US Treasury and IRS Issue Final Regulations on Abusive Transactions

The IRS examined several types of plans after seeing abuses of the tax treatment of the plans (See  IRS Stepping Up Employee Benefit Plan Examinations ).   The final regulations address arrangements that use artificial means to understate the value of insurance contracts in order to avoid taxes, according to a US Treasury press release.

The IRS describes a “section 412(i) plan” as a tax-qualified retirement plan that is funded entirely by a life insurance contract or an annuity, and today’s release isn’t the first time tax officials have attempted to rein in abuses under the programs (see  Regulations Released to Shut Down Abuse in 412(i)s ). 

An employer may claim tax deductions for contributions that are 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.

How it “Works”

According to the IRS, some firms have promoted a tax avoidance arrangement where an employer establishes a section 412(i) plan 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 the arrangement, the cash surrender value, or the amount that the contract states the policy is worth if it were cashed-in, 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 set up so that the cash surrender value increases significantly after it is transferred to the employee. This arrangement results in a mismatch between the employer’s deduction and the employee’s recognition of income, according to the IRS. The employer takes a deduction for the entire value of the premiums paid into the insurance plan while the employee pays taxes only on the artificially depressed value of the contract.

The regulations announced today, which finalize regulations proposed in  February 2004  require that the insurance contract be valued at its fair market value.  These regulations will be effective for transfers made on or after the proposed regulations were announced on February 13, 2004.

The final regulations can be seen  here .