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Internal Revenue Bulletin - March 8, 2004 - REG-126967-03
Internal Revenue Bulletin: 2004-10 March 8, 2004 REG-126967-03
Notice of Proposed Rulemaking and Notice of Public Hearing; Value of Life Insurance Contracts When Distributed From a Qualified
Retirement Plan Table of Contents
This document contains proposed amendments to the regulations under section 402(a) of the Internal Revenue Code regarding
the amount includible in a distributee’s income when life insurance contracts are distributed by a qualified retirement plan
and the treatment of property sold by a qualified retirement plan to a plan participant or beneficiary for less than fair
market value. This document also contains proposed amendments to the regulations under sections 79 and 83 conforming the
language in those regulations to the language in the proposed amendments to the section 402(a) regulations. These regulations
will affect administrators of, participants in, and beneficiaries of qualified employer plans. These regulations also provide
guidance to employers who provide group-term life insurance to their employees that is includible in the gross income of the
employees and to employers who transfer life insurance contracts to persons in connection with the performance of services.
This document also provides notice of a public hearing on these proposed regulations.
Written or electronic comments must be received by May 13, 2004. Requests to speak and outlines of topics to be discussed
at the public hearing scheduled for June 9, 2004, at 10 a.m., must be received by May 19, 2004.
Send submissions to: CC:PA:LPD:PR (REG-126967-03), room 5226, Internal Revenue Service, POB 7604, Ben Franklin Station, Washington,
DC 20044. Submissions may be hand-delivered Monday through Friday between the hours of 8 a.m. and 4 p.m. to: CC:PA:LPD:PR
(REG-126967-03), Courier’s Desk, Internal Revenue Service, 1111 Constitution Avenue, NW, Washington D.C. Alternatively, taxpayers
FOR FURTHER INFORMATION CONTACT: Concerning the proposed amendments to the section 79 regulations, Betty Clary at (202) 622-6080; concerning the proposed amendments
to the section 83 regulations, Robert Misner at (202) 622-6030; concerning the proposed amendments to the 402 regulations,
Linda Marshall at (202) 622-6090; concerning submissions and the hearing and/or to be placed on the building access list to
attend the hearing, Robin Jones at (202) 622-7180 (not toll-free numbers).
This document contains proposed amendments to the Income Tax Regulations (26 CFR Part 1) under section 402(a) of the Internal
Revenue Code (Code) relating to the amount includible in a distributee’s income when a life insurance contract, retirement
income contract, endowment contract, or other contract providing life insurance protection is distributed by a retirement
plan qualified under section 401(a) of the Code and to the sale of property by a retirement plan to a plan participant or
beneficiary for less than the fair market value of the property. This document also contains proposed amendments to the regulations
under sections 79 and 83 relating, respectively, to employer-provided group-term life insurance and life insurance contracts
transferred in connection with the performance of services.
Section 402(a) provides generally that any amount actually distributed to any distributee by any employees’ trust described
in section 401(a) which is exempt from tax under section 501(a) shall be taxable to the distributee, in the taxable year of
the distributee in which distributed, under section 72.
Section 1.402(a)-1(a)(1)(iii) of the current regulations provides, in general, that a distribution of property by a section
401(a) plan shall be taken into account by the distributee at its “fair market value.” Section 1.402(a)-1(a)(2) of the regulations
provides, in general, that upon the distribution of an annuity or life insurance contract, the “entire cash value” of the
contract must be included in the distributee’s income. The current regulations do not define “fair market value” or “entire
cash value” and questions have arisen regarding the interaction between these two provisions and whether “entire cash value”
includes a reduction for surrender charges.
Prohibited Transaction Exemption (PTE) 77-8 (1977-2 C.B. 425), subsequently amended and redesignated as Prohibited Transaction
Exemption 92-6, was jointly issued in 1977 by the Department of Labor and the Internal Revenue Service. PTE 77-8 permits
an employee benefit plan to sell individual life insurance contracts and annuities to (1) a plan participant insured under
such policies, (2) a relative of such insured participant who is the beneficiary under the contract, (3) an employer any of
whose employees are covered by the plan, or (4) another employee benefit plan, for the cash surrender value of the contracts,
provided the conditions set forth in the exemption are met.
