Steve Leimberg's Employee Benefits and Retirement Planning Email Newsletter - Archive Message #300
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Date: |
11-Apr-05 |
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From: |
Steve Leimberg's Employee Benefits and Retirement Planning Newsletter |
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Subject: |
FLASH! Rev. Proc. 2005-25 IRS Issues New Life Insurance Valuation Guidance |
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Can you "incubate" life insurance inside a qualified pension plan, let tax deductible employer dollars do the "heavy lifting" and "fatten up" the policy, and then a few years later "bail out" the policy and get it into the hands of the company owner's irrevocable life insurance trust – at a tax discount? Some had claimed you could do just that, i.e., by creating temporary artificial surrender charges that would magically go away fairly soon after the policy left the retirement plan's hands, the cash surrender value at the time of the distribution or sale was far less than would be expected based on the sum of the premiums the qualified retirement plan had paid – and therefore – these individuals posited – the plan participant would report as income (or pay for) only a fraction of the otherwise reportable income. They called it "Pension Rescue". EXAMPLE: Dr. Smith and his three employees participate in a profit sharing plan. The profit sharing plan is amended to allow participants to direct investments in their accounts and, specifically, to purchase life insurance. Dr. Smith directs that $50,000 of his profit sharing account be invested in a universal life insurance policy with a death benefit of $4,000,000 (Assume he is not violating the incidental death benefit limits). He does this for five years and at the end of the fifth year (after he has paid in $250,000), the policy has a cash value of $200,000 and a surrender charge of $140,000. To avoid inclusion of the insurance in his estate, Dr. Smith has the trustee of the profit-sharing plan sell the policy to Dr. Smith's family insurance trust (let us also assume the transfer for value rule has been avoided through proper planning) for an amount equal to the net cash surrender value, i.e. $60,000 ($200,000 cash value less $140,000 surrender charge). What a deal! Purchase the policy with 250,000 tax deductible corporate dollars, and transfer it out of the plan for an after-tax cost of only $60,000! Last year on Friday the 13th, the IRS issued the first round of guidance, Rev. Proc. 2004-16 and the proposed amendments to the regulations. At that time, the IRS said "game over," and that a proper measurement of the policy's fair market value had to be used, not an artificially depressed value.
That
guidance essentially moved us from the use of cash surrender value
(especially as applied to pensions) as the measure of taxable
value to a fair market value standard coupled with safe harbor
formulas that essentially added premiums paid to the interest and
other income credited and subtracted reasonable mortality and
other charges actually paid or expected to be paid. New York life insurance guru Lee Slavutin of Stern Slavutin 2, Inc. shares his thoughts on Rev. Proc. 2005-25. As you read what the Rev. Proc. states (and intuit the meaning of what it doesn't), understand that the IRS has deliberately not been as specific as it might otherwise have been – mainly because it just isn't going to tolerate an unethical promoter's hypertechnical interpretations of IRS rules.
