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.”

Another way

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.

Case study

Like most of his contemporaries, Bob Businessowner has many assets tied up in the business. He recognizes a need for personal life insurance and is looking for a cost-efficient approach to purchase it.

Bob has a balance of $600,000 in his profit-sharing plan, all of which his tax advisor deems is available for the purchase of life insurance as a funding vehicle. Bob likes the idea of using pretax dollars to purchase the policy and decides to buy $4 million of universal life insurance coverage with a lapse protection rider. Due to some health issues, Bob is rated Table C and is quoted as paying premiums of $63,464 per year.

The pretax dollars used to purchase the policy equate to a minimum savings of 30% and five years hence, a total basis of $317,320. Bob now chooses to retire and realizes he may have an estate tax liability.

As such, Bob wishes to have his irrevocable life insurance trust own the policy. The ILIT’s trustee will purchase the policy from the profit-sharing plan for its fair market value. Under the aforementioned safe harbor rules, this equals $174,892. Bob can fund his ILIT with either a one-time gift using his unified credit, or through annual gifts using his annual exclusion.

What has Bob accomplished? First, he has funded the policy over the first five years with pretax dollars. Second, Bob realizes a significant discount on the taxable amount. Even with $56,000 in economic benefit costs taxed over the five years, this is a cost-efficient approach. In sum, Bob has received a discount of premiums used to fund the policy, as well as a discount of the fair market value of the policy when it is removed from the profit-sharing plan.

Conclusion

Using life insurance in a suitable qualified plan involves several complexities. Also, unless clients use an “insurance sub-trust technique” (the validity of which the IRS has not ruled on), the policy death benefit is fully includable in their taxable estate.

Finally, because the IRS deems the death benefit portion of the policy to be a current benefit, the participant must pay a current economic benefit cost. This is commonly known as the Table 2001 rate, or a carrier’s compliant alternate term rate.

Despite these issues, the future looks bright for this concept. After many years of speculation, the IRS has given taxpayers a safe harbor method in which to calculate a policy fair market value. As such, producers now can have comfort in knowing how to plan an exit strategy with numbers to support their presentation.

To this end, producers would do well to work with an insurance carrier having an illustration proposal system showing the safe harbor amount, economic benefits amounts and numeric values that tell the story of “doing nothing” vs. following the strategy. In addition, some carriers offer selling systems, which include a producer guide, submission forms, retirement plan comparison guides, confidential client questionnaires and a sample prototype checklist.

In sum, producers who partner with a carrier proficient in this market will soon find that opportunities abound in the small business marketplace. With much anticipated guidance from the IRS, life insurance inside a qualified plan is understandably back in vogue.