The preamble to PTE 77-8 (citing Rev. Rul. 59-195; 1959-1 C.B. 18) notes that, for Federal income tax purposes, the value
of an insurance policy is not the same as, and may exceed, its cash surrender value, and that a purchase of an insurance policy
at its cash surrender value may therefore be a purchase of property for less than its fair market value. The regulations
under section 402 do not address the consequences of a sale of property by a section 401(a) plan to a plan participant or
beneficiary for less than the fair market value of that property. In this regard, the preamble to PTE 77-8 states that the
Federal income tax consequences of such a bargain purchase must be determined in accordance with generally applicable Federal
income tax rules but that any income realized by a participant or relative of such participant upon such a purchase under
the conditions of PTE 77-8 will not be deemed a distribution from the plan to such participant for purposes of subchapter
D of chapter 1 of the Internal Revenue Code (i.e., sections 401 to 424 of the Code) relating to qualified pension, profit-sharing, and stock bonus plans.
Section 79 of the Code generally requires that the cost of group-term life insurance coverage provided by an employer on the
life of an employee that is in excess of $50,000 of coverage be included in the income of the employee. Pursuant to §1.79-1(b)
of the regulations, under specified circumstances, group-term life insurance may be combined with other benefits, referred
to as permanent benefits. A permanent benefit is defined in §1.79-0 of the regulations as an economic value extending beyond
one policy year (for example, a paid-up or cash surrender value) that is provided under a life insurance policy. The regulations
further provide that certain features are not permanent benefits, including (a) a right to convert (or continue) life insurance
after group life insurance coverage terminates, (b) any other feature that provides no economic benefit (other than current
insurance protection) to the employee, and (c) a feature under which term life insurance is provided at a level premium for
a period of five years or less.
Permanent benefits provided to an employee are subject to taxation under rules described in §1.79-1(d) of the regulations.
Under those rules, the cost of the permanent benefits, reduced by the amount paid for those benefits by the employee, is
included in the employee’s income. The regulations provide the cost of the permanent benefits can be no less than an amount
determined under a formula set forth in the regulations. One of the factors used in this formula is “the net level premium
reserve at the end of that policy year for all benefits provided to the employee by the policy or, if greater, the cash value
of the policy at the end of that policy year.”
Section 83(a) provides that when property is transferred to any person in connection with the performance of services, the
service provider must include in gross income (as compensation income) the excess of the fair market value of the property,
determined without regard to lapse restrictions, and determined at the first time that the transferee’s rights in the property
are either transferable or not subject to a substantial risk of forfeiture, over the amount (if any) paid for the property.
Section 1.83-3(e) of the regulations generally provides that in the case of “a transfer of a life insurance contract, retirement
income contract, endowment contract, or other contract providing life insurance protection, only the cash surrender value
of the contract is considered to be property.”
In T.D. 9092, 2003-46 I.R.B. 1055 [68 FR 54336], published in the Federal Register on September 17, 2003, relating to split-dollar life insurance arrangements, §1.83-3(e) was amended to add the following
sentence: “Notwithstanding the previous sentence, in the case of a transfer of a life insurance contract, retirement income
contract, endowment contract, or other contract providing life insurance protection, or any undivided interest therein, that
is part of a split-dollar life insurance arrangement (as defined in §1.61-22(b)(1) or (2)) that is entered into, or materially
modified (within the meaning of §1.61-22(j)(2)), after September 17, 2003, the policy cash value and all other rights under
such contract (including any supplemental agreements thereto and whether or not guaranteed), other than current life insurance
protection, are treated as property for purposes of this section.”
