The first major potential problem relates to the funding of the plan itself. If life insurance is used in combination with an annuity as a funding vehicle for the 412(i) plan, advisors must follow the incidental benefit rules. The IRS considers any nonretirement benefit in a qualified plan to be incidental so long as that benefit is less than 25% of the total cost of the plan.
There are two practical tests developed by the IRS to consider whether a death benefit is “incidental”:
The participants insured death benefit must be no more than 100 times the expected monthly retirement benefit, or
The aggregate premiums paid (premiums over the life of the plan) for a participants insured death benefit are at all times less than the following percentages of the plan cost for that participant: whole life insurance, 50%; term insurance, 25%; universal life, 25%.
Any funding design that violates both of these tests should be scrutinized very carefully because any funding design that violates the incidental benefit rules threatens the qualification of the plan and threatens adverse tax consequences to the client.
The second major area for potential problems relates to the distribution or sale of the policy from the plan to the business owner or other participant. As mentioned above, the plan participant may, under certain circumstances, receive the policy as a distribution from the plan.
At least three major issues should be considered when discussing this:
1. First, the plan must be a permanent plan. A potential problem may arise where the sole intent of the client is to merely incubate the policy for a few years and then distribute the policy. This is an issue that must be evaluated carefully by the attorney.
2. Second, valuation of the policy is an important issue as well. A “springing cash value” policy may utilize heavy surrender charges in the early years of the policy to lower the value of the policy when distributed or sold to the business owner or other participant. Shortly after distribution or sale of the policy, the policy dramatically increases in value or “springs up.”
In such a situation, the overall effect of this transaction is that the client may be taxed on a lower amount than what the policy is actually worth. IRS Notice 89-25 makes it clear the IRS will audit such transactions and evaluate the true value of the policy on a case-by-case basis.
Both the Treasury Department and the IRS are aware of the many products and 412(i) plan vendors that comply with both the letter and the spirit of the law governing fully insured plans. Consequently, future regulatory guidance is expected to distinguish between what will be seen as traditional/conservative plans and problematic plan design and products.
3. The third situation that requires special care and attention from the clients attorney and tax advisors is where the policy is sold to the plan participant or to the plan participants trust. The attorney must consider the ERISA fiduciary rules and prudent investment guidelines and ensure that the plan receives fair value for the policy. In addition, the specific requirements of the Prohibited Transaction Rule 92-6, which govern such sales, must be followed. In addition, the legal and tax advisors must evaluate the transactions tax consequences.
Finally, the attorney and tax advisor must render opinions to the client regarding these issues and any other issues presented by the facts of the situation.
–Brett Berg and Richard Landsberg
Reproduced from National Underwriter Life & Health/Financial Services Edition, September 15, 2003. Copyright 2003 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.