Final Regulations Issued Regarding Distribution of Life Insurance from
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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.
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
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
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
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.
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
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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