A. Overview These proposed amendments to the regulations under section 402(a) clarify that the requirement that a distribution of property
must be included in the distributee’s income at fair market value is controlling in those situations where the existing regulations
provide for the inclusion of the entire cash value. Thus, these proposed regulations provide that, in those cases where a
qualified plan distributes a life insurance contract, retirement income contract, endowment contract, or other contract providing
life insurance protection, the fair market value of such a contract (i.e., the value of all rights under the contract, including any supplemental agreements thereto and whether or not guaranteed)
is generally included in the distributee’s income and not merely the entire cash value of the contracts.
These proposed regulations also provide that if a qualified plan transfers property to a plan participant or beneficiary for
consideration that is less than the fair market value of the property, the transfer will be treated as a distribution by the
plan to the participant or beneficiary to the extent the fair market value of the distributed property exceeds the amount
received in exchange. Thus, in contrast to the statement to the contrary in the preamble to PTE 77-8, any bargain element
in the sale would be treated as a distribution under section 402(a). It is also intended that any bargain element would be
treated as a distribution for other purposes of the Code, including the limitations on in-service distributions from certain
qualified retirement plans and the limitations of section 415.
These proposed regulations also amend the current regulations under sections 79 and 83 to clarify that fair market value is
also controlling with respect to life insurance contracts under those sections and, thus, that all of the rights under the
contract (including any supplemental agreements thereto and whether or not guaranteed) must be considered in determining that
fair market value. With respect to section 79, these proposed regulations would amend §1.79-1(d) to remove the term cash value from the formula for determining the cost of permanent benefits and substitute the term fair market value. With respect to section 83, these proposed regulations would amend §1.83-3(e) generally to apply the definition of property
for new split-dollar life insurance arrangements to all situations involving the transfer of life insurance contracts. Section
83(a) requires that the excess of the fair market value of the property over the amount paid for the property be included
in income. The current definition of property outside the context of a split-dollar life insurance arrangement may lead taxpayers
to believe that it is appropriate upon receiving a transfer of a life insurance contract to include only its cash surrender
value on the day of the transfer when, due to supplemental agreements, the fair market value of the transferred property is
much greater. The purpose of the changes to these regulations is to clarify that, unless specifically excepted from the definition
of permanent benefits or fair market value, the value of all features of a life insurance policy providing an economic benefit
to a service provider (including, for example, the value of a springing cash value feature) must be included in determining
the employee’s income.
The proposed regulations will not affect the relief granted by the provisions of Section IV, paragraph 4 of Notice 2002-8,
2002-1 C.B. 398, to the parties to any insurance contract that is part of a pre-January 28, 2002, split-dollar life insurance
arrangement. Also, consistent with the effective date of the final split-dollar life insurance regulations, §1.61-22, these
proposed regulations will not apply to the transfer of a life insurance contract which is part of a split-dollar life insurance
arrangement entered into on or before September 17, 2003, and not materially modified after that date. However, taxpayers
are reminded that, in determining the fair market value of property transferred under section 83, lapse restrictions (such
as life insurance contract surrender charges) are ignored.
B. Determination of Fair Market Value As noted above, §1.402(a)-1(a)(1)(iii) does not define fair market value. In Rev. Rul. 59-195, the Service ruled that, in
situations similar to those in which an employer purchases and pays the premiums on an insurance policy on the life of one
of its employees and subsequently sells such policy, on which further premiums must be paid, the value of such policy for
computing taxable gain in the year of purchase should be determined under the method of valuation prescribed in §25.2512-6
of the Gift Tax Regulations. Under this method, the value of such a policy is not its cash surrender value but the interpolated
terminal reserve at the date of sale plus the proportionate part of any premium paid by the employer prior to the date of
the sale which is applicable to a period subsequent to the date of the sale. Section 25.2512-6 of the Gift Tax Regulations
also provides that if “because of the unusual nature of the contract such approximation is not reasonably close to the full
value, this method may not be used.” Thus, this method may not be used to determine the fair market value of an insurance
policy where the reserve does not reflect the value of all of the relevant features of the policy.
