NewsNotes

Lesli S. Laffie, J.D., LL.M.

Abusive Life Insurance in Retirement
Plans Business Purpose Requirement

From the IRS

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 employers establishment of a plan and deduction of plan contributions used to purchase specially designed life insurance contracts for highly compensated employees (HCEs). The contracts 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 distributees income, not just the contracts CSV.

If a qualified plan transfers property to a plan participant or beneficiary for consideration less than the propertys 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 employees 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 participants 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 partys death benefit under the plan are 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 participants 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 be treated as that contracts 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 contracts 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.

Business Purpose Requirement

In Rev. Rul. 2004-23, the IRS concluded that a distribution expected to cause the aggregate value of a distributing and a controlled corporations stock to exceed the predistribution value of the distributing corporations stock met the Sec. 355 and Regs. Sec. 1.355-2(b) business purpose requirement when the increased value is expected to serve a corporate business purpose of either the distributing corporation or the controlled corporation (or both), even if it benefits the formers shareholders.

Under one situation in the ruling, because a corporation, which indirectly conducts two businesses through its subsidiaries, believes that the increased value of its stock expected to result from the separation will enhance the value of its employee compensation, providing a real and substantial benefit to the corporation, the distribution is motivated by a non-Federal tax purpose germane to the corporations business. Further, because the purpose cannot be achieved through another nontaxable transaction that is neither impractical nor unduly expensive, the distribution is carried out for a corporate business purpose. Although the increase in stock value is expected to benefit the shareholders by increasing the amount they would realize on a stock sale, this shareholder purpose is so nearly coextensive with the corporate business purpose as to preclude distinction; thus, the distribution is treated as carried out for a corporate business purpose.

In the second situation, as part of its overall strategic planning, the corporation has expanded both businesses through acquisitions of other corporations assets and stock. In some of the acquisitions, the corporation has used stock in whole or in part as consideration. The corporations directors expect to continue expanding one business as they identify appropriate acquisition opportunities. The corporation expects to offer its common stock as consideration in connection with future acquisitions. Thus, the corporation undertakes the separation of the businesses with the expectation that its stock value will increase to permit it to effect such acquisitions in a way that preserves capital with significantly less dilution of the existing shareholders interests, providing the corporation with a real and substantial benefit