Taxation Of Distribution Of Life Insurance Contract
March 13, 2024
140 / If a qualified plan trust distributes a life insurance policy to an employee, is the value of the contract taxable to the employee in the year of distribution?
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If the contract is a life insurance, retirement income, endowment, or other contract providing life insurance protection, the <em>fair market value</em> of the contract at the time of distribution must be included in the distributee’s income to the extent that it exceeds the distributee’s basis ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3837">3837</a>).<a href="#_ftn1" name="_ftnref1"><sup>1</sup></a> Inclusion of the contract’s fair market value in the distributee’s income is not required at the time of distribution, however, to the extent that within 60 days after it is distributed (1) all or any portion of the contract is irrevocably converted to an annuity with no life insurance element, or (2) the contract is treated as a rollover contribution under IRC Section 402(c).<a href="#_ftn2" name="_ftnref2"><sup>2</sup></a><br />
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The fair market value standard also applies if the contract is sold by the plan to a participant or beneficiary. If the fair market value of the contract exceeds the value of the consideration, then such excess (i.e., the “bargain element”) is treated as a distribution to the distributee under the plan for all purposes under the IRC. This treatment of the “bargain element” as a distribution applies for transfers occurring after August 28, 2005. For transfers occurring before August 29, 2005, the “bargain element” is includable in the distributee’s gross income, but is not treated as a distribution for qualification purposes.<a href="#_ftn3" name="_ftnref3"><sup>3</sup></a><br />
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The fair market value standard is effective for distributions or sales occurring after February 12, 2004.<a href="#_ftn4" name="_ftnref4"><sup>4</sup></a> Fair market value includes the policy cash value and all other rights under the contract (including any supplemental agreements thereto, whether or not guaranteed).<a href="#_ftn5" name="_ftnref5"><sup>5</sup></a> The IRS has issued safe harbor guidance for determining the fair market value of life insurance contracts.<a href="#_ftn6" name="_ftnref6"><sup>6</sup></a> Under the safe harbor, fair market value may be the greater of (1) the interpolated terminal reserve and any unearned premiums, plus a pro rata portion of a reasonable estimate of dividends expected to be paid for that policy year, and (2) the product of the “PERC amount” (PERC stands for premiums, earnings, and reasonable charges) and the applicable “Average Surrender Factor.” For details on these calculations, <em>see</em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="144">144</a>.<br />
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<em>Conversion to annuity contract</em>. If a policy is converted, it then will be subject to the rules for annuity contracts (provided the annuity is nontransferable). The IRS has taken the position that the mere elimination of the element of risk in a retirement income contract when the reserve exceeds the face amount does not convert the insurance contract into an annuity contract. According to the IRS, the insured must act to convert the contract into an annuity contract that has at no time contained an element of life insurance protection.<a href="#_ftn7" name="_ftnref7"><sup>7</sup></a> If the policy is distributed in a lump sum distribution, the taxable amount is eligible for favorable capital gains and special averaging treatment to the extent that such rules are still applicable.<br />
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<em>Death benefit</em>. When a life insurance contract matures by reason of the insured’s death <em>after</em> the policy has been distributed from the plan, the proceeds are wholly tax-exempt to the beneficiary.<a href="#_ftn8" name="_ftnref8"><sup>8</sup></a><br />
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<a href="#_ftnref1" name="_ftn1">1</a>. Treas. Reg. § 1.402(a)-1(a)(1)(iii).<br />
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<a href="#_ftnref2" name="_ftn2">2</a>. Treas. Reg. § 1.402(a)-1(a)(2).<br />
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<a href="#_ftnref3" name="_ftn3">3</a>. Treas. Reg. § 1.402(a)-1(a)(1)(iii).<br />
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<a href="#_ftnref4" name="_ftn4">4</a>. Rev. Proc. 2005-25, 2005-17 IRB 962.<br />
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<a href="#_ftnref5" name="_ftn5">5</a>. Treas. Reg. § 1.402(a)-1(a)(2)(iii).<br />
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<a href="#_ftnref6" name="_ftn6">6</a>. Rev. Proc. 2005-25, 2005-17 IRB 962.<br />
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<a href="#_ftnref7" name="_ftn7">7</a>. Rev. Rul. 66-322, 1966-2 CB 123.<br />
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<a href="#_ftnref8" name="_ftn8">8</a>. Rev. Rul. 63-76, 1963-1 CB 23.<br />
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