Abstract. The Internal Revenue Code. Discrimination Rules

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1 Life Insurance as an Asset Class in Defined Contribution Plans: A Detailed Analysis Richard D. Landsberg, JD, LLM, MA, CLU, CPM, ChFC, RFC, AIF Director, Advanced Consulting Group Nationwide Financial Abstract At a glance, offering life insurance in a qualified defined contribution plan sounds like a cost efficient way to provide plan participants with life insurance protection. However, there are certain considerations that need to be taken into account before a decision is made whether to offer life insurance as an investment option under a qualified plan. This article examines what a plan sponsor should consider from a practical perspective before offering life insurance as an investment option under a qualified defined contribution plan. The Internal Revenue Code Discrimination Rules It is well established that life insurance is a benefit, right, and feature under a qualified plan. Accordingly, in order to offer life insurance as an investment option under a plan, it must be offered in a manner that is not discriminatory, both in form and in effect. Internal Revenue Code ( IRC or Code ) Section 401(a)(4) states that either the contributions or benefits provided under a plan must not discriminate in favor of the highly compensated employees. Specifically, all benefits, rights, and features under a plan must be currently and effectively available in a nondiscriminatory manner. 1 The regulations promulgated under Code Section 401(a)(4) reflect that the currently available requirement is satisfied if the group of employees to whom a benefit, right or feature is offered satisfies the mathematical tests of Section 410(b). In a nutshell, Code Section 410(b) indicates that, in order for a plan to be qualified, either: 1 Treas. Reg (a)(4)-1(b)(3); LaCombe, Elizabeth A. Life Insurance in Qualified Defined Contribution Plans Journal of Pension Benefits (Vol. 15, No. 2, Winter 2008) 1

2 The plan benefits at least 70% of the Non-Highly Compensated Employees (NHCEs); The percentage of NHCEs who benefit under the plan is at least 70% of the Highly Compensated Employees (HCEs) that are benefiting under the plan; or The plan satisfies the nondiscriminatory classification test under the average benefit test of Treasury Regulation Section 1.410(b)-5. If an ancillary benefit is available on different terms to different participants then each level of availability is tested separately. 2 Taken a step further, this can be read with substantial authority to mean that each term under a policy is considered to be a benefit, right and feature. 3 Probably, the biggest breach of this discriminatory rule is where practitioners advocate using permanent, cash value life insurance for some plan participants and term life policies for the balance of participants in a single plan. 4 Keep in mind, that each benefit, right and feature must not only be available to a group of participants that satisfies coverage testing under Sec. 410(b) but also effectively be available to a group of participants that does not favor the highly compensated under Reg. Sec (a)(4)-4. Consequently where a different series of policies are used in a single plan or where entirely different policies are used in a qualified plan, the differences themselves would be subject to testing under Sec. 401(a)(4) and would inevitably cause the plan to fail to be qualified. As indicated by the IRS in numerous private letter rulings, the intent of the plan sponsor is not conclusive in determining whether a benefit is currently available. It simply makes sense to offer life insurance to all NHCEs. Even if no NHCEs accept the offer, the life insurance benefit should satisfy the current availability test. The Treasury Regulations provide an example of a benefit offered under a plan that substantially favors HCEs, and is therefore not effectively available to the NHCEs. In that example, an age and service condition precludes all but two NHCEs from qualifying for the plan s early retirement benefit, and is therefore not effectively available to the NHCEs. If a plan sponsor offered life insurance, carte blanche, to all participants, it would be difficult to argue that this benefit is not effectively available to all employees or that it discriminates in favor of highly compensated employees. To summarize, if life insurance is offered under a tax qualified plan, it must be currently and effectively available to all employees on a nondiscriminatory basis. Plan fiduciaries should 2 Treas. Reg. Sec (a)(4)-4(e)(2). 3 Treas. Reg (a)(4)-3(b)(vii); LaCombe, Elizabeth A. Life Insurance in Qualified Defined Contribution Plans Journal of Pension Benefits (Vol. 15, No. 2, Winter 2008) 4 Treas. Reg (a)(4)-2(c), 1.401(a)(4)-3(d), 1.401(a)(4)-8(b), 1.401(a)(4)-8(c), 1.401(a)(4)- 9(b), 1.410(b)-5. Landsberg, Richard D. Section 412(e) Fully Insured Defined Benefit Plans & the Perils of Unintended Consequences Journal of Pension Planning & Compliance (Vol. 29, No. 3, Fall 2004) 2

