IRS and Treasury Complete Guidance on Valuation of Life Insurance Contracts in Employee Benefit Arrangements

By Carol A. Weiser, George H. Bostick, Adam B. Cohen, Ian A. Herbert, Carol T. McClarnon, Alice Murtos, Robert J. Neis, W. Mark Smith, William J. Walderman, Brendan M. Wilson and Walter H. Wingfield

On August 29, 2005, the Internal Revenue Service and the Treasury completed a two-year project to provide guidance on the valuation of life insurance contracts in employee benefit arrangements. The final regulations were issued under Internal Revenue Code sections 402, 79 and 83 regarding the amount of taxable income recognized on the distribution or transfer of a life insurance contract. Previously, in February 2004, and in conjunction with guidance issued by the Service aimed at certain products being marketed for section 412(i) plans:

• The Treasury proposed regulations providing that fair market value is the measure of the value of a life insurance contract distributed from a qualified retirement plan to a participant (§1.402(a)-1(a)(iii)) or transferred to an employee in connection with the performance of services (§1.83-3(a)), and of a "permanent benefit" provided under a group term-life insurance program (§1.79-1(d)(3)). The proposed regulations did not specify how fair market value is to be determined, but indicated that it included the surrender value plus the value of all other rights under the contract, such as a springing cash value feature and surrender charges that are not expected to be actually paid; and
• The Service issued an interim safe harbor (Rev. Proc. 2004-16) for using the cash value without reduction for surrender charges as fair market value, subject to certain conditions.

See Legal Alert sent March 5, 2004. In response to public comments, earlier this year the Service modified those safe harbor formulas (Rev. Proc. 2005-25).

The final regulations substantially retain the approach of the proposed regulations, with some refinements. The net effect of this guidance project is as follows:

• Effective February 13, 2004, (i) the fair market value of a life insurance contract distributed to a participant from a qualified plan is taxable unless within 60 days the life insurance contract is converted to a nontransferable annuity contract or the contract is treated as a rollover contribution, and (ii) in the case of a life insurance contract transferred from a qualified plan to a participant for consideration, any difference between fair market value and the consideration paid by the participant is also treated as a taxable distribution.
• Effective August 29, 2005, any such bargain sale element is also treated as a distribution for all other purposes of the Code, including section 401(a) qualification requirements, limitations on in-service distributions and section 415 limitations.
• Similarly, fair market value is used to value permanent benefits provided under a section 79 program on or after February 13, 2004, that must be included in an employee’s taxable income, less any amount for such benefits paid by the employee.
• Finally, the fair market value of a life insurance contract transferred to an employee in connection with the performance of services on or after February 13, 2004, less the amount paid by the employee, is taxable under section 83 – that is, the new section 83 definition of "property" for split-dollar arrangements is extended to all situations involving the transfer of contracts providing life insurance protection. This final regulation does not, however, apply to (i) pre-January 28, 2002, split-dollar life insurance contracts that qualify for relief under Notice 2002-8, or (ii) the transfer of a life insurance contract that is part of a split-dollar arrangement entered into on or before September 17, 2003, and not materially modified thereafter, as described in existing Reg. §1.61-22(j).
• Fair market value includes the policy cash value and the value of all rights under the contract, including any supplemental agreements and whether or not guaranteed. In determining fair market value, the safe harbor formulas of Rev. Proc. 2005-25 may be relied on for all periods; the formulas of Rev. Proc. 2004-16 may alternatively be used for periods on or after February 13, 2004, and before May 1, 2005.

The final regulations also incorporate a rule proposed under ERISA in 1975 but not previously adopted in final form, providing that the distribution of an annuity contract must be treated as a lump sum distribution for purposes of determining the tax due under the 10-year averaging rule of section 402(e) (as in effect prior to the Tax Reform Act of 1986) even if the distribution of the annuity contract itself is not taxable.

© 2005 Sutherland Asbill & Brennan LLP. All Rights Reserved.

This article is for informational purposes and is not intended to constitute legal advice.