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August 26, 2005
JS-2694
Treasury Releases Final Regulations Shutting Down Abusive Valuation of Life Insurance Contracts
WASHINGTON, DC -- Today, the Treasury Department and the IRS issued final regulations clarifying that any life insurance contract transferred from an employer or a tax-qualified plan to an employee must be taxed at its full fair market value. Issuing these regulations completes a 2-year project to shut down abusive transactions involving "section 412(i) plans" and other similar arrangements. The final regulations are aimed at arrangements that attempt to avoid taxes by using artificial devices to understate the value of insurance contracts.
A "section 412(i) plan" is a tax-qualified retirement plan that is funded entirely by a life insurance contract or an annuity. An employer may claim tax deductions for contributions that are used by the plan to pay premiums on an insurance contract covering an employee. The plan may hold the contract until the employee dies, or it may distribute or sell the contract to the employee at a specific point, such as when the employee retires.
Some firms have promoted a tax avoidance arrangement where an employer establishes a section 412(i) plan under which the contributions made to the plan, which are deducted by the employer, are used to purchase a specially designed life insurance contract. Under the arrangement, the cash surrender value, or the amount that the contract states the policy is worth if it were cashed-in, is temporarily depressed to a level significantly below the premiums paid. The contract is then distributed or sold to the employee for the amount of the temporarily depressed cash surrender value.
The contract is structured so that the cash surrender value increases significantly after it is transferred to the employee. The use of this springing cash value life insurance results in a mismatch between the employer's deduction and the employee's recognition of income. The employer takes a deduction for the entire value of the premiums paid into the insurance plan and the employee pays taxes only on the artificially depressed value of the contract allowing the employee to avoid taxes on the true value of the contract while the employer taxes the full deduction for the premiums paid.
The regulations announced today, which finalize regulations proposed in February 2004 require that the insurance contract be valued at its fair market value.
These regulations will be effective for transfers made on or after the proposed regulations were announced on February 13, 2004.
A copy of the final regulations is attached.
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