3 familiarize themselves with the nondiscrimination rules before offering life insurance as an investment option under the plan. The failure to satisfy the Section 401(a)(4) rules is difficult to correct under the Employees Plan Compliance Resolution System, or EPCRS, and may result in plan disqualification. 5 However, there is the possibility of retroactive correction within 9½ months following the close of the plan year under the Treasury Regulation. Where an employer maintains one or more defined benefit and defined contribution plans the combined plan limits come into play. This is often misunderstood in light of new tax laws. For limitation years that began before 2000, if an employee participated in both a defined benefit and defined contribution plan, a special formula the 1.0 rule was used to determine the combined maximum limit on benefits and contributions. 6 This combined plan funding limitation was repealed by the 1996 tax law changes. 7 After the repeal of the 1.0 rule, a participant will be able to receive the maximum benefit under a defined benefit plan and the maximum contribution under a defined contribution arrangement at the same time. What is important to realize with regard to combined plans is that although the combined plan limitations have been repealed, nothing has changed the deductibility of contributions to combined plans. 8 Consequently, the greater of 25% of the aggregate compensation of all employees or the amount necessary to meet the minimum funding standard for the defined benefit plan is the deductible amount under Sec. 404(a)(7). The bottom line is that although both plans can be fully funded under existing limitation rules, not all of the contributions will be deductible in the year contributed. 9 Another issue, closely related is that of plan aggregation for discrimination and coverage testing. The rules are fairly straight forward that when testing for nondiscrimination of benefits under Sec. 401(a)(4) or for compliance with plan coverage under Sec. 410(b), the plan can be aggregated with other plans. 10 The hang-up, however, is that if a plan is aggregated with another plan to demonstrate compliance for nondiscriminatory benefits it also has to be 5 Rev. Proc , C.B LaCombe, Elizabeth A. Life Insurance in Qualified Defined Contribution Plans Journal of Pension Benefits (Vol. 15, No. 2, Winter 2008) 6 Treas. Reg (a)(4)-3(d)(e). Landsberg, Richard D. Section 412(e) Fully Insured Defined Benefit Plans & the Perils of Unintended Consequences Journal of Pension Planning & Compliance (Vol. 29, No. 3, Fall 2004) 7 Treas. Reg (a)(4)-5. Landsberg, Richard D. Section 412(e) Fully Insured Defined Benefit Plans & the Perils of Unintended Consequences Journal of Pension Planning & Compliance (Vol. 29, No. 3, Fall 2004) 8 Rev. Rul , C.B. 169; Rev. Rul , C.B Landsberg, Richard D. Section 412(e) Fully Insured Defined Benefit Plans & the Perils of Unintended Consequences Journal of Pension Planning & Compliance (Vol. 29, No. 3, Fall 2004) 9 Treas. Reg (a)(4)-4(e)(2). Landsberg, Richard D. Section 412(e) Fully Insured Defined Benefit Plans & the Perils of Unintended Consequences Journal of Pension Planning & Compliance (Vol. 29, No. 3, Fall 2004) 10 Treas. Reg. Secs (b)-7(d) and 1.401(a)(4)-13. Landsberg, Richard D. Section 412(e) Fully Insured Defined Benefit Plans & the Perils of Unintended Consequences Journal of Pension Planning & Compliance (Vol. 29, No. 3, Fall 2004) 3

4 aggregated to determine compliance for coverage purposes. In other words, if aggregated to pass 401(a)(4), it must be aggregated to pass 410(b). 11 The Incidental Benefit Rule A plan may offer life insurance as an investment option provided that the death benefit protection is an incidental benefit; i.e., a benefit incidental and subordinate to the plan s primary purpose of providing deferred compensation to participants and their beneficiaries. Specifically, Treasury Regulations indicate that [a] profit-sharing plan within the meaning of Section 401 is primarily a plan of deferred compensation, but the amounts allocated to the account of a participant may be used to provide for him or his family incidental life or accident or health insurance. 12 In other words, the payment of premiums for life insurance is limited to ensure that the benefit being offered, i.e., death benefit protection, is incidental to the plan s primary purpose of providing deferred compensation. The amount from a participant s account which may be allocated towards the payment of premium due under a life insurance policy varies in accordance with the type of plan being sponsored, as well as the type of insurance that is being offered. An employees pension, profitsharing, or stock bonus plan, intended to qualify under Code Section 401, must provide primarily for benefits, the distribution of which is deferred. 13 The IRS has indicated that a trust forming a part of a profit-sharing plan having once established its qualification under Section 401(a) may subsequently lose its exemption from tax, if its funds are distributed in a prohibited manner. 14 The use of trust funds to pay for the cost of current benefits, such as life insurance protection, for participants and their beneficiaries, is a distribution. 15 The IRS has ruled that if the terms of a defined contribution plan provide for the use of trust funds to pay premiums for life insurance, and the contributions have been held for at least two years, the incidental benefit test is satisfied, and the distribution that occurs as a result of purchasing insurance is not one that disqualifies the plan Internal Revenue Code of 1986, as amended, 415(e), 415(f); Treas. Reg ; SBA (a), (d); IRS Notice 99-44, IRB 326. Landsberg, Richard D. Section 412(e) Fully Insured Defined Benefit Plans & the Perils of Unintended Consequences Journal of Pension Planning & Compliance (Vol. 29, No. 3, Fall 2004) 12 Treas. Reg (b)(1)(ii). LaCombe, Elizabeth A. Life Insurance in Qualified Defined Contribution Plans Journal of Pension Benefits (Vol. 15, No. 2, Winter 2008) 13 LaCombe, Elizabeth A. Life Insurance in Qualified Defined Contribution Plans Journal of Pension Benefits (Vol. 15, No. 2, Winter 2008) 14 Revenue Ruling 60-83, , C.B LaCombe, Elizabeth A. Life Insurance in Qualified Defined Contribution Plans Journal of Pension Benefits (Vol. 15, No. 2, Winter 2008) 15 Treas. Reg (a)-1(a)(3)]. LaCombe, Elizabeth A. Life Insurance in Qualified Defined Contribution Plans Journal of Pension Benefits (Vol. 15, No. 2, Winter 2008) 16 LaCombe, Elizabeth A. Life Insurance in Qualified Defined Contribution Plans Journal of Pension Benefits (Vol. 15, No. 2, Winter 2008) 4

