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GT Alert

Final Regulations Issued Regarding Distribution of Life Insurance from Qualified Plans

October 2005

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The IRS issued final regulations to address the transfer of life insurance from qualified plans.1 Although the regulations were intended to target transactions involving the transfer of policies with artificially depressed cash surrender values, they apply to the transfer of any policy (not just those with depressed cash surrender values). The regulations mark a significant change in the IRS’ position. They will affect the insurance industry, plan administrators, plan participants and beneficiaries. Moreover, in certain circumstances, the application of the new regulations could trigger plan disqualification.

In brief, the final regulations provide that, in the event of a transfer of a life insurance policy from a qualified plan, the taxable amount resulting from that transfer will include the policy’s cash value and all other rights under the policy, whether or not guaranteed.2 In addition, distributions will be taken into account for the purposes of determining the amount taxable to the plan participant and for the purpose of determining plan qualification.

Prior Law

When a qualified plan distributes property to a plan participant, the participant generally is taxable on an amount equal to the “fair market value” of the property. However, in the case of a distribution of a life insurance policy, prior regulations provided that the policy’s “entire cash value” is includible in the recipient’s income. The regulations’ failure to define fair market value or entire cash value created uncertainty.

In 1977, the IRS and Department of Labor jointly issued a Prohibited Transaction Exemption (PTE) addressing the sale of a life insurance contract from a qualified plan to a plan participant. The PTE was amended in 1992 and permitted the sale of a life insurance contract from a qualified plan to a plan participant for the policy’s cash surrender value. This sale would not trigger a deemed distribution, even if the transaction constituted a bargain sale (i.e., the cash surrender value was less than the policy’s fair market value). By not requiring qualified plans to treat the bargain element of the sale as a deemed distribution, the PTE protected from disqualification plans that did not permit in-service distributions.

Using this protection against disqualification, insurance products were designed to take advantage of the uncertainty surrounding the valuation of an insurance policy when transferred from a qualified plan to plan participants. The key feature of these policies was that, for a period of time, neither the policies’ reserves nor their cash surrender value adequately represented the policies’ fair market value. By transferring this type of policy during the period in which the reserves and cash value were significantly less than fair market value, significant tax savings could be achieved and plans were not at risk for disqualification.

The Final Regulations

In response to the insurance industry’s creativity, the IRS decided to clarify the issue of valuing life insurance policies transferred from a qualified plan to a participant or beneficiary. Although the regulations were prompted by the transfer of policies with artificially depressed cash surrender values, they apply to all transfers.

In contrast to the PTE, the final regulations provide that all transfers of an insurance policy after August 29, 2005, from a qualified plan to a participant for less than fair market value, will be treated (to the extent that the fair market value exceeds the consideration received) as a deemed distribution from the qualified plan to the participant. The deemed distribution will be taxable to the participant and will also be taken into account in determining plan qualification.3 Moreover, the final regulations provide that the fair market value of a policy is determined by taking into account a policy’s cash value and all rights under the contract, including supplemental agreements, whether or not guaranteed.

Impact of the Final Regulations

The final regulations clarify that fair market value (as opposed to simple cash value) will serve as the valuation measuring stick. However, they do not provide any practical valuation guidance or the specificity that planners had hoped would be forthcoming. Revenue Procedure 2005-25 describes safe-harbor valuation guidelines,4 but questions surrounding valuation methodology remain unanswered. As a practical matter, valuation remains a challenge. For example, how should “all rights under the contract” be valued? Taxpayers and plan administrators will likely look to insurers to provide a statement of valuation. Other than the use of the safe-harbor guidelines set forth in Revenue Procedure 2005-25, what other valuation methods will be accepted by the IRS as a determination of a policy’s fair market value? Will detailed appraisals be acceptable? Perhaps comparable sales on the viatical settlement market could serve as a source of data for determining fair market value. Practical valuation solutions will be devised and tested. In the meantime, uncertainty will prevail.

In light of the continued uncertainty surrounding valuation, qualified plan administrators must exercise caution before permitting the transfer of an insurance policy to a plan participant. The consequences of the transfer being characterized as a deemed distribution could be severe. Pension plans that distribute life insurance policies risk disqualification and all qualified plans need to consider whether the distribution will cause a Section 415 violation resulting in plan disqualification.

With the issuance of the final regulations, the ability to structure policies in a manner that permits their transfer for less than fair market value is lost. In addition, qualified plans are no longer sheltered from potential disqualification if a policy is transferred from the plan at less than fair market value. Parties involved in the transfer of an insurance policy from a qualified plan must review the policy’s fair market value to ensure that the parties understand the potential income tax consequences of the transaction and the transaction’s impact on the plan’s qualification.

 


Footnotes

1 Treasury Decision 9223 (8/26/05).

2 However, in the event of a grand-fathered split-dollar arrangement, the regulations provide that only cash value is considered.

3 Pension plans are prohibited from making in-service distributions. Also, qualified plans that are permitted to make in-service distributions are limited by Section 415, which, if violated, could result in plan disqualification.

4 Rev. Proc. 2005-25 modifies and supersedes the safe harbor rules set forth in Rev. Proc. 2004-16.

 

This alert was written by Jonathan M. Forster and Rebecca S. Manicone in the Tysons Corner office. Please contact Mr. Forster or Ms. Manicone at 703.749.1300 or your Greenberg Traurig liaison if you have any questions regarding the subject matter of this Alert.

© 2005 Greenberg Traurig


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This GT ALERT is issued for informational purposes only and is not intended to be construed or used as general legal advice. Greenberg Traurig attorneys provide practical, result-oriented strategies and solutions tailored to meet our clients’ individual legal needs.