BenefitsSpectrum
May 2005  |  No: 2005 - 05
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Revenue Procedure Outlines Insurance Contract Valuation Safe Harbor

The IRS has issued a new revenue procedure that modifies and supersedes Rev. Proc. 2004-16, which was issued in February 2004 to provide an interim safe harbor for determining the fair market value of variable and non-variable contracts that provide life insurance. Rev. Proc. 2005-25.

Background

Rev. Proc. 2005-25 provides guidance on how to determine the fair market value of a life insurance contract, retirement income contract, endowment contract, or any other contract providing life insurance. The guidance is to be used for applying the rules of sections 79, 83, and 402.

Sections 83, 402(a), and 402(b) require that distributions or transfers of property (including contracts providing life insurance) be taken into the gross income of the recipient at "fair market value" or a value reflecting the contract's cash surrender value, together with all other contract rights (Reg. Sec.1.83-3(e)). Section 79 (as interpreted by Reg. Sec. 1.79-1(d)) requires that the fair market value of permanent insurance benefits be included in an employee's income.

The Past

The IRS made three attempts to provide guidance regarding the fair market value of contracts providing life insurance.

Rev. Rul. 59-195 used the interpolated terminal reserve, rather than the cash surrender value, as the fair market value of a contract where premiums were still due.

Notice 89-25, Q/A-10, stated that the cash surrender value of a contract may not be used as its fair market value when the policy's total reserves represent a much more accurate approximation of a contract's fair market value.

Rev. Proc. 2004-16 provided safe harbor methods for determining the fair market value of both variable (as defined in section 817(d)) and non-variable contracts. After receiving comments from the public, the IRS determined that adjustments to the Rev. Proc. 2004-16 safe harbors were appropriate.

Variable Contract

Section 817(d) defines "variable contract" as a contract providing for the allocation of all or part of the amounts received under the contract to an account that is segregated from the general assets of the issuing company under a state law or regulation. The contract is an annuity or insurance contract, or one that funds insurance on retired lives. Also, the benefits available under the contract must reflect the value of the segregated asset account.

Safe Harbor Formulas

Rev. Proc. 2005-25 provides two safe harbor formulas that, if used to determine the value of a contract providing life insurance, will meet the fair market value requirements of section 402(a) for qualified plan distributions. These safe harbor formulas will meet the definition of fair market value for purposes of sections 79, 83, and 402(b), and will provide a value that will meet the definition of "vested accrued benefit" for purposes of section 402(b)(4).

Safe Harbor Valuation for Non-Variable Contracts

The fair market value of a non-variable contract may be measured as the greater of:

A.   The sum of the interpolated terminal reserve and any unearned premiums, plus a pro rata portion of estimated dividends for the year, and
B.   The product of the PERC amount (see below) and the applicable Average Surrender Factor (also below).

The PERC (premiums, earnings and reasonable charges) amount is the aggregate of:

1.   Premiums paid from the issue date to the valuation date (without offset for dividends used to reduce premiums), plus
2.   Dividends applied to buy paid-up insurance, plus
3.   Any amounts credited to the policy holder with respect to premiums (not including dividends described in 1 and 2 above), minus
4.   Reasonable mortality and other charges actually charged, minus
5.   Any distributions.

Average Surrender Factor

Sections 79, 83, and 402(b) permit no adjustment to a contract's fair market value for potential surrender charges. Therefore, the Average Surrender Factor for calculations under these sections is 1.00.

For distributions of insurance contracts from qualified plans, if the contract provides an explicit surrender charge, the Average Surrender Factor is the un-weighted average of the applicable surrender factors over the 10 years beginning with the policy year of the distribution or sale. For this purpose, the Applicable Surrender Factor for a year is the greater of 0.70 and a fraction, the numerator of which is the projected amount of cash that would be available if the policy were surrendered on the first day of the policy year (or the sale/distribution date), and the denominator of which is the PERC amount on that same date. The Applicable Surrender Factor for a year without a surrender charge is 1.00. A surrender charge must be contractually specified and non-increasing in order to be taken into account.

Safe Harbor Valuation for Variable Contracts

The fair market value of a variable contract may be measured as the greater of:

A.   The sum of the interpolated terminal reserve and any unearned premiums, plus a pro rata portion of estimated dividends, and
B.   The product of the variable PERC amount (see below) and the Average Surrender Factor (above).

The variable PERC amount is the aggregate of:

1.   Premiums paid from date of issue through valuation date without reduction for dividends that offset premiums, plus
2.   Dividends applied to increase the value of the contract (including dividends used to buy paid-up insurance), plus or minus,
3.   All adjustments that reflect investment return and market value of segregated asset accounts, minus
4.   Reasonable mortality and other charges actually charged, minus
5.   Any distributions.

Reasonable Application of Safe Harbor Formulas

Section 3.05 of Rev Proc. 2005-25 states that the formulas in the revenue procedure "must" be interpreted in a reasonable manner consistent with the purpose of identifying the fair market value of the contract. For example, income calculated under a contract must be included in the formulas, even though the income can only be realized through an exchange that gives rise to springing cash value in another policy. Mortality charges that are to be refunded under any written or verbal agreement cannot be considered. Also, the rules cannot be interpreted in a manner that allows the formulas to be used to understate the fair market value of a contract. If an insurance contract has not been in force for some time, the premium cost is the best way to establish fair market value.

Effective Dates

Rev. Proc. 2005-25 applies to sales, transfers, and distributions made on or after February 13, 2004. Rev. Proc. 2005-25 applies to permanent benefits provided on or after February 13, 2004. For non-exempt trusts under section 402(b), Rev. Proc. 2005-25 applies for periods on or after February 13, 2004. However, the IRS states that the Rev. Proc. 2005-25 safe harbors may be relied upon for periods before May 1, 2005. Taxpayers can rely on Rev. Proc. 2004-16 for periods between February 13, 2004, and May 1, 2005.

Effect on Companies

It appears that the IRS is forcefully addressing the insurance policy valuation issue that has been at the core of many tax-avoidance transactions over the years. The IRS is also addressing the situation where a literal reading of its previously published position yields an unintended result.

 

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