5 If the trust funds that are being used to pay premiums on a whole life insurance policy have not been held for at least two years, the plan must satisfy what is known as the 50%/25% rule. That is, the total amount of premiums paid on a whole life policy must at all times be less than 50% of the aggregate of contributions and forfeitures allocated to the credit to a participant (disregarding trust earnings and capital gains and losses). In addition, the plan must: 17 require the trustee to convert the entire value of the life insurance contract at or before retirement into cash, provide periodic income so that no portion of the value may be used to continue life insurance protection after retirement, or distribute the policy to the participant. If, instead of purchasing whole life insurance protection, plan assets that have not been held for two years are being used to purchase term or universal life insurance, the rules reflected above generally apply with one exception. That is, the total amount of premiums paid must not exceed 25% of the aggregate of contributions and forfeitures allocated to the credit to a participant (disregarding trust earnings and capital gains and losses). 18 Fair Market Value Proposed Regulations There has never been a complete and thorough definition of life insurance for federal tax purposes. To support this hypothesis it is only necessary to look at the sections of the Internal Revenue Code for which the proposed regulatory package seeks to address. Under Code Sec. 83 the cash surrender value is considered property for purposes of determining the income tax effects to the employee. Under Sec. 79, the economic benefit focuses on the current value of life insurance protection without regard, it seems, to cash equity buildup. Finally, under Sec. 402 the interpolated terminal reserve value of the equity component has always been emphasized to exclusion of net life insurance protection. 19 Under the qualified plan rules, Notice recognized that a life insurance policy may have a value substantially higher than the stated cash surrender value. Specifically, the Notice provided that cash surrender value may not be used as a proxy for policy value where total policy reserves represent a more accurate approximation of value. The IRS, has recognized further that even reserves can be manipulated and like cash surrender value, may not accurately represent a policy s true value. Consequently, the IRS has provided 20 that for a non-variable 17 Rev. Rul , C.B. 127, as modified by Rev. Rul , C.B. 126; Rev. Rul , C.B. 89, as modified by Rev. Rul , C.B. 132; Rev. Rul , C.B. 99; LaCombe, Elizabeth A. Life Insurance in Qualified Defined Contribution Plans Journal of Pension Benefits (Vol. 15, No. 2, Winter 2008) 18 Rev. Rul , C.B. 99, and Rev. Rul , C.B. 79; LaCombe, Elizabeth A. Life Insurance in Qualified Defined Contribution Plans Journal of Pension Benefits (Vol. 15, No. 2, Winter 2008) 19 Landsberg, Richard D. Valuation Rules & Safe Harbors The Journal of the Society of Financial Service Professionals (Vol. 59, No. 4, July 2005) 20 Revenue Procedure ; Landsberg, Richard D. Valuation Rules & Safe Harbors The Journal of the Society of Financial Service Professionals (Vol. 59, No. 4, July 2005); Section 412(e) Fully Insured Defined Benefit 5

6 policy, cash surrender value (without any reduction for surrender charges) may be used as the fair market value of the policy provided that the cash surrender value is at least as large as the aggregate of: The premiums paid from the date of issue through the date of determination (of fair market value); plus Any amounts credited or otherwise made available to the policyholder with respect to those premiums, including interest, dividends, and similar income items; minus Reasonable mortality charges and other reasonable charges but only if those charges are actually charged on or before the date of determination and are expected to be paid. For a variable policy, investment return and current market value of segregated asset accounts are considered rather than dividends in a whole life policy or interest crediting in a universal life policy. The date of determination of fair market value is generally the date of transfer or distribution for purposes of Sec. 83 and 402 in qualified plans. The date of transfer or distribution is the date of the provision of permanent benefits for Sec. 79 purposes. 21 Revenue Ruling addressed issues of excess benefits. Close scrutiny of the ruling reveals that IRS is addressing the exclusive purpose requirement that qualified plans exist for the purpose of providing retirement benefits. In one issue, the IRS concluded that the death benefit provided by the life insurance was in excess of the death benefit under the terms of the plan and the IRS held that the excess amount was nondeductible. It is important to remember in any discussion of excess benefits that Sec. 404 and its regulations determine the limits of deductibility, which are generally based upon the amounts determined under Sec. 412 for an applicable plan year. Revenue Ruling addressed non-discrimination issues between highly compensated employees and non-highly compensated employees with respect to purchase rights to each in life insurance policies held in a qualified plan. Revenue Ruling holds that qualified plans that include life insurance do not meet the non-discrimination test of Sec. 401(a)(4) where a plan: Permits highly compensated employees prior to distribution of retirement benefits to purchase their life insurance policy prior to retirement; and Non-highly compensated employees purchase rights under the plan, prior to distribution of retirement benefits are not of inherently equal or greater value than the purchase rights of highly compensated employees. Plans & the Perils of Unintended Consequences Journal of Pension Planning & Compliance (Vol. 29, No. 3, Fall 2004) 21 Landsberg, Richard D. Valuation Rules & Safe Harbors The Journal of the Society of Financial Service Professionals (Vol. 59, No. 4, July 2005); Section 412(e) Fully Insured Defined Benefit Plans & the Perils of Unintended Consequences Journal of Pension Planning & Compliance (Vol. 29, No. 3, Fall 2004) 6

