Using Life Insurance to Reduce the Tax Bite on Retirement Plan Assets at Death (CC 03-10)

Assets remaining in a retirement plan account upon the death of the account owner are potentially subject to income taxes and estate taxes, the cumulative impact of which may leave for the heirs an astonishingly small portion of the value of the account at the date of death -- often as little as 30 percent! This is a potential problem for any type of qualified retirement plan involving an account that passes to heirs upon the death of the account owner.

This Current Comment explores a technique for transferring assets out of profit sharing plans at reduced tax costs through the purchase by the plan trustee of a life insurance contract on the life of the account owner. A key element in the potential tax savings from this technique is the valuation of the distributed life insurance policy at an amount less than the plan account assets used for its purchase. The valuation of a life insurance contract for tax purposes is a somewhat murky proposition, a subject that is explored in detail in the separate companion Current Comment 03-09.

Reducing the Tax Bite Through Life Insurance: The Basic Strategy

Individuals who are able to provide for their retirement income needs with after-tax assets held outside of their retirement plan account(s) are potentially in a position to preserve their retirement account(s) for their heirs; and with a tax planning strategy utilizing retirement account assets to purchase life insurance, the substantial tax burden described above can be materially reduced. 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.

This planning approach can achieve the following major tax savings:

·         To the extent that assets in the retirement account are invested in a life insurance contract, they can ultimately be distributed from the account at a lower income tax cost than if distributed in cash or other investment vehicles.

·         Once the life insurance policy is transferred to an ILIT, in which the insured holds no incidents of ownership, the death benefit can eventually go to the same heirs as would have received the heavily taxed retirement plan assets, but because the inheritance is in the form of a beneficiary interest in an ILIT, there will be no income or estate taxes to reduce the net proceeds.

Tax Consequences

·         Annual Income Resulting From Life Insurance Protection 

·         Income Upon Distribution of the Insurance Contract from the Plan

·         Gift Tax Upon Transfer of the Policy to an ILIT

·         Avoiding Income and Gift Taxes by Purchasing the Policy from the Plan Trustee

Annual Income Resulting From Life Insurance Protection

When the retirement plan account pays premiums for the purchase and maintenance of an insurance policy on the life of the account owner, this will result in taxable income to the account owner. The measure of income is not the amount of the premiums paid on the policy (with the pre-tax funds in the account), but rather, the value of the pure insurance protection. The so-called pure insurance protection is that portion of the policy death benefit, which exceeds the policy`s cash value; i.e., the amount for which the insurance company is at risk should the insured die. The value of this "at risk" portion is essentially measured by what it would have cost the insured participant to purchase one year`s pure term insurance coverage in such amount at the insurer`s standard rates for the insured`s age applicable during the tax year. Or, as an alternative, such value may be determined from an IRS table, if that amount is lower.

This method of determining the amount of taxable income realized by an insured employee as a result of life insurance coverage paid for by the plan account is the same as is applicable with respect to split-dollar life insurance arrangements. In both contexts the theory underlying taxation is that the employee realizes a current economic benefit that represents taxable income. In the case of split-dollar, the pure insurance protection represents compensation arising out of the employment relationship; in the case of an insurance purchase by a retirement plan account, the value of the pure insurance protection is deemed to be a taxable distribution from the account.

As stated above, the value of the pure insurance protection is determined by reference to an IRS table, or by reference to the insurer’s standard term insurance rates, if lower. With regard to the IRS table, the so-called P.S. 58 table was traditionally used for this purpose; however, since the promulgation of IRS Notice 2002-8, mandating the use of an updated table (Table 2001) in connection with split-dollar arrangements, Table 2001 should also be used (rather than the outdated P.S. 58 table) for purposes of measuring income in the context of insurance purchased by a retirement plan account. Moreover, new split-dollar regulations proposed in 2002 (but not yet finalized) raise doubt as to whether the insurer’s published standard term rates may even be allowed in the future as an alternative to Table 2001.

If the insured/participant makes any contribution to the plan for the tax year, this is deemed applicable first to the payment of the insurance premium (unless terms of the plan specify otherwise), and thus, would be netted against the income attributable the insurance coverage.

