Life Insurance Plans Must be Taxed at Full Value When
Transferred to an Employee
The Treasury Department and the Internal Revenue Service (IRS)
have issued final regulations stating clearly that any life insurance contract
transferred from an employer or a taxqualified plan to an employee must
be taxed at its full fair market value. These regulations constitute a crackdown
on transactions involving "section 412(i) plans" and other similar
arrangements meant to avoid taxes by using artificial devices to understate
the value of insurance contracts.
A "section 412(i) plan" is a tax-qualified retirement
plan funded entirely by a life insurance contract or an annuity. Employers
may claim tax deductions for contributions used by the plan to pay premiums
on an insurance contract covering an employee. The plan may hold the contract
until the employee dies, or it may distribute or sell the contract to the
employee at a specific point, such as when the employee retires.
Some employers have established section 412(i) plans under
which the contributions made to the plan (which are deducted by the employer)
are used to purchase a specially designed life insurance contract. Under
this arrangement, the cash surrender value, or the amount that the contract
states the policy is worth if it were cashedin, is temporarily depressed
to a level significantly below the premiums paid. The contract is then distributed
or sold to the employee for the amount of the temporarily depressed cash
surrender value.
The contract is structured so the cash surrender value increases
significantly after it is transferred to the employee. The use of this springing
cash value life insurance results in a mismatch between the employer's deduction
and the employee's recognition of income. The employer takes a deduction
for the entire value of the premiums paid into the insurance plan and the
employee pays taxes only on the artificially depressed value of the contract,
allowing the employee to avoid taxes on the true value of the contract while
the employer takes the full deduction for the premiums paid.
The recently issued regulations (which finalize regulations
proposed in February 2004) require the insurance contract be valued at its
fair market value.
These regulations will be effective retroactively for transfers
made on or after the proposed regulations were announced on February 13,
2004.
A copy of the final regulations can be viewed at: http://www.ustreas.gov/press/releases/reports/js2694attachment.pdf.
Source: U.S. Treasury, 8-26-05
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