The authority for this technique dates back to a pair of Private Letter Rulings: 8108110 and 8426090. Although PLR rulings apply only to the taxpayer who requests them, they do indicate the general thinking of the IRS.
Private Letter Ruling 8108110 discussed a fact pattern where the specific purpose was to fund a buy-sell agreement. With this fact pattern in mind, three questions were asked of the IRS:
1. Whether an insurance policy on the life of a plan participant B, could be purchased by the plan trustee and allocated to the account of plan participant A;
2. Whether the payment of insurance premiums would be treated as a current distribution of plan assets to A, resulting in taxable income to A and/or disqualification of the plan; and
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3. Whether the proposed arrangement would disqualify the plan for any other reason.
The IRS provided a favorable ruling. With respect to the first question they deferred to the Department of Labor, noting that the department has sole authority for determining fiduciary standards for plan investments under Title I of ERISA.
With respect to the second question, the IRS noted that under IRC 72 (m)(3)(A) and (B), amounts paid for the purchase of life insurance in a qualified plan are includable in the income of the participant for the tax year in which they are applied, directly or indirectly, to the participant. The amount taxable is the P.S. 58 cost.