Impact Upon Basis in Account

To the extent that the account owner realizes income based upon the value of the pure insurance protection each year, his or her basis in the retirement account will be increased by a like amount. However, if the policy is eventually surrendered at the plan level, this basis disappears and cannot be used to offset subsequent taxable plan distributions.

Death Prior to Distribution of the Policy by the Plan 

In the event that the account owner/insured should die while the insurance policy is still owned by the plan, the then cash value of the policy would be taxable as income to the beneficiary; the excess of the death benefit amount over the cash value would not be taxable income [Reg. §1.72-16(c)]. Additionally, the entire death benefit amount would be includable in the gross estate of the insured. If the policy were a second-to-die-policy and the account-owner insured were the first to die, the gross estate would include only the fair market value of the policy at the time of death.

Income Upon Distribution of the Insurance Contract from the Plan

Distributions from qualified plans are taxable as ordinary income, reduced by any unrecovered basis in the account. This would also apply with respect to a distribution of an insurance contract; the measure of income would be based upon the market value of the insurance policy at the time of the distribution. Since one of the major costs of this planning strategy is the income that will result from the distribution of the policy from the plan (assuming that it is not done as a sale), policy design is important. The objective is to minimize the market value of the policy as of the date of its distribution.

How is a policy’s value measured? Reg. §1.402(a)-1(a)(2) provides that the distributee must include in income the “cash value” of the policy. But this may not necessarily be the policy’s cash surrender value. The development of so-called springing- cash-value policies, designed to depress policy valuation in the early years of the contract, has resulted in IRS pronouncements that deny the use of surrender value as a measure of fair market value when such a policy is distributed by a retirement plan. The net result of an IRS disallowance of the surrender value in such a situation can be disastrous. Valuation of insurance policies for tax purposes, including springing cash value policies, is explored in detail in the accompanying Current Comment 03-09.

To the extent that income was recognized by the account owner when policy premiums were paid by the plan trustee during the period prior to the distribution, this would have created basis in the account, and the income realized upon distribution of the policy would be net of such basis. As discussed below, income can be avoided altogether if the policy is purchased from the plan for its fair market value, rather than merely distributed.

Gift Tax Upon Transfer of the Policy to an ILIT

Following distribution of the policy from the retirement plan account to the account owner, the policy is then transferred to an ILIT. This transfer is considered a gift to the ILIT beneficiaries, and thus, potentially subject to gift tax. Here again the tax would be based upon the fair market value of the contract at the time of the gift (an amount that would be the same, or very close to the same, as the value used in measuring the taxable income upon distribution from the retirement plan, assuming that the transfer to the ILIT occurs immediately or very shortly after the distribution from the plan). In may cases gift tax can be avoided or reduced through utilization of the per-donee annual exclusion and unified transfer tax exemption amount.

Avoiding Income and Gift Taxes by Purchasing the Policy from the Plan Trustee

The transfer of the policy out of the plan can be accomplished as either a plan withdrawal coupled with a gift over to the insurance trust (as discussed above), or as a purchase of the policy from the plan by the ILIT. Since a withdrawal will involve both an income tax and potential gift tax, the purchase alternative, which avoids both of these taxes, is often favored; although it has its own particular concerns:

·         potential gift tax if the funds for the purchase are provided by the account owner/insured to the ILIT purchaser;

·         income taxation of the death benefit if tainted by the “transfer for value” rule, as discussed below;

·         the purchase must comply with applicable ERISA prohibited-transaction exemptions, as discussed below.

Prohibited Transactions Under ERISA

In general, ERISA prohibits transactions between a qualified plan and “a party in interest,” even if it is an arms-length transaction at fair market value. A “party in interest” includes: the employer; the participant; a fiduciary of the plan; a relative of any of the above or a corporation or other entity owned more than 50% by any of the above.

However, the Department of Labor, which administers ERISA, has authority to promulgate exemptions to the general “prohibited-transaction” rule, and since 1977 an exemption has existed for sales by a plan of an individual life insurance policy.  This exemption was updated and clarified in 1992 in Prohibited Transaction Exemption (“PTE”) 92-6.  PTE 92-6 permits the sale by a qualified plan of an individual life insurance contract, provided that certain conditions are met.