In Q&A-10 of Notice 89-25, 1989-1 C.B. 662, the IRS addressed the question of what amount is includible in income under section
402(a) when a participant receives a distribution from a qualified plan that includes a life insurance policy with a value
substantially higher than the cash surrender value stated in the policy. The notice noted the practice of using cash surrender
value as fair market value for these purposes and concluded that this practice is not appropriate where the total policy reserves,
including life insurance reserves (if any) computed under section 807(d), together with any reserves for advance premiums,
dividend accumulations, etc., represent a much more accurate approximation of the policy’s fair market value.
Since Notice 89-25 was issued, life insurance contracts have been marketed that are structured in a manner which results in
a temporary period during which neither a contract’s reserves nor its cash surrender value represent the fair market value
of the contract. For example, some life insurance contracts may provide for large surrender charges and other charges that
are not expected to be paid because they are expected to be eliminated or reversed in the future (under the contract or under
another contract for which the first contract is exchanged), but this future elimination or reversal is not always reflected
in the calculation of the contract’s reserve. If such a contract is distributed prior to the elimination or reversal of those
charges, both the cash surrender value and the reserve under the contract could significantly understate the fair market value
of the contract. Thus, in some cases, it would not be appropriate to use either the net surrender value (i.e., the contract’s cash value after reduction for any surrender charges) or, because of the unusual nature of the contract,
the contract’s reserves to determine the fair market value of the contract. Accordingly, Q&A-10 of Notice 89-25 should not
be interpreted to provide that a contract’s reserves (including life insurance reserves (if any) computed under section 807(d),
together with any reserves for advance premiums, dividend accumulations, etc.) are always an accurate representation of the
contract’s fair market value.
For example, it would not be appropriate to use a contract’s reserve or the net surrender value of the contract as fair market
value at the time of distribution if under that contract those amounts are significantly less than the aggregate of: (1) the
premiums paid from the date of issue through the date of distribution, plus (2) any amounts credited (or otherwise made available)
to the policyholder with respect to those premiums (including interest, dividends, and similar income items), or, in the case
of variable contracts, all adjustments made with respect to the premiums paid during that period that reflect investment return
and the current market value of segregated asset accounts, minus (3) reasonable mortality charges and reasonable charges (other
than mortality charges) actually charged from the date of issue to the date of distribution and expected to be paid.
The following example provides an illustration of a contract where it would not be appropriate to use a contract’s reserve
or its net surrender value as its fair market value:
A participates in a plan intended to satisfy the requirements of section 401(a). In Year 1, the plan acquires a life insurance
contract on A’s life that is not a variable contract and with a face amount of $1,400,000. In that year and for the next
four years, the plan pays premiums of $100,000 per year on the contract. The contract provides for a surrender charge that
is fixed for the first five years of the contract and decreases ratably to zero at the end of ten years. The contract also
imposes reasonable mortality and other charges as defined by section 7702(c)(3)(B)(i) and (ii) of the Code.
The contract provides a stated cash surrender value for each of the first ten years (the first five years are guaranteed),
as set forth in the table below. The reserves under the contract, including life insurance reserves and reserves for advance
premiums, dividend accumulations, etc. (calculated using the rules in section 807(d) of the Code) at the end of the fifth
year are $150,000.
These regulations clarify that the contract is included in A’s income at its fair market value rather than the $100,000 cash
surrender value. Furthermore, A could not treat the $150,000 reserve as of the end of the fifth year as the fair market value,
because this amount is less than the amount a willing buyer would pay a willing seller for such a contract, with neither party
being under a compulsion to buy and sell and both having reasonable knowledge of the relevant facts.