EXECUTIVE
SUMMARY:
RELEVANCE OF FAIR MARKET VALUE (1) Distributions from Qualified Plans Under Code Section 402(a). Generally, any amount actually distributed to any distributee by any qualified retirement plan's trust is taxable to the distributee. The tax is reportable in the taxable year of the distributee in which distributed. Generally, that distribution must be reported at its "fair market value." Generally, upon distribution of a retirement income, endowment, or other life insurance contract, the "entire cash value" at the time of distribution must be included in the distributee's income. Last year, the Treasury issued proposed changes to the regulations under Code Section 402. The intention of these regulations was to clarify that whether the life insurance or annuity policy was (a) distributed or (b) sold, the distributee had to include in income – not the policy's reserve or its cash surrender value but rather - the fair market of the contract. Those proposed rules applied to distributions or sales occurring on or after February 13, 2004. (2) Permanent Benefits Provided Under Code Section 79. Generally, Code Section 79 requires that the cost of group-term life insurance coverage on the life of an employee that is in excess of $50,000 of coverage be included in the employee's income. Section 79 regulations provide that, if certain tests are met, group-term life insurance may be combined with permanent benefits. In such cases, the employee must report the cost of those permanent benefits but may reduce otherwise reportable income by the amount the employee paid for the benefits. The cost of the permanent benefits is determined under a formula provided in the regulations that is based in part on the increase in the employee's deemed death benefit during the year. One of the factors used for determining the deemed death benefit is "the net level premium reserve at the end of that policy year for all benefits provided to the employee by the policy or, if greater, the cash value of the policy at the end of that policy year." Amendments to the regulations under § 79 were proposed on February 13, 2004 that would delete the term "cash value" from the formula for determining the cost of permanent benefits and substitute the term "fair market value." The proposed regulations applied to permanent benefits provided on or after February 13, 2004. (3) Transfers Under Code Section 83(a). Code Section 83(a) provides that, when property is transferred to any person in connection with the performance of services, the service provider must include in gross income (as compensation income) the excess of (a) the fair market value of the property, determined without regard to lapse restrictions (such as life insurance contract surrender charges), and determined at the first time that the transferee's rights in the property are either transferable or not subject to a substantial risk of forfeiture (i.e., when those rights become "substantially vested"), over (b) the amount (if any) paid for the property by the service provider. When life insurance is the subject of the transfer, only the cash surrender value of the contract is considered to be property. Last year's proposed amendments to the regulations provided that the policy's cash value and all other rights under the contract (including any supplemental agreements, whether or not guaranteed), other than current insurance protection, are treated as property for purposes of Code Section 83. The proposed regulations applied to transfers occurring on or after February 13, 2004 (with an exception for any contract that was part of a split-dollar arrangement entered into on or before September 17, 2003, and which is not materially modified after that date). (4) Contributions To and Distributions From Nonexempt Employees' Trusts. Code Section 402(b)(1) provides that contributions to a employees' trust made by an employer during a taxable year for which the trust is not exempt from tax are included in the gross income of the employee under Code Section 83 (as property transferred in connection with the performance of services). In this case, the value of the employee's interest in the trust is substituted for the fair market value of the property for purposes of applying Code Section 83. An employer's contributions to a nonexempt trust are included as compensation in the employee's gross income in the employee's taxable year during which the contribution is made - to the extent that the employee's interest in such contribution is substantially vested at the time the contribution is made. If an employee's rights under a trust become substantially vested during a taxable year of the employee and a taxable year for which the trust is not exempt ends with or within such year, the value of the employee's interest in the trust on the date of such change (substantially nonvested to substantially vested) is included in the employee's gross income for that taxable year. The term "the value of the employee's interest in a trust" means the amount of the employee's beneficial interest in the net fair market value of all the assets in the trust as of any date on which some or all of the employee's interest in the trust becomes substantially vested. The net fair market value of all the assets in the trust is the total amount of the fair market values (determined without regard to any lapse restriction of (a) all the assets in the trust, less (b) the amount of all the liabilities to which such assets are subject or which the trust has assumed (other than the rights of any employee in such assets), as of the date on which some or all of the employee's interest in the trust becomes substantially vested. Any amount actually distributed or made available to any distributee by an employee's trust in a taxable year in which it is not exempt is taxable under Code Section 72 (relating to annuities) to the distributee in the taxable year in which it is so distributed or made available. If, for example, the distribution consists of an annuity contract, the amount of the distribution is considered to be the entire value of the contract at the time of the distribution. Such value is includible in the gross income of the distributee to the extent that such value exceeds the investment in the contract. The distributions are included in income under the rules of § 72 whether or not the employee's rights in the contributions become substantially vested beforehand. If one of the reasons a trust is not exempt from tax is the failure of the plan to meet the requirements of § 401(a)(26) or 410(b), then a highly compensated employee must include, in lieu of the amount determined under § 402(b)(1) or under § 402(b)(2), an amount equal to his vested accrued benefit (other than the employee's investment in the contract) as of the close of such taxable year of the trust. PRIOR GUIDANCE REGARDING FAIR MARKET VALUE (1) Rev. Rul. 59-195 - Interpolated Terminal Reserve. Under Rev. Rul. 59-195, the value of a life insurance contract that has been in force for some time and on which further premium payments are to be made is not its cash surrender value, but rather, (a) the interpolated terminal reserve as of the date of sale plus (b) the proportionate part of any employer-paid unearned premiums. NOTE: If, "because of the unusual nature of the contract such approximation is not reasonably close to the full value, this method may not be used." Thus, this method is appropriate only where the reserve reflects the value of all of the relevant features of the policy.
