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On Feb. 13, the IRS issued extensive guidance intended to shut down abuses involving the purchase of excess insurance coverage and the use of certain specially designed life insurance policies in retirement plans. The guidance addresses situations where such policies, often used in conjunction with fully insured retirement plans allowed under Code Section 412(i), are used to artificially increase the sponsoring employer’s deductible plan contributions while greatly reducing the amount of taxable income recognized when the policies are distributed or sold to plan participants. A Section 412(i) plan is a tax-qualified retirement plan that is funded entirely by life insurance policies or annuity contracts. In a Section 412(i) Plan, the sponsoring employer claims tax deductions for contributions that are used by the plan to pay premiums on the insurance policies covering participating employees. The plan may hold each policy until the insured employee dies or may distribute or sell the policy to the employee at a specific time, such as when the employee retires. Section 412(i) Plans are generally subject to all of the requirements for tax qualification imposed under Code Section 401(a), and they are also subject to the prohibited transaction and fiduciary responsibility rules contained in the Employee Retirement Income Security Act of 1974, as amended. However, one of the primary attractions of a Section 412(i) plan, from an employer’s perspective, is the general inapplicability of the traditional benefit accrual rules and the limitations on the deductibility of contributions that apply to most other types of qualified plans. The deductibility of contributions to qualified retirement plans is governed by Code Section 404, which provides that for defined benefit plans, the amount that is annually deductible by an employer cannot exceed the actuarially determined “normal cost” of funding the projected benefits under the plan. Code Section 412 and the regulations there under contain complex rules for the determination of the appropriate “normal cost.” However, in a Section 412(i) plan, the annual deduction for plan contributions is limited only to the annual premium cost associated with the life insurance policies owned by the plan. Accordingly, the maximum deductible contributions to a Section 412(i) plan tend to be significantly higher than the deduction limitations applicable to traditional defined benefit plans, especially in the first few years of the plan’s existence. This higher limitation on deductible contributions has made Section 412(i) plans especially attractive to smaller employers, including partnerships and sole proprietorships, that desire the “shelter” of higher deductible plan contributions. The recently issued guidance covers three specific issues. First, new proposed regulations under Code Section 402 (REG-126967-03) provide that any life insurance policy transferred from an employer or from a tax-qualified plan to an employee must be taxed at its full fair market value. In a departure from prior guidance, the proposed regulations further state that neither the distributed policy’s net surrender value (i.e., cash value less surrender charges) nor the amount of a policy’s reserves are the appropriate measure of an insurance policy’s fair market value. In recent years, some insurance companies have promoted the use of insurance policies in connection with Section 412(i) plans where the policies are designed so that both the cash surrender value of each policy and the policy’s reserves are temporarily depressed to a level that it is significantly below the total amount of premiums paid. Under prior IRS guidance, when such a policy was distributed to the employee, the employee has been able to recognize only the depressed net surrender value or policy reserve as taxable income. Typically, such policies are subsequently restructured or exchanged by the employee with the issuing insurance company so that the cash surrender value increases significantly thereafter. This use of so-called “springing cash value life insurance” provides the employer with a significant tax deduction for amounts that are far in excess of what the employee is subsequently required to recognize in income when the policy is distributed. In conjunction with the proposed regulations under Code Section 402, the IRS issued Revenue Procedure 2004-16, which reaffirms that any life insurance policy distributed by a qualified plan, including a Section 412(i) Plan, must be taxed at its fair market value and further provides that the cash value of a contract may be treated as its fair market value provided such value is at least as large as the aggregate of all premiums paid from the date the contract was issued to the date of distribution, plus any amount credited to the policy holder with respect to contract premiums, less reasonable mortality charges and non-mortality charges, only if the charges are actually charged on or before the date of distribution and are expected to be paid. The use of “springing cash value” policies and the impact of the new guidance can be illustrated as follows: “A” participates in a plan intended to satisfy the requirements of Code Section 412(i). In Year 1, the plan acquires a life insurance policy on A’s life with a death benefit of $1.4 million. In that year and for the next four years, the plan pays premiums of $100,000 per year on the policy. The policy provides for a surrender charge that is fixed for the first five years of the policy and decreases ratably to zero at the end of 10 years. The policy provides a stated cash surrender value for each of the first 10 years (the first five years are guaranteed), as set forth in the accompanying table. The reserves under the policy, including life insurance re-serves and reserves for advance premiums, dividend accumulations, etc. at the end of the fifth year are $150,000. At the end of Year 5, A retires and receives a distribution of the insurance policy that was purchased on his life. Under prior guidance, A would likely claim $150,000 (i.e. the greater of the net surrender value or the policy reserve) as the amount recognized on the distribution. Therefore, A’s employer received aggregate deductions of $500,000, while A would only be required to recognize $150,000 as income, even though the policy has much greater intrinsic value. Under the new proposed regulations, the amount of income A must recognize is the policy’s true fair market value. Under Revenue Procedure 2004-16, the fair market value would likely be $450,000, representing the premiums paid, less reasonable charges. The second area of guidance involves the purchase of excessive life insurance coverage. In Revenue Ruling 2004-20, the IRS examined two different excess coverage situations. In the first situation, where the benefits provided by the life insurance policies at normal retirement age exceeded the benefits at normal retirement age specified in the plan, the IRS concluded that such excess benefits under the insurance policies caused the plan to fail to qualify as a Section 412(i) plan and, therefore, the deductibility of contributions to the plan would have not be determined in accordance with the rules applicable to all other types of defined benefit plans under Code Section 412. In the second situation discussed in Revenue Procedure 2004-20, the death benefits provided by the insurance polices owned by the plan exceeded the death benefits provided under the terms of the plan (with the excess insurance proceeds reverting to the plan as a return on investment). Although the IRS ruled that such excess death benefits did not cause the plan to fail to qualify as a Section 412(i) plan, the IRS ruled that contributions used to pay premiums for such excess death benefits are not deductible. Revenue Ruling 2004-20 also provides that plans which provide excess death benefit coverage must be characterized as “listed transactions” subject to the tax shelter registration requirements of Code Section 6111, the tax shelter disclosure requirements of Code Section 6011 and the “investor” list maintenance requirements of Code Section 6112. The third area addressed by the recent guidance is contained in Revenue Ruling 2004-21, which provides that where a qualified retirement plan owns life insurance policies on its participants and the participants are allowed to purchase such policies, those rights would be deemed made available on a discriminatory basis if the features of the policies made the purchase of the contracts more attractive to highly compensated participants than to non-highly compensated participants. For example, if the policies for highly compensated participants were structured to have depressed values at the time of purchase followed by “springing cash value” after the dates of purchase by the highly compensated participants while the values of the policies offered to the non-highly compensated participants were not equally depressed (and therefore not as attractive to purchase), the difference in policy features would be a violation of the discrimination rules contained in Code Section 401(a)(4) and the regulations there under which provide that all plan benefits, rights and features must be made available to all participants in a non-discriminatory manner. Section 412(i) plans are an attractive option for small employers that wish to provide retirement benefits to a small group of employees, especially if that group consists of highly compensated employees and the employer desires to maximize the amount of its deductible contributions. However, as is often the case, promoters have pushed the envelope in plan and insurance policy design to create clearly abusive arrangements. The recently issued IRS guidance should effectively eliminate the abuses while still preserving the benefits of Section 412(i) plans.

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