Section 412(i) Plans Still Viable Under Recent Regulations

By David B. Mandell

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Section 412(i) plans typically have three features:

• The plan is funded solely with individual or group life insurance or annuity contracts that are part of the same series and use the same mortality tables and rates for all participants.
• The insurance contracts must fund benefits using level premiums for all benefits. When a participant enters the plan, payments are made and may extend no later than the retirement date stated in the plan.
• Only the insurance contacts can provide the plan benefits, and an insurance company must guarantee these contracts.

Potential Advantages of a 412(i) Plan

Maximum current tax-deductible contributions. Generally, a defined benefit plan will allow larger deductions than a defined contribution plan for employees older than 40 because of the IRS tables used in the actuarial formula to determine the maximum deductible contributions. For 412(i) plans, where the products funding the plan have guaranteed returns, the IRS allows the plans to use the guaranteed return rate as the “hurdle” rate in the formula that distinguishes between a future retirement benefit and a present value contribution. Because these guaranteed rates (1%–3%) are much lower than the typical hurdle rates (4%–6% or higher), participants aiming for a particular retirement savings amount will be allowed significantly higher contribution amounts under a 412(i) plan than they would be under a typical defined benefit plan. In some conservative 412(i) plans, businesses have made annual deductible contributions in excess of $200,000 for employees over age 50.

For business owners over 40 years of age with few employees (or young employees whose contributions would be much lower), the large potential tax deductions of a 412(i) plan can be extremely attractive.

Solid creditor protection. Section 412(i) plans offer tremendous tax-subsidized creditor protection. Essentially, the business owner is able to move several hundred thousands of dollars out of the business and into an asset-protective structure (the plan). A plan that conforms to the Employee Retirement Income Security Act of 1974 (ERISA), particularly the anti-alienation restrictions, will enjoy tremendous asset protection against creditors of the business or plan participants. This creditor protection, based on a 1992 U.S. Supreme Court decision [Patterson v. Schumate, 112 S. Ct. 2242, 2251 (1992)], is extremely strong in all 50 states. For many businesses, the creditor protection benefits of 412(i) plans are as important as the tax benefits.

Other benefits. Contributions are based solely on the guaranteed provision of the level premium insurance and annuity contacts, so a plan cannot be overfunded or underfunded. In addition, there is no full-funding limitation under ERISA section 404(a)(1)(A) or current liability test to limit contributions, and no actuarial certification is required. Finally, unlike traditional defined benefit plans, no quarterly contributions are required, and the plan may be funded annually without interest.

Potential Disadvantages of a 412(i) Plan

Because of their large required contributions, these plans work only with established, highly profitable businesses. They usually work best when the business owner is within 10 years or so of retirement and is older than most of the company’s relatively few employees. In addition, the plan cannot make policy loans. Such a loan invalidates the plan altogether. There is no flexibility in investments, because the plan is funded entirely with insurance and annuity contracts. Finally, there may be limitations to the deductions or the amount of insurance that is purchased, and there may be an income component that is recaptured by the business owner.

Recent Abuses

During the past five years, the life insurance industry promoted a number of techniques to distort the conservative use of 412(i) plans. One common distortion was to encourage the plan to invest heavily in a life policy rather than an annuity. In many plans, 100% of the plan is invested in the life policy, with no annuity at all. Although this strategy is good for the insurance agent’s commission, it does not meet the business’ goal of a retirement plan. Conservative plans have at least 50% of the plan invested in annuities.

Most notably, however, some insurance promoters have used the 412(i) plan as a tool for purchasing a very large life insurance policy with tax-deductible dollars that would then be transferred out, by either distribution or purchase from the plan, at a value much less than the amount paid for it. Prior to Revenue Procedure 2004-16 (issued February 13, 2004), one could make a case that the value used for the purchase or distribution of a life policy out of a plan could be the policy’s cash surrender value (CSV). Often, specially designed life insurance contracts were used to suppress the CSV at the time of transfer from the plan. This would allow the participant to reduce his cost of purchasing the policy, or his tax liability if the plan were to distribute the policy to him. Then, either by the design of the product itself or by language in the contract allowing for certain changes (e.g., a right of exchange to another contract or a right to reduce the face amount), the contract would be structured so that the CSV increased significantly after it was transferred to the employee. Eventually, the IRS figured out this “pension rescue” structure, and on February 13, 2004, it released proposed regulations dealing with this valuation strategy.

New rules. On February 13, 2004, the U.S. Treasury Department and the IRS issued guidance to shut down abusive transactions involving specially designed life insurance policies in retirement plans, and further guidance specific to 412(i) plans. “The guidance targets specific abuses occurring with section 412(i) plans,” stated Assistant Secretary for Tax Policy Pam Olson. “There are many legitimate section 412(i) plans, but some push the envelope, claiming tax results for employees and employers that do not reflect the underlying economics of the arrangements.”

The guidance covered three specific issues. First, a set of proposed regulations stated that any life insurance contract transferred from an employer or a tax-qualified plan to an employee must be taxed at its full “fair market value.” Until the regulations are finalized, the IRS has given interim guidance for determining the fair market value to be used. In the author’s opinion, conservative planners should assume that the interim guidance will be finalized. The fair market value formula under Revenue Procedure 2004-16 is as follows:

Cash Value (without reduction for surrender charges) may be treated as the fair market value of a contract as of a determination date provided such cash value is at least as large as the aggregate of: (1) the premiums paid from the date of issue through the date of determination, plus (2) any amounts credited (or otherwise made available) to the policyholder with respect to those premiums, including interest, dividends, and similar income items (whether under the contract or otherwise), minus (3) reasonable mortality charges and reasonable charges (other than mortality charges), but only if those charges are actually charges on or before the date of determination and are expected to be paid.

Under this definition, an artificially low CSV can no longer be used to enjoy a valuation arbitrage. Furthermore, CSV in general is no longer a relevant figure. In the commentary subsequent to the release of these regulations, it has generally been accepted that the IRS accomplished its intent: to put an abrupt end to this valuation scheme. “Pension rescue” as applied to both 412(i) plans and qualified plans is effectively dead.

Second, a revenue ruling released at the same time stated that where excessive amounts of life insurance are purchased on 412(i) plan participants, one of two outcomes is possible:

• If the death benefit payable to the beneficiaries is in excess of amounts allowed by the IRC, the plan would be disqualified.
• If the excess death benefit is payable to the plan to offset future premium requirements, the premiums for any death benefit amounts in excess of what would be allowed by the plan documents will not be fully deductible in the year paid. Instead, only the “normal cost” would be deductible in the year the full premium is paid, with the balance deductible in later years. In addition, these payments will be considered “listed transactions” as part of a tax avoidance scheme, with additional reporting burdens. If records are not kept or reports not filed as required, penalties may be due under the tax shelter rules of IRC sections 6111 and 6112.

Through this revenue ruling, the IRS also achieved its goal of discouraging unscrupulous insurance agents from funding 412(i) plans with disproportionate amounts of life insurance.

Finally, another revenue ruling stated that a section 412(i) plan cannot use differences in life insurance contracts to discriminate in favor of highly paid employees. This guidance has been effective in curtailing abusive 412(i) arrangements aimed only at benefiting the highest-paid employees at the expense of other employees. Even under the new regulations, 412(i) plans remain effective tools. As long as a business does not engage in valuation schemes, buy disproportionate amounts of insurance, or inappropriately allow top employees to benefit, section 412(i) plans still make good planning sense.