The IRS is putting a halt to abusive 412(i) plans as announced in this press release: “Treasury and IRS shut down abusive Life Insurance Policies in Retirement Plans.” According to the press release, Assistant Secretary for Tax Policy Pam Olson says that “[t]here are many legitimate section 412(i) plans, but some push the envelope, claiming tax results for employees and employers that do not reflect the underlying economics of the arrangements.”
The guidance issued is as follows:
1. New proposed regulations state that any life insurance contract transferred from an employer or a tax-qualified plan to an employee must be taxed at its full fair market value. (The regulations make changes to Treas. regulations 1.79-1, 1.83-3, and 1.402(a)-1.)
According to the press release, some firms have promoted an arrangement whereby the employer establishes a section 412(i) plan under which the contributions made to the plan, which are deducted by the employer, are used to purchase a specially designed life insurance contract, made available only to highly compensated employees. The insurance contract is designed so that the cash surrender value is temporarily depressed, so that it is significantly below the premiums paid. The contract is then distributed or sold to the employee for the amount of the current cash surrender value during the period the cash surrender value is depressed. However, the contract is structured so that the cash surrender value increases significantly after it is transferred to the employee.
According to the IRS, use of this “springing cash value life insurance” gives employers tax deductions for amounts far in excess of what the employee recognizes in income. The regulations are designed to prevent taxpayers from artificially understating the value of these contracts.
2. Revenue Procedure 2004-16 issued today along with the proposed regulations provides a temporary safe harbor for determining fair market value.
3. Revenue Ruling 2004-20 states that an employer cannot buy excessive life insurance (i.e., insurance contracts where the death benefits exceed the death benefits provided to the employee’s beneficiaries under the terms of the plan, with the balance of the proceeds reverting to the plan as a return on investment) in order to claim large tax deductions. These arrangements generally will be listed transactions for tax-shelter reporting purposes.
4. Revenue Ruling 2004-21 states that a qualified plan funded with life insurance contracts which discriminate in favor of highly paid employees will not meet the requirements of section 401(a)(4) of the Internal Revenue Code and the benefits, rights, and features provisions of Treas. regulation section 1.401(a)(4)-1(b)(3) and section 1.401(a)(4)-4(a).