3831 / What tests are used to determine whether life or health insurance benefits provided by a qualified plan to participants are “incidental”?

The basic approach taken by the IRS in determining whether life insurance benefits in a pension plan, or life or health insurance benefits in a profit sharing plan, are incidental begins by determining what proportion the cost of providing such benefits bears to the cost of providing all benefits under the plan. If the cost of providing current life and health insurance benefits generally is less than 25 percent of the cost of providing all the benefits under the plan (both deferred and current), the incidental limitation is satisfied.

Despite the fact that an element of savings is involved in universal life coverage, the IRS has taken the position that universal life coverage must be treated under the rules applicable to term coverage and thus is subject to the 25 percent rule.¹ For purposes of the incidental rule, the IRS defines permanent insurance as insurance on which the premium does not increase and the death benefit does not decrease.²

The IRS has ruled privately that a variable contract in which the death benefit might decrease as a result of a decline in cash values and the operation of IRC Section 7702 ( Q 65), and unscheduled extra premiums were permitted, would be treated as permanent insurance.³

The IRS also ruled for an insurer where an adjustable life contract was to be used as a funding vehicle for a defined contribution plan. The IRS stated that it would apply the incidental rule applied in Revenue Ruling 61-164, below. In other words, one-half the premiums paid while the contract was providing lifetime protection plus the whole premium paid while the policy was providing term protection must total less than 25 percent of the total plan contributions to date.⁴

In the case of a plan that provides life insurance benefits, the 25 percent rule is applied to the portion of the premium used to provide current life insurance protection (the cost of the “amount at risk”). In the case of a profit sharing plan that provides health insurance benefits, the 25 percent rule is applied to the entire cost of providing current health insurance protection for participants and their families. Rulings discussed and cited below illustrate the application of the 25 percent requirement in various circumstances.

Profit Sharing Plans—The 50 Percent Test

A profit sharing plan that provides that less than one-half the amount allocated annually to each participant’s account will be used to purchase ordinary life insurance on his or her life meets the 25 percent requirement (assuming the plan provides no other current benefits purchased with nondeferred funds). The reason is that by IRS reckoning, on the average, during an employee’s working years, about one-half of each annual premium on ordinary life contracts bought by the plan on his or her life is required to pay the cost of current life insurance protection.

In a profit sharing plan funded by a combination of ordinary life policies and a side fund, the aggregate premiums that have been paid (with nonaccumulated funds) for insurance on a participant’s life must be at all times less than 50 percent of the aggregate employer contributions and forfeitures (without regard to trust earnings and capital gains and losses) that have been allocated to the participant. The plan also must require the trustee, at or before each employee’s retirement, either to convert the employee’s policies into cash to provide income (without life insurance protection that continues past the employee’s retirement) or to distribute the policies to the employee.⁵

Thus, where at all times cash values under a whole life insurance policy equaled or exceeded the minimum cash values under an ordinary whole life insurance policy and less than 50 percent of the total contributions allocated to the participant were applied to premiums, the IRS determined that the death benefits were incidental.⁶

If the 25 percent requirement is met with respect to insurance purchased by a plan, the plan may pay as a death benefit both the face amount of the insurance and the amount accumulated in the side fund allocated to the participant.⁷ There appears to be no reason a profit sharing plan could not provide for the purchase of term insurance (individual or group) rather than ordinary life, so long as aggregate premiums paid for insurance on each participant are less than 25 percent of aggregate employer contributions and forfeitures allocated to him. The IRS has applied the 25 percent limitation in the manner just described to an ordinary life contract to which was added a 10 year decreasing term rider in a ratio of one-to-one (i.e., $1,000 initial face amount of term for each $1,000 face amount of ordinary life).⁸

The IRS also has applied the 25 percent limitation as described to a policy combining 70 percent participating whole life and 30 percent one year term insurance under which dividends are used to purchase paid-up additions; as the additions total increases, the amount of term insurance is reduced, so that a level death benefit is provided.⁹

If a profit sharing plan provides for the purchase of both ordinary life and health insurance for participants from funds that have not been accumulated for the period required by the plan for deferment of distributions, the amount expended on health insurance premiums plus one-half the amount expended on ordinary life premiums must not exceed 25 percent of such accumulated funds. For example, assume the account of an employee has been allocated $1,000, no part of which has been accumulated for the requisite period. If $300 is expended for the purchase of ordinary life, not more than $100 may be expended on health insurance.¹⁰

The “100-to-1” Test

In a pension plan of any type, and in a profit sharing plan, on the assumption that there is no other current benefit to be considered, the incidental limitation automatically is satisfied if a death benefit is provided that does not exceed the amount of (1) the death benefit that would be paid if all benefits under the plan were funded by retirement income endowment policies that have a death benefit of $1,000, or (2) the reserve, if greater, for each $10 per month of life annuity the policy guarantees at retirement age. The reason is that the IRS has determined that the cost of providing such a death benefit will not in any case exceed 25 percent of the cost of providing all benefits under the plan.¹¹ This so-called 100-to-1 ratio test therefore is merely a “safe harbor” rule; it is not a limitation on the amount of death benefit that may be provided.

Miscellaneous Rulings

Postretirement death benefits in a pension plan are subject to the incidental limitation, presumably in the same way preretirement death benefits are subject to the limitation.¹² These benefits are to be distinguished from post-death payments derived from amounts accumulated under a plan for payment to a retired employee or his or her beneficiaries (e.g., the annuity paid to the survivor under a joint and survivor annuity). These latter type payments are subject to entirely different rules ( Q 3909).

A plan providing only such benefits as are afforded through the purchase of ordinary life contracts, which are converted to annuities at retirement, is not a pension plan within the meaning of the regulations and will not qualify.¹³ A prototype pension plan providing for funding solely through ordinary life contracts will not qualify even if it requires the adopting employer to maintain a second plan containing provisions such that, when the two plans are considered as one, the death benefit does not exceed 100 times the monthly retirement annuity.¹⁴

A pension plan that permits a participant to invest a portion of his or her account in life insurance on the life of anyone in whom he or she has an insurable interest will not qualify because it would provide a benefit that is not “definitely determinable” ( Q 3736).¹⁵