7 Finally, it is important to note that the IRS released Revenue Procedure which modifies and supersedes Revenue Procedure , regarding the valuation of life insurance contracts for purposes of Sections 79, 83 and 402 of the Code. The new rules under are applicable for all valuations on or after May 1, For valuations determined on or after the prior guidance of February 13, 2004 and before May 1, 2005 either the old or new safe harbor can be used as the taxpayer elects. 23 In other words, we now have a refined approach to the problem of manipulating cash surrender values. The guidance expressly addresses valuation of life insurance contracts in three situations. Of paramount importance to the reader is that addresses distributions and sales from qualified plans under Sec. 402 including Sec. 412(e) arrangements. The guidance of does not set forth a valuation methodology or process or formula for the determination of fair market value of a life insurance policy. Rev. Proc instead articulates a guiding principle that life insurance contracts reflect fair market value only when taking into consideration the value of all guaranteed and non-guaranteed rights under the contract including any supplemental agreements to the policy. 24 Rev. Proc provides new safe harbors for variable and non-variable life policies while introducing the concept of average surrender factor that is used to adjust potential surrender charges. The governing principle creates compliance by exclusion as if to say, the parameters of policy valuation under the safe harbors are predicated upon not falling beyond the general rules of construction enumerated within the Rev. Proc. These general rules are: 25 Guidance must be interpreted in a reasonable manner, consistent with the purposes of identifying fair market value; Mere compliance with the letter of the guidance will not necessarily prevail where schemes to suppress or attempt to suppress the fair market value are present. Income calculated as premiums paid must be accounted for as an amount credited Mortality and expense where expected to be directly or indirectly returned to the contract holder cannot be deducted. Surrender charges will be ignored where used to artificially understate market value in the calculation of average surrender factor Safe harbor valuations are not formally tied to the cash surrender value of the policy. 22 Revenue Procedure Internal Revenue Bulletin No , April 25, 2005, at Landsberg, Richard D. Valuation Rules & Safe Harbors The Journal of the Society of Financial Service Professionals (Vol. 59, No. 4, July 2005); 24 Id. 25 Id. 7

8 What this means to every producer in the advanced markets is that any compensatory life insurance arrangement whether involving a qualified plan or non-qualified plan or welfare benefit plan is now subject to the policy valuation rules of Revenue Procedure Non compensatory arrangements are also subject to the new fair market rules where issues of estate and gift taxation are involved with life insurance policy valuation. As stated previously, in discussion of discrimination testing benefits, rights and features of a qualified retirement plan must be available and as valuable to non-highly compensated participants as those same elements are to highly compensated employees. To this commentator, without splitting hairs, it is clear from this guidance that unless life insurance policies are provided to the highly and non-highly compensated in an administrative format that is identical in all respects then the nondiscrimination requirement of Sec. 401(a)(4) will not be met and plan disqualification is a possibility. Structuring Life Insurance in Defined Contribution Plans Although it may sound simplistic, a best practice in setting up the policy is to designate the plan as the policy owner and beneficiary, and designate the participant as the insured. Because qualified trust funds are being used to fund the policy, the policy itself is a plan asset and, hence, is subject to the exclusive benefit and anti-assignment and alienation provisions. 26 Code Section 401(a)(2) provides that the trust instrument of a qualified trust must make it impossible, at any time prior to the satisfaction of all liabilities with respect to employees and their beneficiaries under the trust, for any part of the corpus or income to be (within the taxable year or thereafter) used for, or diverted to, purposes other than for the exclusive benefit of his employees or their beneficiaries. This rule, generally referred as the exclusive benefit rule, ensures that plan assets will be held for the exclusive benefit of plan participants and their beneficiaries. 27 If the owner or beneficiary of a life insurance policy is someone other than a plan participant, arguably the exclusive benefit rule would be violated as these parties could exercise their rights under the policy to divert plan assets away from the participant, and his or her beneficiaries. In addition, allowing an individual other than a plan participant to serve as the owner or beneficiary of a life insurance policy may cause the plan to run afoul of the anti-assignment and alienation provisions set forth in Code Section 401(a)(13). Those provisions generally prohibit the assignment or alienation of benefits under the plan LaCombe, Elizabeth A. Life Insurance in Qualified Defined Contribution Plans Journal of Pension Benefits (Vol. 15, No. 2, Winter 2008) 27 Id. 28 Id. 8

