Last week, we discussed the Matthies case, which tagged a taxpayer with a substantial deficiency in a “pension rescue”/springing life insurance situation involving the use of valuation mechanisms and life insurance to attempt to remove assets from a qualified retirement plan through the purchase and sale of a life insurance contract whose value was depressed through the existence of substantial surrender charges. The transaction that took place in Matthies preceded the “safe harbor” life insurance valuation rules that were issued by the IRS in Rev.Proc. 2005-25 and a 2005 revision to the Regulations.
The Revenue Procedure did allow for safe-harbor reductions in value due to surrender charges, but caps the aggregate reduction at 30% of the value. Further, the Procedure did not bless pension rescue-type transactions, per several restrictions included in the Procedure, including:
a. Allowing a reduction for surrender charges, "but only if those charges are actually charged on or before the valuation date and those charges are not expected to be refunded, rebated, or otherwise reversed at a later date;"
b. Not allowing a reduction for charges, "if a mortality charge or other amount charged under a contract can be expected to be directly or indirectly returned to the contract holder (whether through the contract, a supplemental agreement, or under a verbal understanding and regardless of whether there is a guarantee);"
c. Allowing for a challenge in other potentially abusive situations, including situations where the contract is sold if not in force "for some time" (whatever that means). In particular, the Procedure reads: "In addition, a surrender charge cannot be taken into account in determining an average surrender factor if it may be waived or otherwise avoided or was created for purposes of the transfer or distribution. Furthermore, at no time are these rules to be interpreted in a manner that allows the use of these formulas to understate the fair market value of the life insurance contracts and associated distributions or transfers. For example, if the insurance contract has not been in force for some time, the value of the contract is best established through the sale of the particular insurance contract by the insurance company (i.e., as the premiums paid for that contract)."
The IRS also issued new Regulations in 2005 that provide valuation methodologies that the IRS can attempt to use to challenge springing value arrangements.
The foregoing limitations and the Matthies case, taken together, appear to provide plenty of maneuvering room for the IRS to successfully challenge pension rescue transaction, at least those of the plain vanilla variety.