The policy must first be offered to the plan participant before it can be sold to any other party. The offer and refusal should be documented in writing. The plan can only sell the policy if it would be otherwise surrendering it. The sale must be to

·         a plan participant insured under the contract,

·         a relative of such participant who is a beneficiary under the contract,

·         an employer whose employees are covered by the plan, or

·         another employee benefit plan. 

The sale must yield cash proceeds to the plan at least equal to what it would have realized upon a surrender of the contract.

Department of Labor Advisory Opinion Interpreting PTE 92-6

In Advisory Opinion 98-07A, (the Department of Labor’s equivalent of an Internal Revenue Service Revenue Ruling), the Department addressed several fine points of interpretation of PTE 92-6, holding essentially as follows:

·         With respect to permitted sales to “a relative” of the insured participant, the requirement will be satisfied if the sale is to more than one relative.

·         PTE 92-6 applies to a sale of an “individual life insurance contract.”  The Advisory Opinion holds that the use of the word “individual” was intended only to distinguish between individual and group type life insurance, and was not intended to imply that there may only be one insured party under an individual contract.  Thus, the exemption would apply to a second-to-die policy covering the participant and his or her spouse.

·         The exemption is not limited to a sale in which the plan’s entire interest in the insurance contract is sold; it would also apply to an otherwise qualified sale of a partial interest in the contract.  (In order to qualify, it would have to be established that the consideration for the partial interest was at least equal to the net realizable surrender proceeds applicable to that same portion.)

The holding regarding second-to-die policies is notable, since this policy type is often used in qualified plan insurance ownership arrangements.

Transfers To Life Insurance Trusts

What about an irrevocable trust as purchaser?   Would a sale to a grantor trust be treated the same as a sale to a “plan participant insured under the contract” for purposes of PTE 92-6?

DOL has recently issued an amendment to PTE 92-6 in order to expand the coverage of the exemption to include the sale by a plan of an individual life insurance or annuity contract to a personal or private trust (e.g., an irrevocable life insurance trust) established by or for the benefit of an individual who is a participant in the plan and the insured under the policy, or by or for the benefit of one or more relatives (as defined in PTE 92-6) of the participant. (But for this amendment to PTE 92-6 the sale to such a trust would otherwise be a prohibited transaction if 50% or more of the beneficial interest of such trust is owned or held by a party in interest or fiduciary under the plan.)

In the preamble to the proposed amendment, DOL recognized that in many circumstances, the participant will have created a trust as part of his or her estate plan to hold a policy or policies on his or her life. The trust beneficiaries are typically the participant`s spouse or children or both, or other relatives. The trust will typically purchase insurance contracts on the life of the participant, including the policy from the plan, if available, with funds contributed by the participant or by one or more relatives. The trust will almost always be irrevocable and will commonly provide for the participant`s spouse or another relative, or an independent person, to be the trustee of the trust. DOL specifically acknowledges that such ILITs are a common and legitimate vehicle to avoid estate taxation of insurance death benefits, and provide planning advantages over the placing of policy ownership directly in a spouse or other relative.

Thus, DOL determined to amend PTE 92-6 to expand the scope of relief for sales of life insurance policies by qualified plans. Effective retroactively February 12, 1992 (the date that PTE 92-6 was originally promulgated), the amendment to PTE 92-6 expands the coverage of the exemption to include the sale by a plan of an individual life insurance or annuity contract to a trust established by or for the benefit of an individual who is a participant in the plan and the insured under the policy, or by or for the benefit of one or more relatives (as defined in PTE 92-6) of the participant. [See PWBA Federal Register Notice, Vol. 67, Number 91, pages 31835 (2002).]

Transfer For Value Rule

Any transfer of an insurance policy in a sale transaction will bring into play the transfer for value rule, which can have a major negative income tax impact. Thus, the general rule of IRC §101, under which the death benefit of a life insurance policy is excludable from gross income, is not applicable if the insurance policy, or any interest in the policy, has been transferred for a valuable consideration. The transfer for value rule does not apply, however, if the transfer is to the insured, to a partner of the insured, to a partnership in which the insured is a partner, or to a corporation in which the insured is a shareholder or officer. Utilizing this exception, the application of the rule can be avoided by creating a bona fide partnership between the insured and the purchaser of the policy. Note, however, that IRS rulings have raised red flags indicating that partnerships structured solely for purposes of qualifying for the “partner of the insured” exception may be challenged. [See PLR 9843024.]

