Abusive life insurance in retirement plans.

• Author: Laffie, Lesli S.
• Position: From The IRS

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...