| A certain type of tax-qualified retirement plan (a section 412(i) plan) is funded completely through a life insurance contract or an annuity. The employer is entitled to 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 certain time, such as when the employee retires.
There are many legitimate 412(i) plans; however, the Internal Revenue Service has determined that many plans claim tax results for employees and employers that do not reflect the underlying economics of the arrangements. In response, the IRS and the Treasury Department are attempting to shut down abusive policies by classifying certain arrangements as "listed transactions" for tax-shelter reporting purposes.
The IRS has issued a series of regulations stating 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. These regulations seek to prevent an arrangement promoted for highly compensated employees under which the insurance contract is sold to the employee at its cash surrender value, which is temporarily depressed and is, therefore, significantly below the premiums paid. However, the contract is structured so that immediately after the contract is transferred to the employee, the cash surrender value increases significantly. Under this abusive arrangement, the employer gets tax deductions for amounts far in excess of the amount recognized as income by the employee. The purpose of the regulations is to prevent taxpayers from using artificial devices to understate the value of the contract.
In addition, the IRS has determined that an employer cannot buy excessive life insurance in order to claim large tax deductions. Excessive life insurance contracts are those where the death benefits exceed the death benefits provided to the employee's beneficiaries under the terms of the plan, with the balance of the proceeds going back into the plan as a return on investment. These arrangements will be listed transactions for tax-shelter reporting purposes.
Finally, the IRS has issued a revenue ruling to prevent an employer from using the differences in life insurance contracts in a section 412(i) plan as a method of discriminating in favor of highly compensated employees. Copyright 2010 LexisNexis, a division of Reed Elsevier Inc. |