In addition to the statutory exceptions to the transfer for value rule, court cases have sustained taxpayer arguments that the rule should not apply in situations where the policy was purchased by a party other than the insured, but under circumstances where the insured was indirectly the effective purchaser. See, e.g., Swanson v. Comm`r, 33 T.C.M. 296 (1974) [sale to the insured’s grantor trust]; Estate of Roth v. U.S., 77-1 USTC ¶9327 (D.C. Mich.) [sale to spouse of the insured pursuant to an employment contract that gave the insured the right to purchase the policy]. Whether this line of reasoning could be extended to a purchase by an ILIT established and funded by the insured is somewhat uncertain—although it is generally recognized that if the ILIT is structured as a grantor trust, there will be no problem. Additionally, the recent DOL amendment to PTE 92-6 (discussed above) lends indirect support to treating a sale to the insured’s ILIT as a sale to the insured, since the amendment also dealt with a rule that on its face had permitted a sale only to the insured (or a relative/beneficiary).

In any event, the transfer for value rule must be dealt with in any planning which contemplates the ownership and eventual sale (to avoid estate tax or otherwise) of a life insurance policy by a qualified plan.

The transfer for value rule is covered in detail in Section 19.1, Subdivision B2.

Purchase by the Insured Followed by Gift to the ILIT

The transfer for value problem can clearly be avoided by structuring a 2-step transaction under which the policy is first purchased by the insured, who then transfers it by gift to the ILIT. Of course, this still leaves a potential gift tax, but the gift tax issue would also be present if the policy were sold directly to a newly-created ILIT, where the funds for the purchase were provided by the grantor/insured.

Such a course does, however, involve its own potential risk—the so-called three-year rule. Under I.R.C. §2035, if incidents of ownership in a life insurance policy (which would have caused the death benefit to be included in the owner’s gross estate) are transferred within three years of the transferor’s death, the death benefit will nonetheless be includable in the transferor’s gross estate. The three-year rule can be avoided if the policy is sold directly to the ILIT (which, as pointed out above, would avoid the transfer-for-value rule if the ILIT is a grantor trust).

The three year rule is covered in detail in Section 2, Subdivision B.

Other Technical Considerations

In addition to the tax issues discussed above, there are a number of important technical issues that must be understood and appropriately dealt with in implementing the strategy and achieving the objective.

·         Plan Authorization to Invest in Life Insurance

·         I.R.C. Limits on Retirement Plan Investments in Life Insurance: The Incidental Benefit Rule

·         Important Exception Applicable In The Case Of A Profit Sharing Plan—Seasoned Money (2-Year And 5-Year Rule)

Plan Authorization to Invest in Life Insurance

Since the tax reduction strategy we are dealing with involves the purchase of life insurance by a qualified plan account, a threshold issue is whether or not a life insurance contract falls within the types of investments permitted under the plan documents. If not, or if the answer is unclear, the plan trustee would risk being in violation of its fiduciary duty by so investing plan assets—even if specifically requested by the account owner. If such an investment might be considered unauthorized under the plan documents, the plan would have to be amended to expressly permit the trustee to invest in life insurance contracts. Such an amendment might be easily accomplished in the case of a closely held small business utilizing a trustee with flexibility to accommodate the employer-sponsor, but would be more difficult or impossible, for example, in the case of a profit-sharing plan account of an employee who is not a major owner of the business.  

The plan documentation should also permit the distribution of assets in kind, which would allow for distribution of the life insurance contract.

I.R.C. Limits on Retirement Plan Investments in Life Insurance: The Incidental Benefit Rule

The tax advantages accorded to qualified retirement plans are aimed at arrangements designed primarily to provide income security for retirees.  If a plan also provides an insurance-funded death benefit, this is viewed as outside the scope of the retirement security objective. However, such a benefit is permitted without disqualifying the plan, as long as the death benefit remains only an “incidental” benefit in the plan as a whole [see Regs §1.401-1(b)(1)], i.e., small in economic value relative to the value of the retirement benefit.  This is measured by one or the other of two tests.  As long as either of the two tests is satisfied, the insurance-funded death benefit will qualify.