The amendments to §1.402(a)-1(a)(2) of the regulations are proposed to be applicable to any distribution of a transferable
retirement income, endowment, or other life insurance contract occurring on or after February 13, 2004. The amendment to
§1.79-1 is proposed to be applicable to permanent benefits provided on or after February 13, 2004. The amendment to §1.83-3(e)
is proposed to be applicable to any transfer occurring on or after February 13, 2004. The amendments to §1.402(a)-1(a)(1)(iii)
of the regulations are proposed to be applicable to any transfer of property by a plan to a plan participant or beneficiary
for less than fair market value where the transfer occurs on or after the date of publication in the Federal Register of the final regulations adopting these amendments. Taxpayers may rely upon these proposed regulations for guidance pending
the issuance of final regulations.
The IRS and the Treasury recognize that taxpayers could have difficulty determining the fair market value of a life insurance
contract after the clarification in this preamble that Notice 89-25 should not be interpreted to provide that a contract’s
reserves (including life insurance reserves (if any) computed under section 807(d), together with any reserves for advance
premiums, dividend accumulations, etc.) are always an accurate representation of the contract’s fair market value. Accordingly,
in connection with this guidance, the IRS has issued Rev. Proc 2004-16, 2004-10 I.R.B. ), which provides interim rules under
which the cash value (without reduction for surrender charges) of a life insurance contract distributed from a qualified plan
may be treated as the fair market value of that contract. The interim rules in Rev. Proc. 2004-16, permit the use of values
that should be readily available from insurance companies, because the cash value (without reduction for surrender charges)
is an amount that, in the case of a flexible insurance contract (including a variable contract), is generally reported in
policyholder annual statements, and in the case of traditional insurance contracts, is fixed at issue and provided in the
Under those interim rules, a plan may treat the cash value (without reduction for surrender charges) as the fair market value
of a contract at the time of distribution 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 distribution, 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 charged on or before the date of distribution and are expected to be paid.
In those cases where the contract is a variable contract (as defined in section 807(d)) a plan may treat the cash value (without
reduction for surrender charges) as the fair market value of the contract at the time of distribution 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 distribution, plus
(2) all adjustments made with respect to those premiums during that period (whether under the contract or otherwise) that
reflect investment return and the current market value of segregated asset accounts, minus (3) reasonable mortality charges
and reasonable charges (other than mortality charges), but only if those charges are actually charged on or before the date
of distribution and are expected to be paid.
Applying those interim rules to the example above, A could treat the cash value (without reduction for surrender charges)
of $450,000 as the fair market value of the contract as of the end of the fifth year, because, in this example, that amount
exceeds the aggregate of the five $100,000 premiums ($500,000), plus the amounts credited to A with respect to those premiums,
minus the reasonable mortality and other charges actually imposed and expected to be paid.
Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations, and, because the regulations do not
request comments on the clarity of the proposed regulations and how they may be made easier to understand. In addition, the
Treasury Department and the IRS specifically request comments regarding the interim rules set forth in Rev. Proc. 2004-16
and proposals for appropriate permanent methods for valuing life insurance contracts when distributed from qualified retirement
plans and for valuing such contracts for purposes of sections 79 and 83, including appropriate discounts which take into account
the probability that contracts will be surrendered during the period during which surrender charges apply. The IRS and the
Treasury are also reviewing other types of contracts, such as annuities, which have cash surrender value but where that cash
surrender value may not reflect the fair market value of the contracts. Accordingly, the IRS and the Treasury also request
comments regarding the valuation of these other contracts. All comments will be available for public inspection and copying.
A public hearing has been scheduled for Wednesday, June 9, 2004, at 10 a.m. in the auditorium, Internal Revenue Building,
1111 Constitution Avenue, NW, Washington, DC. Due to building security procedures, visitors must use the main building entrance
on Constitution Avenue. In addition, all visitors must present photo identification to enter the building. Because of access
restrictions, visitors will not be admitted beyond the immediate entrance area more than 30 minutes before the hearing starts.
For more information about having your name placed on the list to attend the hearing, see the “FOR FURTHER INFORMATION CONTACT”
time to be devoted to each topic by Wednesday, May 19, 2004. A period of 10 minutes will be allotted to each person for making
comments. An agenda showing the scheduling of the speakers will be prepared after the deadline for receiving outlines has
passed. Copies of the agenda will be available free of charge at the hearing.
