So often in estate and wealth planning, producers are asked to maximize an asset’s value for the benefit of future generations. This proposition, when taken in the context of a qualified plan, may be difficult to achieve. While many benefits exist for holding assets in a qualified plan while the participant is alive, the story changes upon the participant’s death.
Classified as income in respect of a decedent, pension account values payable at death to named beneficiaries are subject to both estate and income tax. An itemized deduction for estate taxes allocated to the survivor beneficiary income benefit may alleviate, but not preclude, income taxation of these benefits.
In addition, many small business owners know they need life insurance but are unable or unwilling to bear transition costs to make the funds available. These options include pulling money out of the company and paying ordinary income taxes, gifting large sums of money to an irrevocable life insurance trust, or using a portion or all of one’s unified credit. As the old adage goes, “He who finds the premium dollars makes the sale.”
Owning a life insurance policy inside a qualified plan may be a solution for the business owner and key executives. The policy significantly can magnify plan assets and enjoy substantial tax savings.
Because the plan uses pretax dollars, funding requirements are lower than a regime employing after-tax dollars. If the policy covers an owner-participant, he or she pays for the insurance with tax-deductible dollars.
If the policy is distributed from the plan to the plan participant, the value generally will be taxed many years later. The taxable amount–typically less than the premiums paid–is a major benefit of using a qualified plan to purchase life insurance, as the plan provides extra cost “leverage.”
Some guidance at last
Over the past few years, determining the policy’s fair market value (FMV) for life insurance has been a changing dynamic. In April of last year, the Internal Revenue Service released a revenue procedure (Rev. Proc. 2005-25), which provides guidelines on how to determine the fair market value of life insurance contracts in varied situations, including the sale or distribution of life insurance policies from qualified plans.
Significantly, Rev. Proc. 2005-25 also provides two safe harbor formulas. These formulas, if used to determine a contract’s value, will meet the definition of fair market value for federal income tax purposes. In addition, the new revenue procedure applies to all in-force plans and policies and new sales. Apparently, the IRS saw no need to “grandfather” arrangements that in its opinion were abusive.
The revenue procedure aims to curb arrangements in which the employer or qualified plan invests substantial premiums into a life insurance policy on the life of a plan participant, then distributes or sells the policy for an artificially low cash surrender value. Until the new guidance, the result had been a distribution with an economic value far greater than the cash value that was used as the basis for taxable value of the distribution. Examples of this include policies with “springing cash values” used in “retained earnings bailouts,” and in qualified “pension rescue” plans.
The new procedure additionally offers a safe harbor approach. Taxpayers are free to scuttle these formulas in favor of another method to arrive at the fair market value, though an alternate approach risks being challenged by the IRS.