9 Often overlooked, but jus as important to the discussion is whether a participant who currently owns an individual life insurance policy, can transfer it to the plan. To the extent the terms of the plan permit, a participant may be able to transfer an existing individual life insurance policy to the plan without running afoul of the prohibited transaction rules set forth under the Internal Revenue Code as well as ERISA. 29 Specifically, the Department of Labor has opined that if: A plan pays, transfers, or otherwise exchanges not more than the lesser of: the cash surrender value of the contract; or in the case of a defined contribution plan, the value of the participant s account balance; Such sale, transfer, or exchange does not involve any contract which is subject to a lien which the plan assumes; Such sale, transfer, or exchange does not contravene any provision of the plan or trust document; and A plan does not with respect to such sale, transfer, or exchange, discriminate in form or in operation in favor of participants who are officers, shareholders, or highly compensated employees then, the exemption from the restrictions set forth in ERISA Sections 406(a) and 406(b)(1) and (2) and from the taxes imposed by Code Section 4975(a) and (b), by reason of Code Section 4975(c)(1) (A) through (E), is available. In other words, as long as the proposed sale, transfer, or exchange of an individual life insurance policy owned by a plan participant to a plan satisfies the conditions set forth above, the participant and the plan will enjoy immunity from the penalties and taxes on prohibited transactions set forth in the Internal Revenue Code and ERISA. Getting the Policy Out of the Plan When evaluating the prudence of offering life insurance as an investment option, it would behoove a plan sponsor to consider the federal income tax consequences associated with transferring life insurance out of a plan. Life insurance, unlike other investment options under a plan, is not liquid and presents unique challenges from a tax planning perspective. 30 Accordingly, the plan sponsor should consider the options that are available to plan participants if the participant no longer wants to have insurance through the plan or the plan sponsor wants to cease offering life insurance as an investment option under the plan. 31 If a participant does not want or need death benefit protection, he or she may ask the trustee to cash in the policy and reallocate the proceeds among other investment options under the plan. Because neither the proceeds nor the policy would ever leave the tax qualified trust, the participant would not be subject to federal income taxation on this reallocation of trust funds Prohibited Transaction Exemption (PTE) 92-5, (57 FR 5019, February 11, 1992); 30 LaCombe, supra 31 Id. 32 Id. 9

10 If a participant wants to own the policy in an individual capacity for estate planning purposes, are there any options? Assuming that the terms of the plan permit, and that there has been a distributable event under the plan, the following options may be available: The participant could request and receive a distribution of the policy from the plan. In 2005, the IRS amended regulations promulgated under Code Sections 79, 83, and 402(a), to address distributions of life insurance and related products from qualified plans. These regulations provide that if a qualified plan transfers property to a plan participant in exchange for consideration that is less than the fair market value of the property, the transfer will be treated as a distribution by the plan to the participant to the extent the fair market value of the distributed property exceeds the amount received in exchange. 33 For federal income tax purposes, the participant would include in income the cash surrender value of the policy distributed less any annual renewable term ( ART ) life insurance costs. ART costs are one-year term premiums that are treated as taxable distributions and are reported annual on Forms 1099-R. The participant receives basis or credit for amounts previously subject to taxation to ensure that such amounts are not subject to taxation again. 34 Federal taxation could be avoided if the participant converted the policy into an annuity without a life insurance element, or directly rolled the policy over into a new employer s plan. The latter option would be available if the new employer offered life insurance as an investment option under the plan and the requirements of Department of Labor Prohibited Transaction Exemption 92-6 were satisfied. 35 To qualify for relief from the prohibited transaction rules under ERISA as well as under the Internal Revenue Code, the following requirements must be satisfied: the sale must be to a participant or to a relative of the participant who is a beneficiary under the contract; the plan, but for the sale, would surrender the contract; and the purchase price must put the plan in the same cash position as if it had retained the contract, surrendered it, and distributed the participants vested interest in the plan. 36 The Department of Labor expanded PTE 92-6 in 2002 to allow transfers of contracts directly to life insurance trusts and other personal trusts. The trustee could cash in the policy and distribute the proceeds of the policy to the participant. The participant would be subject to federal income tax on the cash surrender value of the policy without regard to ART costs. Consequently, the 33 Id. 34 LaCombe, supra; Landsberg, supra 35 PTE 92-6 (May 10, 2002), FR, vol. 67, no. 91; LaCombe, supra; Landsberg, supra 36 Id. 10

11 distribution is taxed in the same manner as any other distribution from the plan. However, by cashing in the policy, the participant would be able to roll over the proceeds of the policy to an IRA. Please note that a life insurance policy itself may not be rolled over into an IRA because life insurance is not a permitted investment for IRAs. 37 Finally, the trustee of the plan could take a loan against the cash surrender value of the policy, leaving just enough cash surrender value to equal the policy s ART costs. The plan could then distribute the policy to the participant income tax free. The amount borrowed by the trustee from the policy could be rolled over into an IRA. The participant could then cash in the policy or continue to maintain it using after tax money or withdrawals from the IRA to repay the loan. The participant, of course, would also be responsible for the payment of future premiums due under the policy, as well as repayment of the policy loan. 38 Selection of which option may be best for the participant depends upon the facts and circumstances of each case with guidance from local tax counsel. For example, if the life insurance policy is a Modified Endowment Contract, or a MEC, as defined under Code Section 7702A, distributions from such policy, including loans, are taxed on an income-out-first basis and, if the participant is not age 59½, may also be subject to a 10% premature distribution penalty. If the policy is a MEC while owned by the plan, the policy will, absent IRS correction, also be a MEC when transferred to the individual. The federal income tax treatment of MECs may dissuade plan sponsors from cashing out such policies, or allow participants to take loans against them, while they are still owned by the plan as they could generate unrelated business income tax for the qualified trust. 39 Having said that, if a plan sponsor is thinking of offering life insurance as an investment option under a plan, he or she should ensure that the terms of the plan are flexible enough to cover those situations where the participant either no longer desires insurance protection or wants to own such coverage outright. Springing Cash Values on Policy Exit Our tax code is predicated upon symmetry. Deduction requires income inclusion simultaneously. There is, of course, the legislative grace that is the basis of the qualified retirement plan disconnect to tax code symmetry. The point of this hypothesis is that qualified retirement plans permit a current tax deduction for employer contributions to an arrangement intended to comply with the rules of Sec. 401(a) of the IRC. This deduction is allowed without immediate income recognition and inclusion to the individual on whose behalf those contributions were made. The symmetry is, therefore, disconnected. Deduction currently, income inclusion in the future. Consistent with tax code symmetry is the concept of fair market value. Income inclusion requires 37 LaCombe, supra 38 Id. 39 Id. 11