Par. 2. Section 1.79-1, paragraph (d)(3) is revised to read as follows:
§1.79-1 Group-term life insurance—general rules. * * * * * (d) * * * (3) Formula for determining deemed death benefit. The deemed death benefit (DDB) at the end of any policy year for any particular employee is equal to:
R is the net level premium reserve at the end of that policy year for all benefits provided to the employee by the policy
or, if greater, the fair market value of the policy at the end of that policy year; and
Y is the net single premium for insurance (the premium for one dollar of paid-up, whole life insurance) at the employee’s
age at the end of that policy year. * * * * * Par. 3. In §1.83-3, paragraph (e), the last two sentences are revised to read as follows:
§1.83-3 Meaning and use of certain terms. * * * * * (e) * * *In the case of a transfer of a life insurance contract, retirement income contract, endowment contract, or other contract
providing life insurance protection, or any undivided interest therein, the policy cash value and all other rights under such
contract (including any supplemental agreements thereto and whether or not guaranteed), other than current life insurance
protection, are treated as property for purposes of this section. However, in the case of the transfer of a life insurance
contract, retirement income contract, endowment contract, or other contract providing life insurance protection, which was
part of a split-dollar arrangement (as defined in §1.61-22(b)) entered into (as defined in §1.61-22(j)) on or before September
17, 2003, and which is not materially modified (as defined in §1.61-22(j)(2)) after September 17, 2003, only the cash surrender
value of the contract is considered to be property.
* * * * * Par. 4. Section 1.402(a)-1 is amended by:
§1.402(a)-1 Taxability of beneficiary under a trust which meets the requirements of section 401(a). (a) * * * (1) * * * (iii) Except as provided in paragraph (b) of this section, a distribution of property by a trust described in section 401(a)
and exempt under section 501(a) shall be taken into account by the distributee at its fair market value. In the case of a
distribution of a life insurance contract, retirement income contract, endowment contract, or other contract providing life
insurance protection, or any interest therein, the policy cash value and all other rights under such contract (including any
supplemental agreements thereto and whether or not guaranteed) are included in determining the fair market value of the contract.
In addition, where a trust described in section 401(a) and exempt under section 501(a) transfers property to a plan participant
or beneficiary in exchange for consideration and where the fair market value of the property transferred exceeds the amount
received by the trust, then the excess of the fair market value of the property transferred by the trust over the amount received
by the trust is treated as a distribution by the trust to the distributee.
* * * * * (2) * * * If, however, the contract distributed by such exempt trust is a life insurance contract, retirement income contract, endowment
contract, or other contract providing life insurance protection, the fair market value of such contract at the time of distribution
must be included in the distributee’s income in accordance with the provisions of section 402(a), except to the extent that,
within 60 days after the distribution of such contract, all or any portion of such value is irrevocably converted into a contract
under which no part of any proceeds payable on death at any time would be excludable under section 101(a) (relating to life
insurance proceeds). If the contract distributed by such trust is a transferable annuity contract, a life insurance contract,
a retirement income contract, endowment contract, or other contract providing life insurance protection (whether or not transferable),
then notwithstanding the preceding sentence, the fair market value of the contract is includible in the distributee’s gross
income, unless within such 60 days such contract is also made nontransferable.
* * * * * Mark E. Matthews,Deputy Commissioner for Services and Enforcement. Note
(Filed by the Office of the Federal Register on February 13, 2004, 8:45 a.m., and published in the issue of the Federal Register
for February 17, 2004, 69 F.R. 7384)
The principal authors of these regulations are Robert M. Walsh, Employee Plans, Tax Exempt and Government Entities Division,
and Linda Marshall, Office of Division Counsel/Associate Chief Counsel (Tax Exempt and Government Entities). However, other
personnel from the IRS and Treasury participated in the development of these regulations.