The Internal Revenue Service has completed regulations that are supposed to keep employers and insurers from playing games with the values of life insurance contracts used in employee compensation arrangements.[@@]

Some aggressive tax planners have been using life insurance policies and annuities with artificially low cash values, or taxable values, to fuel compensation programs.

Some of the products, for example, have cash surrender values that increase dramatically after the products are transferred to employees, IRS officials say. The IRS calls those products “springing cash value” products.

Now, the new final regulations, based on proposed regulations released in February 2004, are supposed to require employers to come up with reasonable estimates of “fair market value” when reporting on 412(i) defined benefit retirement plans and other plans that qualify for special tax breaks.

The IRS will be calculating the “bargain element” in a transaction by subtracting the value of the consideration an employee pays for a life insurance policy or annuity from the fair market value.

From now on, “any such bargain element is treated as a distribution,” Bruce Perlin and Linda Marshall, IRS tax exempt entities specialists, write in the preamble to the final regulations.

Employees usually have to include benefit plan distributions in taxable income.

The final life policy valuation regulations are somewhat more relaxed than the original regulations released in 2004, and they offer more forgiving rules, released in May, for estimating the fair market value of traditional whole life insurance policies. The new rules let taxpayers include adjustments for policy surrender charges in calculations of fair market value.

But, in general, taxpayers are supposed to include the value of all product features when coming up with policy fair market values, Perlin and Marshall write.

“Unless specifically excepted from the definition of permanent benefits or fair market value, the value of all features of a life insurance policy providing an economic benefit to a service provider (including, for example, the value of a springing cash value feature) must be included in determining the employee’s income,” Perlin and Marshall write.

The final regulations apply to “any distribution of a retirement income, endowment, or other life insurance contract occurring on or after Feb. 13, 2004,” Perlin and Marshall write.

The IRS has posted a link to a copy of the proposed regulations on the Web site of its parent, the U.S. Treasury Department, at http://www.treasury.gov/press/releases/js2694.htm