12 that property, cash, stocks, bonds, etc. be recognized for tax purposes at the fair market value at the time of the transfer or income recognition. Fair market value is a consistent measure under the tax code. 40 Springing Cash Value is a form of intellectual dishonesty at odds with the framework of tax code symmetry. The purpose of a springing cash value transaction is to transfer value from the plan to the participant, with a large portion of the value of the life insurance policy escaping taxation. Under Code Sec. 402(a) and Treas. Reg. Sec (a)-1(a)(iii) the transfer of a policy from a qualified plan to a participant is a taxable event and the value of the transaction should reflect the market value of the policy. For years, it was assumed that the cash value of the policy represented the value of the transaction to the participant. 41 Most life insurance contracts generate very little cash value (relative to premiums paid) in the first five years. Thus, paying premiums with the retirement plan s pre-tax dollars results in a write-off of the policy's acquisition costs. Once the policy acquisition costs have been paid, the life insurance contract cash values accumulate on an accelerated basis. A participant frequently wishes to personally own the contract once the cash value starts to increase faster than the premiums (usually year 7 to 10). How is this done? The Department of Labor ("DOL") has granted an exemption to the prohibited transaction rules for a transfer of a life insurance contract from a qualified retirement plan to a participant/insured (see, discussion infra). What price does the participant pay? The IRS has weighed in and expressed concern that the value was, has and is being understated. In IRS Announcement 88-51, 42 the IRS put taxpayers on notice that contracts with "artificially low cash surrender values" were under study. These contracts typically had "springing cash values" which would be available tax-free to the participant through policy loans once the policies had been distributed from the plan. Following up with IRS Notice 89-25, Question and Answer Number 10, 43 the IRS stated that the value of the contract is the "fair market value of such property." As to whether the net cash surrender value or some other benchmark is supposed to be utilized, Notice states: "...the stated cash surrender value...is not appropriate where the total policy reserves, including life insurance reserves (if any), computed under Section 807(D), together with any reserves for advance premiums, dividend accumulations, etc., represent a much more accurate approximation of the fair market value of the policy..." The example used in the Notice shows a single premium of $400,000, and a change in the cash surrender value from year four ($126,248) to year five ($489,900). The abusive example leads 40 Landsberg, Richard D. Section 412(e) Fully Insured Defined Benefit Plans & the Perils of Unintended Consequences Journal of Pension Planning & Compliance (Vol. 29, No. 3, Fall 2004) 41 Treas. Reg (b)(1)(e). 42 Smith, Richard C., Giaconda, Kathleen M., In Defense of 412(e) Plans, Journal of the Society of Financial Service Professionals (November 2003), vol. 57, no IRS Notice 89-25, C.B

13 one to believe that traditional level premium policies with gradual cash value increments should not be subject to the valuation method of Notice The Notice stands for the principle that where reserves of the policy exceed the cash value of the policy at distribution then reserves should be used as the value of measure. Notice gave rise to the term springing cash value and the example used therein was not meant to be exhaustive. The IRS, through clear and unambiguous language, reserved the right to use other measures to accurately reflect market value of a life insurance contract. In summary, the important precedent is that springing reserves are just as suspect as springing cash values. 44 On February 13, 2004, the Treasury Department and IRS released much anticipated guidance on the subject of life insurance valuation. The guidance was in four segments two revenue rulings, a revenue procedure and proposed regulations regarding the valuation of policies for income tax purposes. The IRS has long been threatening to disallow springing cash value policies in qualified plans and the most recent guidance attempts to target specific abuses. 45 Another Look at 92-6 The concept is a straight-forward one. Why would you pay for life insurance with after-tax dollars if you could use tax deductible dollars for the premiums? Within certain parameters a qualified retirement plan such as a profit sharing, money purchase, and 401(k) can buy a life insurance policy as an investment for the account of the participant. The Department of Labor, through the Pension and Welfare Benefits Administration (now the Employee Benefits Security Administration) issued expanded amendatory relief under Prohibited Transaction Exemption The exemption now permits the sales of life insurance contracts between qualified retirement plans and employers, other plans, plan participants and certain other relatives. PTE 92-6 has now been expanded to permit transfers of life insurance contracts directly to life insurance trusts and other personal trusts that are commonly used for estate planning. Basically, PTE 92-6 permits the sale of an individual life insurance contract insuring a participant in a qualified retirement plan to: A relative of the insured who was named the beneficiary under the policy; An employer who is the plan sponsor; Another employee benefit plan; 44 Landsberg, Richard D. Valuation Rules & Safe Harbors The Journal of the Society of Financial Service Professionals (Vol. 59, No. 4, July 2005); Section 412(e) Fully Insured Defined Benefit Plans & the Perils of Unintended Consequences Journal of Pension Planning & Compliance (Vol. 29, No. 3, Fall 2004) 45 Treas. Reg.1.402(a)-1(a)(iii),1.83-3(a),1.79-1(d)(3). 13