The Premium Percentage Test

Under this test, applicable to defined contribution type plans, the cumulative employer contributions for life insurance premiums must at no time exceed a certain percentage of the overall aggregate cost of the plan account.  The applicable percentage varies, depending upon the type of life insurance contract involved, as follows:  

Maximum percentage of total plan cost that may be paid for life insurance:

Term Insurance

25%

Whole Life

50%

Universal Life and VUL

25%

The applicable percentages are not definitively set forth in the Code or Regulations, but have emerged from a series of Revenue Rulings which apply the “incidental” standard to various fact patterns involving different types of life insurance contracts.  The percentages shown in the text represent a distillation of the holdings of several rulings.  See e.g., Rev. Rul. 61-164, 1961-2 C.B. 99; Rev. Rul. 66-143, 1966-1 C.B. 79; Rev. Rul. 68-31, 1968-1 C.B. 151; Rev. Rul. 68-453, 1968-2 C.B. 163; Rev. Rul. 70-611, 1970-2 C.B. 89; Rev. Rul. 73-501, 1973-2 C.B. 127; Rev. Rul. 76-353, 1976-2 C.B. 112.

(In the case of a defined benefit plan a test referred to as the "100-times test” is applied. This is not discussed here, since the tax reduction strategy that is the subject of this Current Comment relates to profit sharing plans.)

Important Exception Applicable In The Case Of A Profit Sharing Plan—Seasoned Money (2-Year And 5-Year Rule)

In the case of a profit sharing plan, funds which have been held for at least two years may be distributed to the plan participant without disqualifying the plan; thus, if any such accumulated funds, regardless of amount, are used to purchase life insurance for the plan participant, such a purchase would not be subject to the "incidental benefit" tests, regardless of the size of the policy. Moreover, a policy acquired with funds held in the plan at least two years could be distributed immediately after purchase.

For a newly-established profit-sharing plan account, during the first two years, the portion of contributions allocable to premium payments would be subject to the percentage limitations discussed above: 50 percent for a whole life policy and 25 percent for term, UL or VUL. See Rev. Rul. 60-83, 1960-1 C.B. 157;  Rev. Rul. 61-164, 1961-2 C.B. 99 and Rev. Rul. 71-295, 1971-2 C.B. 184.

Also, a profit sharing plan may allow participants with at least five years of participation to withdraw all employer contributions. Thus, in the case of any such participant, if any accumulated funds, regardless of amount and regardless of when contributed, are used to purchase life insurance for the participant, such a purchase would not be subject to the "incidental benefit" tests, regardless of the size of the policy, and the policy could be distributed to the account owner at any time after its purchase. See Rev. Rul. 60-83, 1960-1 C.B. 157 and Rev. Rul. 61-164, 1961-2 C.B. 99; Rev. Rul. 68-24, 1968-1 C.B. 150 and Rev. Rul. 71-295, 1971-2 C.B. 184.

Assets held in a plan for two years or more and all assets in an account that has been established under the plan for five years or more (including any amounts contributed within the prior 24 months) are sometimes referred to as “seasoned money” in connection with the application of the foregoing rules.

Summary and Conclusion

The utilization of a profit-sharing plan for the purchase of insurance on the life of the account owner can be an effective estate planning technique, with potential for materially reducing the dual tax impact that can devastate a sheltered retirement plan account balance upon the owner’s death.  The technique involves the key element of valuing the insurance policy upon its transfer from the plan, at an amount that is  less than the premiums paid for the policy by the plan trustee. However, achieving this through so-called springing cash value contracts can risk serious adverse consequences. Planners ought be mindful of  valuation concepts discussed in the companion Current Comment 03-09 and adhere to prudent design strategies in an effort to obtain favorable valuations.

Planners must also be aware of numerous technical issues, including the incidental benefit test, the transfer-for-value rule, and the ERISA prohibited-transaction rules.  

(April 2003 Current Comment)