for whole life policies. It is not true, however, for NLG UL policies. In an NLG UL contract, the cash value does not mirror ITR. In an NLG UL contract the cash surrender value shrinks and disappears, while the ITR grows. In addition to that divergence, there are different ways to calculate the ITR, different terminology for it, and differing views on what constitutes FMV.
For ITR there is:
- Statutory reserve (for state reporting) with deficiency reserve;
- Statutory reserve without deficiency reserve;
- Tax reserve (for federal tax reporting, similar to the statutory reserve but using slightly different interest rate assumptions—it is usually smaller than the statutory reserve);
- Actuarial Guideline (AG) 3819 statutory reserve with deficiency reserve;
- AG 38 statutory reserve without deficiency reserve;
- AG 38 tax reserve with deficiency reserve; and
- AG 38 tax reserve without deficiency reserve.
And, since there is still the old rule of thumb about the ITR and cash value, these values are still considered:
- Cash surrender value;
- In a universal life contract, policy value, accumulated value, or cash value (depending on the insurer’s terminology) are the internal policy values before the surrender charge is subtracted; and
- In a whole life policy, the net cash value (for whole life contracts where there is no separately stated surrender charge).
And finally there is:
- The California method, which is the average of the policy value before and after the surrender charge.
Clearly, there are many different values by which one might determine the FMV of a permanent life insurance policy.
To return to the beginning, the critical issue is determining the FMV of the life insurance policy at the date of sale to the ILIT.
The Insurer’s Reaction
As part of the sales process, and in an effort to get an idea of what the insurer will report in the future, the producer will often ask the insurer’s representative how the insurer will respond two or more years after policy issue when the client asks for a determination of the FMV of the NLG UL policy. This puts the insurer in a difficult position, for several reasons.
First, if the insurer responds in line with Treasury guidance, it will answer with the ITR, which will probably be a relatively large number, larger than cash surrender value. Responding with a large number may mean the insurer will be dropped from the case because the producer wants a low number. In addition, doing a prospective ITR calculation involves making several assumptions that certainly will not be exactly matched with the passage of time. In other words, the insurer is uncomfortable because whatever it calculates as a prospective ITR will probably be wrong. Further, the insurer may not want to spend the time and resources to do the calculation. Finally, the insurer is reluctant to give any FMV because it will have taken a position that might have future legal ramifications.
Beyond those considerations, many insurers feel it is the responsibility of the client and the client’s tax counsel to determine the policy’s FMV. Therefore, when asked for estimated FMVs or ITRs, those insurers refuse to provide them, stating that when asked in the future, they will provide several values, advising the client to consult tax counsel for the determination. In doing so, the insurer accomplishes three goals: It avoids potential legal implications of taking a position, its product will remain a competitor in the sale, and it has provided the client with flexibility in its determination of the policy’s FMV. The producer likes that response, too, because it avoids the possibility of getting the big number of the estimated ITR.
Where Does That Leave the Client?
Henry was convinced that cash surrender value was FMV—after all, that is what it was worth to him. The insurance producer had been careful to explain that there was a lot of “gray” in determining FMV and that Henry might have to hire an appraiser to document the valuation as of the date of sale to the ILIT.
When it came time to sell the policy, Henry checked around. He did not get any support for his position, either from a potential appraiser or his tax preparer, so for that year Henry became a “do-it-yourselfer,” doing his own returns.
About a year after those returns were filed, Henry was contacted by an IRS agent, notifying him of an audit of his tax return for the year of the sale. While looking at the returns of related entities, the revenue agent came across the sale of the life insurance policy. The agent did some research and asked Henry to ask the insurance company for the amount of the ITR as of the date of sale. The insurance company said that, as of the date of sale, the ITR was $3.2 million. The agent proposed an adjustment, taxing Henry with a $2.5 million distribution from his profit sharing plan ($3,200,000 – $700,000 = $2,500,000), with a related $2.5 million gift to Henry’s ILIT. During the year of the transaction, the lifetime gifting exclusion had been $1 million, of which Henry had already consumed $700,000 to fund the ILIT, so not only did Henry have a sizable income tax deficiency, he had an additional sizable gift tax deficiency. The agent also added an accuracy-related penalty under Sec. 6662.
There might have been other unpleasant consequences, too. Had Henry’s tax preparer prepared the returns as Harry wished, the agent might have proposed the “unreasonable positions” penalty in Sec. 6694 against the preparer. Had the appraiser appraised the policy at $700,000, as Henry wanted, the accuracy-related penalty in Sec. 6695A might have been assessed against the appraiser. The agent might have proposed the “aiding and abetting understatement penalty” in Sec. 6701—and possibly even the “promoting abusive tax shelter” penalty in Sec. 6700—against the life insurance producer. Finally, had Henry died within three years of the date of sale, because it turned out that the policy had failed the “adequate and full consideration” test in Sec. 2035(d), the policy would have been included in his estate.
