The transfer of ownership of a life insurance contract can occur in a variety of contexts and to achieve a variety of objectives. Such transfers have potential tax consequences—income tax or transfer tax—depending upon the circumstances. In many instances the determination of the fair market value of the life insurance contract as of the date of the transfer will be a critical element in determining the tax consequences.
How is a life insurance contract valued for tax purposes? The answer is not so clear. Of course, the fundamental measure is fair market value—but how is that determined? Is it the cash surrender value as of the date of the transfer; the cumulative total of premiums paid; the interpolated terminal reserve; the insurer’s reserve account with respect to the policy; the replacement cost? Any one of these potential measures of value may be applicable, depending upon the context of the policy transfer.
Measures of value are prescribed in various provisions of the tax regulations, dealing with a variety of different policy transfer situations. The valuation measure most commonly mandated in the regulations is “cash value,” a phrase commonly assumed to be synonymous with cash surrender value, or the amount that could be received from the insurer if the policy had been surrendered as of the date of the transfer.
Yet, the IRS has, in at least one regulation and in several administrative pronouncements, taken the position that “cash value,” may not necessarily be the surrender value, as determined under the contract, when such surrender value is not representative of the true fair market value—which, of course, is the ultimate measure to be determined. Much of the murkiness on this subject results from the IRS’s efforts to quash perceived abuses that have arisen through so-called “springing cash value” insurance contract designs, discussed in more detail below.
Let’s consider several regulations specifically addressing this valuation issue:
Reg. §1.72-16(c)(2)(ii), dealing with the income taxation of the cash value portion of the death benefit from a policy owned by a qualified plan.
If the life insurance contract has a “reserve accumulation” intended to fund benefits under the plan, “such reserve accumulation constitutes the source of the cash value of the contract and approximates the amount of such cash value.”
Reg. §1.83-3(e), dealing with the transfer of property as compensation for services.
In the case of the transfer of a life insurance contract “only the cash surrender value of the contract is considered to be property.”
Reg. §1.402(a)-1(a)(2), dealing with the taxable income resulting from the distribution of a life insurance contract from a qualified plan account to the account owner.
The entire “cash value” of the contract at the time of distribution must be included in the distributee’s income in accordance with I.R.C. §402(a).
Reg. §25.2512-6(a), dealing with valuation, for gift tax purposes, of policies transferred by gift.
In the case of a single-premium or paid-up policy, the value would be measured by the single-premium cost of an identical policy, purchased as of the date of the gift. In the case of a contract requiring future premium payments, “the value may be approximated by adding to the interpolated terminal reserve at the date of the gift” the proportionate part of the gross premium last paid” that relates to any period extending beyond that date. [No reference is made to “cash value” or “cash surrender value.”]
Reg. §301.6332-2(d), relating to the value accessible through enforcement of a federal tax lien against a life insurance contract.
The government is authorized to foreclose a tax lien “to reach the cash surrender value” of a life insurance contract.
As we can see from the foregoing regulations, there is variation among the approaches to valuing a policy. Some regulations use the term “cash surrender value,” the meaning of which seems quite unambiguous—whereas, the more frequently used term is “cash value.” Is there a difference in intended meaning between these two phrases? Probably not, at least as of the points in time that these various regulations were drafted. In the parlance of the insurance industry “cash value” (as opposed to "account value") means the same thing as “cash surrender value.”
Nonetheless, the IRS has found it necessary to interpret “cash value” as not necessarily the same as cash surrender value, in order to thwart valuation practices involving insurance policies structured with artificially deflated cash surrender values, which may not reflect the true fair market value of the policy. These have become known as “springing cash value” policies.
IRS Notice 89-25
One of the early IRS pronouncements dealing with springing cash value policies was Notice 89-25 [1989-1 C.B. 662]. This notice used as an example a situation in which a qualified plan purchased a life insurance policy on the life of the account owner, with a single premium of $400,000. After two years the policy was distributed to the insured. At the time of the distribution, the policy had a stated cash surrender value of $112,360. However, the “life insurance reserves” (calculated using the rules in I.R.C. §807(d), dealing with reserve calculations in determining the tax liability of the insurance company) at that point were $426,596.
(The stated surrender value and the policy reserve amount both increased somewhat in each year but the substantial gap between the two amounts remained relatively constant—until the end of the 5th policy year, at which point the surrender value sprang from $126,248 to $489,908, at that point matching the reserve amount. It is this belated dramatic increase in the surrender value following the taxable transfer of the policy, that gives rises the term “springing cash value.”)
Citing Reg. §1.72-16(c)(2) (mentioned above), which determines value by reference to “reserves,” the IRS takes the position that the policy reserves “represent a much more accurate approximation of the fair market value of the policy when distributed than does the policy’s cash surrender value.” The notice goes on to point out that a distribution that turns out to be nearly four times as great as the parties expected could result in some very serious unexpected consequences under the Code sections governing permissible actions by qualified plans. These consequences could extend to treating the purchase of such a policy by the plan as a prohibited transaction or even as a form of discrimination in favor of a highly compensated employee, which would cause loss of qualified status for the plan. And, of course the taxable income to the distributee of the policy would be more than $310,000 greater than anticipated.
The important point to be taken from this Notice is that even though the governing regulation, §402(a)-1(a)(2), dealing with distributions of insurance contracts from qualified plans, uses the term “cash value” as the measure of fair market value, “cash value” need not necessarily mean cash surrender value. Stated another way, the IRS does not view the regulation as mandating the use of cash surrender value, when the phrase “cash value” is used.
IRS Announcement 92-182
Notice 89-25 was followed up by revisions to the IRS audit manual for employee plans, directing auditors to examine distributions of life insurance policies that might be springing cash value policies. These audit guidelines were announced to the public in IRS Announcement 92-182. In general, if the surrender value at the time a policy is distributed by a plan is “much lower” than the premiums paid by the plan, the policy may be treated as a springing cash value policy, subject to valuation adjustment. The guidelines call for revaluation based on “replacement cost” of the policy, which most likely would be measured by reference to cumulative premiums paid.
It should be noted that this approach by the IRS may arguably be inconsistent with the express provision of Reg. §402(a)-1(a)(2), which uses “cash value” as the basis for valuation. While Notice 89-25 held that this may not necessarily mandate “cash surrender value,” the Service’s position in Announcement 92-182 goes beyond the scope of Notice 89-25, which referred specifically to the policy reserve amount as the measure of cash value (and had at least tangential support for this under another regulation, §1.72-16(c)(2)). However, the policy reserve methodology can not be neatly applied when a universal life or variable universal life policy is involved. Thus, Announcement 92-182 plunges ahead and seems to authorize challenges to valuation without regard to the “cash value” language of the applicable regulation. Technically, it seems difficult to sustain an argument that the term “cash value” can be interpreted as meaning cumulative premiums paid. Nonetheless, it is clear that the IRS’s guidelines call for challenges to what it perceives as springing cash value arrangements.
Considerations for Qualified Plans
Finally, it should be noted that, under certain circumstances, the purchase of a so-called springing cash value contract by a qualified plan, and its subsequent "pre-spring" transfer out of the plan, could represent a risky proposition for the plan administrator/trustee, quite possibly amounting to a breach of fiduciary duty.
Effectively using life insurance to reduce the tax bite on retirement plan assets at death is explored in detail in the separate companion Current Comment 03-10.
While one could argue that the Service is exceeding its
authority, by effectively ignoring the “cash value” standard of measurement
mandated in Reg. §402(a)-1(a)(2), such a stance
involves some risk. As we have seen in several contexts in recent years,
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. Be governed by your
common sense and remember the
(April 2003 Current Comment)