Pensions and Life Insurance
Estate Tax Funding,Life Insurance and Profit Sharing, Plan Purposeand Legal Basis
Under the Internal Revenue Code and Treasury Regulations, a qualified profit-sharing or pension plan may lawfully purchase life insurance on behalf of a participant, provided the insurance coverage is incidental to the plan’s primary purpose of providing retirement benefits. Treasury Regulation § 1.401-1(b)(1)(i)–(ii) expressly permits the inclusion of “incidental death benefits” within qualified plans, and Revenue Ruling 54-51 and Revenue Ruling 74-307 establish the operational limits for such use.
In a profit-sharing plan, premiums ordinarily must be limited to no more than 50 % of employer contributions if using whole life, or 25 % if using term insurance. However, when the plan holds “seasoned money”—funds that have been in the participant’s account for at least two full plan years, or derived from investment earnings rather than recent contributions—the IRS and industry practice recognize that 100 % of the account value may be used to purchase life insurance. This exception, often called the seasoned money rule, rests on the rationale that such funds are no longer considered “employer contributions” and therefore fall outside the 25 % / 50 % incidental-benefit percentage limits of Rev. Rul. 54-51.
Properly structured, the plan may subsequently distribute the policy to the participant upon termination or retirement, after which it may be transferred or sold to an Irrevocable Life Insurance Trust (ILIT) to complete the estate-planning objective—all without disqualifying the plan under IRC § 401(a), and without triggering a prohibited transaction under IRC § 4975, provided fair value and fiduciary standards are observed.
In sum, a profit-sharing plan may purchase and later distribute life insurance on a participant’s life if the policy qualifies as an incidental benefit under Treas. Reg. § 1.401-1. When the plan account contains seasoned money, the incidental-benefit percentage caps no longer restrict the purchase; the entire account value may be applied toward life-insurance premiums. After distribution, the participant may transfer or sell the policy to an ILIT, achieving both income-tax deferral and estate-tax exclusion while preserving the qualified status of the originating plan.
Assumed value of $ 8,000,000* could, in its entirety, be used to purchase a life insurance policy over 4 years to avoid creating a MEC under IRC § 7702(a). I would recommend funding an ILIT to about the $2,000,000 level simultaneously. At the end of the 5th year, the policy will be purchased out of the Profit Sharing Plan. This step avoids two problems: a) recognition of income under IRC § 402(a), and b) upon transfer to the ILIT, the avoidance of the “three-year rule,” or removal of the death benefit from the taxable estate, under IRC § 2035(a) exception to the “three-year rule.” Incidentally, the original value of the tax-free death benefit is around $21,000,000.
*All the numbers are proportionate. $8mm Premium~ $23mm of Insurance, $ 10 mm ~$ 28.75 mm of Insurance.
Upon termination, the participant may elect to treat the life insurance policy as a distribution in kind, or to purchase the policy from the Plan at its Fair Market Value (FMV), as determined under Rev. Proc. 2005-25. The FMV is based on the insurer’s Form 712 and includes the interpolated terminal reserve or PERC plus unearned premium. The transaction is exempt from prohibited-transaction treatment under IRC § 4975, provided the plan receives adequate consideration. The participant may thereafter sell the policy to an ILIT for estate-planning purposes, preserving income-tax exclusion under IRC § 101(a) and avoiding estate inclusion under IRC § 2035 if properly structured. The “three-year rule” of Internal Revenue Code § 2035(a) provides that if an insured transfers an existing life-insurance policy within three years of death, the policy proceeds are pulled back into the insured’s gross estate as though the transfer had never occurred. This inclusion rule is designed to prevent a donor from avoiding estate taxation by making a gratuitous transfer of a policy shortly before death. However, § 2035(a) applies only to transfers by gift (i.e., gratuitous transfers or releases of ownership incidents). It does not apply to a bona fide sale for adequate and full consideration.
In short, at a 50% marginal tax rate, a tax-free return on Death Benefit is economically equivalent to earning approximately 12% annually in a fully taxable investment account for 27 consecutive years.