After receiving the revenue agent’s report proposing the adjustments and penalty, Henry went back to his tax preparer. The preparer thought the IRS might forgive the accuracy-related penalty but was not encouraging. Since it had resulted in the cheapest tax, Henry had wanted to believe in the $700,000 FMV, but his desire blinded him to common sense.
So where does that leave all the other Henrys out there, the ones who think pension rescue is a good idea? The answer may well be “out in the cold.” Because of potential penalties, tax preparers and appraisers may well shy away from participating in pension rescue arrangements, both at inception or when the policy is sold to the ILIT. Litigation is always a possibility, and the taxpayer might win. However, if one is not willing to litigate—and quite possibly lose—shying away from pension rescue as described herein is the prudent course of action. Remember, if it sounds too good to be true, it probably is.
Federal income tax laws are complex and subject to change. The information in this article is based on current interpretations of the law and is not guaranteed. Neither Nationwide, its employees, its agents, brokers, or registered representatives give legal or tax advice. Clients should consult an attorney or competent tax professional for answers to specific tax questions as they apply to the clients’ situations.
1 Pension rescue” is a misnomer. It will not work with a pension plan; it requires a 401(k) or a traditional profit sharing plan. Actually, there are two sales concepts, pension rescue and a variant, IRA rescue. This article refers to both as pension rescue unless otherwise indicated.
2 For the sake of simplicity, the annual gift tax exclusion is ignored.
3 Pension rescue has been around a long time. Before the introduction of no-lapse guarantee universal life (explained later), the technique of choice was “springing cash value.” Relying on the rule of thumb that cash surrender value equaled FMV, some cash-value policies were designed to have extremely large surrender charges. The policy would be distributed or sold using cash surrender value as FMV, and then a year or two later the surrender charge would amortize off, and the cash value would spring to life. Rev. Proc. 2004-16, 2004-10 I.R.B. 559, was issued in part to deal with that concept. It said that cash value, without reduction for surrender charges, could be treated as FMV.
4 Amendment to Prohibited Transaction Exemption 92–6, 67 Fed. Reg. 56313 (Sept. 3, 2002).
5 One of the attractive features of NLG UL is that the client can determine the premium duration; it can be as long or as short as the client wants. So long as the premiums are paid on time or within the catch-up provisions of the policy, the insurance company guarantees to pay the death benefit at the insured’s death, a feature that adds flexibility to the secondary guarantee.
6 Some call it “term for life.”
7 For profit sharing plans, the incidental death benefit rule does not apply to contributions that have accumulated for at least two years or where a participant has participated in the plan for at least five years—this is “seasoned money” (Rev. Rul. 60-83, 1960-1 C.B. 157; Rev. Rul. 66-143, 1966-1 C.B. 79; Rev. Rul. 68-24, 1968-1 C.B. 150). Assets rolled over from another plan or a “conduit” IRA may count as seasoned money (Rev. Rul. 94-76, 1994-2 C.B. 46; May and Fitzpatrick, “Life Insurance Planning With Qualified Plans and IRAs,” 29 Estates, Gifts and Trusts Journal (May 2004)).
8 As discussed above, life insurance products other than NLG UL do not deliver the required discount to make the pension rescue work.
9 Proposed legislation would remove the tax advantages of grantor trusts.
10 The client could have taken the policy as a distribution from the plan, then given it to the ILIT. That would have triggered income tax on the distribution, and the gift to the ILIT would have been subject to the three-year lookback under Sec. 2035(b). The advantage of the sale “for an adequate and full consideration in money or money’s worth” is that it avoids the three-year lookback by qualifying under Sec. 2035(d).
11 Rev. Rul. 2007-13, 2007-1 C.B. 684.
12 Rev. Proc. 2005-25, 2005-1 C.B. 962. Some tend to read the second bullet point and ignore the first.
13 Premiums are due at the beginning of the policy year. If a policy with a $1,000 premium is transferred halfway through the year, $500 would be added to the value.
14 For whole life they would be based on current dividend scales; for universal life they would be the earnings credited to the policy through the date of transfer.
15 The PERC amount is automatically reported on a universal life illustration. It is called the policy value, accumulated value, or cash value; essentially, it is the value before the surrender charge is subtracted and typically is reported in the column to the immediate left of the cash surrender value. For whole life insurance policies, where the surrender charge is not separately stated, the policy owner must contact the insurance carrier for the PERC amount.
16 Presumably, based on the insured’s current medical underwriting.
17 Using the ITR as the FMV makes sense to a life insurance company; that is the amount of money the insurer has invested in the risk.
18 Cash surrender value is a universal life term. On a whole life policy there was no separately stated surrender charge. On a universal life illustration there is a “policy value” or “accumulated value” and a “cash surrender value,” but on a whole life policy there is only the “net cash value.”
19 National Ass’n of Ins. Comm’rs, Actuarial Guideline XXXVIII, The Application of the Valuation of Life Insurance Policies Model Regulation (AG 38).
David Smucker is a director in the Advanced Consulting Group of Nationwide Insurance in Columbus, Ohio. For more information about this article, contact Mr. Smucker at email@example.com.