(2)
Notice 89-25 : (3) Rev. Proc. 2004-16 – Safe Harbor for Determining Fair Market Value. Rev. Proc. 2004-16 provided a safe harbor for determining fair market value of variable and non-variable contracts for purposes of applying the rules under the 2004 proposed regulations. The safe harbor for non-variable contracts allowed the use of the contract's cash value without reduction for surrender charges as the fair market value - so long as this cash value is at least equal to the sum of: (1) the premiums paid, plus (2) interest, dividends or other credits, minus (3) reasonable mortality and other reasonable charges actually charged by the date of determination (e.g., date of the transfer or distribution) that are expected to be paid. If the policy in question is a variable contract, cash value without reduction for surrender charges may be treated as the fair market value of the contract provided such cash value is at least equal to the sum of: (1) the premiums paid, plus (2) all adjustments made with respect to those premiums during that period (whether under the contract or otherwise) that reflect investment return and the current market value of segregated asset accounts, minus (3) reasonable mortality and other reasonable charges actually charged by the date of determination (e.g., date of the transfer or distribution) that are expected to be paid. NEED FOR FURTHER GUIDANCE. Comments were received by the IRS on last year's guidance concerning these safe harbors asserting that the formulas did not function well for certain types of traditional policies. Commentators were also concerned about the possible double-counting of dividends under the formulas.
Finally,
commentators were concerned that the formulas did not make an
explicit adjustment for surrender charges, withdrawals, or
distributions.
SAFE HARBOR FOR NON-VARIABLE CONTRACTS. The fair market value of a non-variable insurance contract, retirement income contract, endowment contract, or other contract providing life insurance protection may be measured as the GREATER of: (A) the sum of the interpolated terminal reserve and any unearned premiums plus a pro rata portion of a reasonable estimate of dividends expected to be paid for that policy year based on company experience, (This formula resembles the one commonly used in the gift tax valuation context under Reg.25.2512-6.) Or, (B) the result of multiplying the PERC amount (the amount described in the following sentence based on Premiums, Earnings, and Reasonable Charges) by the applicable Average Surrender Factor (ASF). EDITOR'S COMMENT: In the case of Universal Life (UL) contracts, since there is no interpolated terminal reserve, the "A" option will not be available and this forces the use of "B". (There is no substitute for "interpolated terminal reserve"). PERC AMOUNT is defined as the aggregate of: (1) the premiums paid from the date of issue through the valuation date without reduction for dividends that offset those premiums, plus (2) dividends applied to purchase paid-up insurance prior to the valuation date, plus (3) any amounts credited (or otherwise made available) to the policyholder with respect to premiums, including interest and similar income items (whether credited or made available under the contract or to some other account), but not including dividends used to offset premiums and dividends used to purchase paid-up insurance, minus (4) explicit or implicit reasonable mortality charges and reasonable charges (other than mortality charges), but only if those charges are actually charged on or before the valuation date and those charges are not expected to be refunded, rebated, or otherwise reversed at a later date, minus (5) any distributions (including distributions of dividends and dividends held on account), withdrawals, or partial surrenders taken prior to the valuation date. EDITOR'S COMMENT: Think of the PERC Amount as premiums, earnings, less "reasonable charges". In a U.L. contract, this should closely approximate the policy's account value on the transaction date. In my opinion, the Service deliberately provided no definition for what "reasonable" means; however, as you'll note as you continue to read, there is an anti-abuse provision that puts the burden on the party doing the evaluation (the insurer). These rules must be interpreted in a fair and reasonable way that avoids games with surrender factors and other unreasonable charges. In the qualified plan area, you get some benefit for some amount of the surrender charge – but it is "capped". There is in essence a 30 percent cap for surrender charges when qualified plans are involved. All of these rules are specifically designed to thwart valuation games through some type of artificial suppression of the policy's value or unreasonably high mortality, surrender, or other charges. SAFE HARBOR FOR VARIABLE CONTRACTS. If the insurance contract, retirement income contract, endowment contract, or other contract providing life insurance protection being valued is a variable contract, the fair market value may be measured as the greater of: (A) the sum of the interpolated terminal reserve and any unearned premiums plus a pro rata portion of a reasonable estimate of dividends expected to be paid for that policy year based on company experience, OR (B) the product of the variable PERC amount (the amount described in the following sentence based on premiums, earnings, and reasonable charges) and the applicable Average Surrender Factor described below. The variable PERC amount is the aggregate of: (1) the premiums paid from the date of issue through the valuation date without reduction for dividends that offset those premiums, plus (2) dividends applied to increase the value of the contract (including dividends used to purchase paid-up insurance) prior to the valuation date, plus (or minus) (3) all adjustments (whether credited or made available under the contract or to some other account) that reflect the investment return and the market value of segregated asset accounts, minus (4) explicit or implicit reasonable mortality charges and reasonable charges (other than mortality charges), but only if those charges are actually charged on or before the valuation date and those charges are not expected to be refunded, rebated, or otherwise reversed at a later date, minus (5) any distributions (including distributions of dividends and dividends held on account), withdrawals, or partial surrenders taken prior to the valuation date. Average Surrender Factor (ASF). Sections 79, 83, and 402(b): The Average Surrender Factor for purposes of Code Sections 79 , 83 , and 402(b) (for which no adjustment for potential surrender charges is permitted) is 1.00. Qualified plans: In the case of a distribution or sale from a qualified plan, if the contract provides for explicit surrender charges, the Average Surrender Factor is the unweighted average of the applicable surrender factors over the 10 years beginning with the policy year of the distribution or sale. For this purpose, the ASF for a policy year is equal to the greater of 1. .70 or 2. (Projected amount of cash that would be available if the policy were surrendered on the first day of the policy year) /(Projected (or actual) PERC amount as of that same date). In the case of the policy year of the distribution or sale, use in place of the projected amount, the amount of cash that was actually available on the first day of that policy year. If there is no surrender charge, the applicable surrender factor for a year is 1.00. A surrender charge is permitted to be taken into account only if it is contractually specified at issuance and expressed in the form of non-increasing percentages or amounts. APPLICATION OF SAFE HARBOR FORMULAS. The Service built in anti-abuse language: You must interpret the formulas above in a reasonable manner, consistent with the purpose of identifying the fair market value of a contract. For instance, if income is calculated with respect to premiums paid under the contract, that amount must be included in the formulas, even if the income can only be realized through an exchange right that gives rise to a springing cash value under another policy. Similarly, if a mortality charge or other amount charged under a contract can be expected to be directly or indirectly returned to the contract holder (whether through the contract, a supplemental agreement, or under a verbal understanding and regardless of whether there is a guarantee), the charge is not permitted to be subtracted under item (4) in the formulas. In addition, a surrender charge cannot be taken into account in determining an average surrender factor if it may be waived or otherwise avoided or was created for purposes of the transfer or distribution. Furthermore, at no time are these rules to be interpreted in a manner that allows the use of these formulas to understate the fair market value of the life insurance contracts and associated distributions or transfers. For example, if the insurance contract has not been in force for some time, the value of the contract is best established through the sale of the particular insurance contract by the insurance company (i.e., as the premiums paid for that contract). DATE AS OF WHICH FAIR MARKET VALUE IS DETERMINED. In the case of a distribution or sale of a contract from a qualified plan, the date as of which the fair market value is to be determined is the date of that distribution or sale. The date of determination in the case of the provision of permanent benefits subject to Code Section 79 is the date those benefits are provided. The date of determination in the case of a transfer of an insurance contract subject to Code Section 83 is the date on which fair market value must be determined under the rules of Section 83. The date of determination in the case of a non-exempt employees' trust under Section 402(b) is the date on which fair market value must be determined under the rules of Section 402(b). ADDITIONAL AMOUNTS THAT MUST BE INCLUDED IN INCOME Treatment of Dividends Held on Deposit. Dividends held on deposit with respect to an insurance contract are not included in the fair market value of the contract. However, such dividends are taxable income to the employee or service provider at the time the rights to those dividends are transferred to that individual. For example, if a qualified plan distributes a contract to an employee along with the rights to dividends held on deposit with respect to that contract, the employee must take into income both the fair market value of the contract and the value of the dividends held on the deposit. This is the case regardless of whether the dividends on deposit are paid directly to the employee at the time the contract is distributed or merely made available for payment at a later time. Treatment of Loans. If a loan (including a loan secured by the cash value of a life insurance contract) is made to an employee or other service provider in connection with the performance of services, to the extent the debt owed by the employee or other service provider is terminated upon distribution or transfer of the collateral, the terminated loan or debt amount constitutes an additional distribution to the employee or service provider at that time. For this purpose, it is irrelevant whether the loan is described as having been forgiven, canceled, satisfied, extinguished, or otherwise offset, provided that the loan no longer exists after the distribution or transfer.