14 A personal or private trust established by or for the benefit of an individual who is a participant in the qualified retirement plan and the insured under the policy, or by or for the benefit of one or more relatives. The sale will be permitted under PTE 92-6 if: The participant is the insured under the policy; The policy would, but for the sale be surrendered by the qualified retirement plan The amount received by the plan in the sale of the policy is at least the amount necessary to put the plan in the same cash position as it would have been had it retained the contract, surrendered it and made a distribution owing to the participant on his vested interest under the plan This DOL response to a legitimate business practice is the result of the original PTE 92-6 which was followed up by ERISA Opinion Letter 98-07A and finally this amended PTE As can be seen by the foregoing, in addition to the proper valuation of the policy, how and when a policy may be distributed is another matter entirely. Distributions may occur either while the participation is ongoing or after a distributable event such as termination from service, termination of the plan or attainment of retirement age (to name a few). If the plan is ongoing the transfer of a policy for less than an accurate market value creates serious problems. 46 PTE 92-6 demands that the plan be in the same cash position after the sale as it was prior to the sale of the policy. Clearly, ERISA fiduciary standards apply. 47 By way of example, if a plan sells an asset guaranteed to be worth $500,000 for the bargained-for price of $250,000 the plan is not in the same cash position after the transaction as it was prior to the sale. ERISA requires that transactions between a party-in-interest and the plan be at arm s length which is to say that the fiduciary rules require that fair market value be attained for the purchase and sale of plan assets. 48 The bottom line is that an unrelated party would not be allowed to purchase a $500,000 asset for $250,000 and therefore a party-in-interest being able to do so raise the specter of wrongdoing on the cusp of a fiduciary breach. Furthermore, one of the conditions of PTE 92-6 is that the contract would, but for the sale, have been surrendered by the plan. It seems improbable under any form of logic to suggest that it would be prudent to surrender for $250,000 that which is worth $500,000. Therefore, it would be wrong to distribute an asset at $250,000 that carries a fair market value of $500,000. In Notice 89-25, the IRS stated that if the market value of the distributed policy exceeds the consideration paid for the policy the excess would be treated as a distribution. In the absence of a distributable event any amount of excess distributed can give rise to plan disqualification for exceeding the benefit limitations of Sec See Rev. Rul , et al. IRC 402(a). 47 PTE 92-5 (57 FR 5019). 48 IRS Ann , IRB Rev. Rul , C.B. 14

15 Therefore, in the case of a distributable event the issues seem to be as laid out in Notice as augmented by Rev. Rul The issue of what is taken into income is basically the fair market value of the life insurance policy and the issue of the Sec. 415 limitations will give rise to a case of facts and circumstances. 50 If a participant is at retirement age and the policy is distributed the transaction on its face implies that the distribution is exactly equal to the amount necessary to provide the 415 limit or plan formula. 51 However, it is important to realize that Treas. Reg. Sec (a) provides that a policy that can at any time exceed the limits of 415 will violate the statute. 52 Consequently, in order to distribute the policy without adverse 415 consequences requires that the policy prohibit the participant from receiving any springing cash value. Finally, if there is a distributable event because of plan termination then a different concern arises. First, the conversion issue is dead on arrival since there is no conversion. Fiduciary issues would appear to have no consequence since the value of the benefit to be paid would equal the fair market value of the policy at the time of termination. However, these matters would only apply to real plan terminations. Of course, financial advisers must be aware of the intent of terminating in a short period of time could give rise to the violation of the permanency doctrine under Treas. Reg. Sec (b)(2). Taxation of the Death Benefit Unlike life insurance that is owned outright by an individual, when a qualified plan owns life insurance, only a portion of the death benefit is free from federal income tax. Specifically, the excess of the face amount of the policy over the policy s cash surrender value is excluded from income for federal income tax purposes. [ See Code Sections 72(m) and 101(a).] The amount included in the beneficiary s gross income is equal to the excess of the cash surrender value of the policy less the insured s cost basis in the policy. 53 Example. A participant in a qualified plan has a life insurance policy with a face amount of $140,000, and P.S. 58 costs totaling $10,000. The participant dies and the proceeds from the policy are distributed to the participant s spouse as beneficiary. Immediately preceding the insured s death, the cash surrender value of the policy is $35,000. The federal income tax free portion of the distribution may be calculated as follows: 54 $140,000 Face Amount -25,000 Net Cash Value $115, PTE 92-6 (May 10, 2002), FR, vol. 67, no Id. 52 ERISA 404(a)(1); PTE 92-5; PTE LaCombe, supra 54 Id. 15

