The New IRS Guidance on Life Insurance Valuation: Implications for Pension Rescue (CC 04-07)

In IRS Issues Guidance on Valuation of Life Insurance in Qualified Plans (CC 04-06), AUS explained the new proposed regulations, revenue procedure, and revenue rulings promulgated by the IRS on February 13, 2004 to curb abuses in the valuation of life insurance policies in qualified plans (Prop. Treas. Regs. §§1.79-1, 1.83-3, and 1.402(a)-1, 69 Fed. Reg. 7384 (Feb. 17, 2004); Rev. Proc. 2004-16, 2004-10 I.R.B.; Rev. Rul. 2004-20, 2004-10 I.R.B.; Rev. Rul. 2004-21, 2004-10 I.R.B).

The IRS press release accompanying the guidance said that it was designed to combat abuses in qualified plans subject to I.R.C. §412(i).  (“’The guidance targets specific abuses occurring with section 412(i) plans,` stated Assistant Secretary for Tax Policy Pam Olson.”)  Only one part of the guidance, Rev. Rul. 2004-20, specifically deals with plans “intended to be a plan described in §412(i),” but §412(i) plans could scarcely avoid being affected by pronouncements about life insurance valuation.  Life insurance is encountered in qualified plans as a funding vehicle for §412(i) plans because funding with insurance policies enables these plans to escape the minimum funding requirements of §412.  However, since life insurance enters into many other qualified plan (and other benefit vehicle) situations than §412(i), the guidance has much broader effects than one might conclude from reading the press release.  A particularly significant area affected by the guidance was discussed in previous Current Comments: Using Life Insurance to Reduce the Tax Bite on Retirement Plan Assets at Death, CC 03-10 and the companion piece, Valuing Life Insurance Policies for Tax Purposes, CC 03-09.

Pension Rescue

The Distribution Version

The so-called pension rescue concept seeks to “rescue” qualified plan (typically profit-sharing plan) assets from the income and estate taxes that they would otherwise incur by distributing them out of the plan.  A favored technique is the purchase by the plan trustee of a life insurance contract on the life of the account owner. The plan involves the following steps:

1.      Assets in the profit sharing plan are utilized to purchase a life insurance policy on the life of the account owner (or, where the plan permits a second-to-die policy on the account owner and spouse). The plan trustee is both policy owner and beneficiary (the ultimate recipients of the death benefit are the designated beneficiaries under the plan).

2.      After the policy is acquired by the plan, it is eventually distributed by the plan trustee to the account owner.  Alternatively, the policy could be purchased from the plan by the account owner or by an irrevocable life insurance trust (ILIT) established by the account owner. 

3.      In the case of a distribution the account owner then transfers the policy to an irrevocable life insurance trust (ILIT). The beneficiary(s) of the trust can be the same as the beneficiary(s) of the retirement account.

Once the policy is in the ILIT the tax advantages are well known.  See, e.g., The Insurance-Funded Family Bank, Section 2.1, Subdivision C.  But in order to reap any tax advantages from the transfer of the policy out of the plan, it is essential that the distributed life insurance policy be valued at an amount less than the plan account assets used for its purchase.  It’s the classic springing cash value scenario.

However, the possibility that the policy could, when distributed, be valued at that lower amount depended completely on the ambiguities between terms such as “cash value,” “cash surrender value,” “entire cash value,” and so on, that had crept into the IRS’s various valuation pronouncements over the years.  CC 03-09, after examining some of these ambiguities and discussing the anti-springing-cash-value orientation of what was then the latest guidance, Notice 89-25 and Announcement 92-182, concluded skeptically: “financial arrangements that are artificial in nature or structure, motivated only by expected tax savings, are susceptible to challenge under a “sham” type rationale—even though the transactions may appear to technically fit within the Code, regulations and/or administrative pronouncements.”  The new guidance, which imposes a uniform if undefined standard of fair market value, fully vindicates that skepticism.  CC 03-10 concluded that “achieving this [the goal of policy valuation less than premiums paid] through so-called springing cash value contracts can risk serious adverse consequences. Planners ought be mindful of valuation concepts . . . and adhere to prudent design strategies in an effort to obtain favorable valuations.”  That is all the truer now, although it is hard to see how any design strategy can now achieve the desired effect.  A successful strategy would somehow have to get around Rev. Proc. 2004-16.  But under Rev. Proc. 2004-16, cash value may only be treated as fair market value when it is at least equal (in a nutshell) to premiums plus credits minus charges (premiums plus credits plus investment return adjustments minus charges for a variable contract), and this is likely to be close to the plan assets spent on the policy, since it contains that number (i.e. premiums). 

The Purchase Version

An alternative to distributing the policy out of the plan is for the participant to purchase it from the plan.  This is permitted under Prohibited Transaction Exemption 92-6, and before the guidance it would have seemed an advantageous course, considering that P.T.E. 92-6 enshrined the distinction between cash surrender value and fair market value.  It stated that when a policy was sold by the plan to a participant for less than fair market value, the difference is not a distribution under the plan.  The Preamble to the Proposed Regulations revokes this statement, making a pension rescue impossible to implement by the sale of the policy.  (Nor would it be possible to arrange a transfer of the policy for services rendered, since Treas. Reg. §1.83-3(e), which had stated that “only the cash surrender value of the contract is considered to be property,” is amended by the proposed regulations.)

Further Implications

Thus, the application of the new guidance is not limited to §412(i) plans. In fact, it extends into any situation involving valuation of a life insurance policy for income tax purposes, not just qualified plans.  Regulations under I.R.C. §§ 79 and 83, which don’t necessarily deal with qualified plans, are amended in the proposed regulations.

Yet however broadly the new guidance is applied, there is no doubt that its core is the IRS’s attempt to eliminate, once and for all, what it sees as a certain kind of valuation abuse. Objective observers might find it hard not to see it the Services way. The fact that multiple uncollated IRS pronouncements created the confusion that allowed these policies to fit into a loophole lacks currency as a counterargument. (Tax loopholes are not like they used to be—when technical gaps in the Code or clever manipulation of provisions to operate in an unintended manner could be exploited until Congress acted to amend the Code. Now the IRS has expanded loophole fighting authority and vigilance, and is quick to act administratively to thwart perceived abuses.) It’s not as if one could argue for these practices on the basis of a body of revenue rulings or other pronouncements, even private letter rulings, upholding them.  To the contrary, as early as Notice 89-25 the IRS tried to address springing cash value policies, but its use of “reserves” ultimately only added another ingredient to the stew that included “cash value,” “cash surrender value,” “entire cash value,” the gift tax notion of interpolated terminal reserve, and even “replacement cost.”  The IRS has guaranteed problems for itself (and now the public) by being so vague about the meaning of “fair market value,” for so long -- no doubt in an attempt to preserve its flexibility, but the proposed adoption of a single concept of life insurance valuation, replacing an ad hoc hodgepodge of concepts has to count as an advance for those seeking to shut down "over-the-top" plans based on hyper-technical readings of statutes and administrative pronouncements.

(March 2004 Current Comment)

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