EXAMPLE:
If the loan to the employee no longer exists after the distribution or transfer so that the amount distributed is $70,000 ($100,000 - $30,000), the entire $100,000 must be taken into account by the employee. If a participant receives a loan from a life insurance contract held by a qualified plan (or other plan subject to the rules of Section 72(p)) and the contract is subsequently distributed to the participant in satisfaction of the participant's benefit under the plan, the reduction in the value of the distribution in order to repay the participant's loan from the plan constitutes a plan loan offset amount, which is treated as a distribution from the plan. EFFECTIVE DATE This revenue procedure applies to distributions, sales, and other transfers made on or after February 13, 2004, to permanent benefits within the meaning of § 1.79-0 provided on or after February 13, 2004, and to non-exempt employees' trusts under § 402(b) for periods on or after February 13, 2004. However, for periods before May 1, 2005, taxpayers may rely on the safe harbors of this revenue procedure and for periods on or after February 13, 2004, and before May 1, 2005, taxpayers may also rely on the safe harbors in Rev. Proc. 2004-16. EFFECT ON OTHER DOCUMENTS Rev. Proc. 2004-16 is modified and superseded. COMMENT: BOTTOM LINE OF REV. PROC. 2005-25 After you weave through the complex new 2005 rules which are ever so slightly kinder and gentler than the 2004 rules, the conclusion is inevitable: The game is STILL over! You must use an appropriate measurement of fair market value when distributing or selling a policy from a qualified plan. And don't even think about trying to get around the spirit of the rules! By introducing a minimum of 0.7 for the ASF and by measuring the ASF's for a period of 10 years beginning in the year of the sale or distribution, most, if not all, gimmicks will be eliminated. In addition, the IRS has strengthened the "fair market value" standard by targeting three "innovative" techniques (exchanging the existing policy for a new springing cash value policy, refunding mortality charges, and waiving surrender charges) and by not allowing the rules to be interpreted in a way that would understate fair value. The IRS reiterates an old rule that the value of a newly issued policy is the amount of premiums paid. (But note that "newly issued" is not defined.) EDITOR'S COMMENT: There's a lot more – and less – than meets the eye here. For instance, How will the insurer, who apparently is responsible for the computation, be able to be sure the charges it states are "reasonable?" (And will insurers have to issue an exculpatory caveat each time it issues a valuation?) I'm sure we'll hear more on this issue. HOPE THIS HELPS YOU HELP OTHERS! Lee Slavutin Edited by Steve Leimberg CITE AS: Steve Leimberg's Employee Benefit and Retirement Planning Newsletter # 300 (April 11, 2005) at http://www.leimbergservices.com Reproduction in Any Form or Forwarding to ANY person Prohibited – Without Express Permission! CITES: Rev. Proc. 2005-25 (26 CFR 601.201); Rev. Proc. 2004-16, 2004-10 I.R.B. 559, is modified and superseded. Rev. Rul. 59-195, 1959-1 C.B. 18; Reg. Sec. 25.2512-6 ; Notice 89-25, 1989-1 C.B. 662 See Tax Planning With Life Insurance (800 950 1216). |