16 The taxable portion of the distribution may be calculated as follows: $35,000 Cash Value -10,000 PS-58 Costs $25,000 If there were any additions to the policy, or riders, such additional amounts would be included in the determination of the tax-free and taxable portions of the distribution. Special Considerations Under ERISA - Does Life Insurance Satisfy the Prudence Standard? Under ERISA, plan fiduciaries must discharge their duties solely in the interest of plan participants and beneficiaries. In doing so, fiduciaries must act with the care, skill, prudence, and diligence under the prevailing circumstances that a prudent person acting in a like capacity would use. ERISA requires that fiduciaries diversify the assets of plans so as to minimize the risk of large losses, unless under the circumstances it is not prudent to do so. Finally, plan fiduciaries must act in accordance with the terms of their plan documents, only insofar as such documents are consistent with the prudence and diversification requirements, and they must avoid prohibited transactions. 55 There are no specific restrictions under the Internal Revenue Code with respect to investments that may be made by the trustees of a trust that qualifies under Code Section 401(a). Generally, the contribution may be used by the trustees to purchase any investments permitted by the trust agreement to the extent allowed by local law. 56 Therefore, a plan fiduciary may determine that it is prudent to offer life insurance as an investment option under a plan, provided that the terms of a plan do not prohibit the purchase of life insurance. Does Life Insurance Qualify for ERISA Section 404(c) Protection? In general, ERISA Section 404(c) insulates an employer from liability with respect to participant directed investment losses. To achieve this protection, an employer must provide an opportunity for a participant or beneficiary to exercise control over the assets in the individual s account. The employer must also provide a participant an opportunity to choose, from a broad range of 55 Trone, Donald B., Albright, William R., Madden, William B. Procedural Prudence (SEI Management, 1991); Serota, Susan P. & Brodie, Frederick A. ERISA Fiduciary Law (BNA Books, Washington, D.C. 2 nd Edition); Landsberg, Richard D. The Procedural Prudence Pipeline: Investment Fiduciaries in the Crosshairs of ERISA Sec. 3(21) Journal of Pension Planning & Compliance (Vol. 37, No. 4, Winter 2012); Landsberg, Richard d. ERISA s New Definition of Fiduciary Journal of Pension Planning & Compliance (Vol. 37, No. 3, Fall 2011); LaCombe, Elizabeth A. Life Insurance in Qualified Defined Contribution Plans Journal of Pension Benefits (Vol. 15, No. 2, Winter 2008) 56 Treas. Reg (b)(5)(iii); LaCombe, supra. 16

17 investment options, the manner in which some or all of the assets in his account are invested. 57 A plan provides a participant with an opportunity to exercise control if, among other requirements, the participant has a reasonable opportunity to give investment instructions to a plan fiduciary who is obligated to follow such instructions. In addition, the participant must be provided with an explanation of the restrictions on transfers to and from an investment alternative. Because life insurance is not a liquid investment option, transfers to or from life insurance are unlikely, and it is doubtful that life insurance would qualify for ERISA Section 404(c) protection. 58 The possibility that life insurance may not receive ERISA Section 404(c) protection may not be a concern for all plan sponsors, particularly those who have chosen not to comply with ERISA Section 404(c). In those cases, the liability of the plan sponsor for a participant s investment losses will turn upon whether the investment choice was prudent under the circumstances. 59 Summary & Conclusion Life insurance as an investment in a defined contribution qualified plan is more than just knowing the contribution limitations applicable. If structured properly, life insurance can be an attractive way to provide death benefit protection to employees through a qualified defined contribution plan. Plan sponsors and fiduciaries must exercise care in selecting the appropriate life insurance product which will pass the nondiscrimination, incidental benefit rules, fair market valuation rules and distribution options before offering it as an investment option. Also, it is imperative for plan fiduciaries to adequately disclose the advantages and disadvantages of life insurance to plan participants in order to execute on the prudence requirement and illustrate due diligence in selection of the life insurance option. Federal income tax laws are complex and subject to change. The information in this brochure is based on current interpretations of the law and is not guaranteed. Neither the company nor it s agents/representatives gives legal or tax advice. You should consult your attorney or tax advisor for answers to your specific tax questions. 57 ERISA Reg c-2(b)(1)(i) and (ii) 58 LaCombe, supra; Landsberg, Richard D. The Procedural Prudence Pipeline: Investment Fiduciaries in the Crosshairs of ERISA Sec. 3(21) Journal of Pension Planning & Compliance (Vol. 37, No. 4, Winter 2012) 59 Landsberg, Richard D. The Procedural Prudence Pipeline: Investment Fiduciaries in the Crosshairs of ERISA Sec. 3(21) Journal of Pension Planning & Compliance (Vol. 37, No. 4, Winter 2012) 17

18 Nationwide and the Nationwide framemark are registered service marks of Nationwide Mutual Insurance Company. Nationwide Financial Services, Inc. All rights reserved. Nationwide Investment Services Corporation, member FINRA. In Michigan only: Nationwide Investment Svcs. Corporation NFM-10215AO.1 (03/13) 18