Guest Article

(From the March 3, 2008 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)

IRS Addresses Long-Term Care Policies Provided as an Investment and Benefit Under 401(k) Plan

IRS recently ruled that the payment of premiums on long-term care policies held by a 401(k) plan for the benefit of electing participants would run afoul of the qualification requirements. IRS reasoned that such payments would be considered taxable distributions and, therefore, would violate the restriction imposed by IRC § 401(k) which permits distribution only on account of severance from employment, death, disability, plan termination, age 59-1/2, hardship, and a qualified reservist distribution. IRS Private Letter Ruling 200806013 (November 15, 2007).

Long-Term Care Proposal

An employer sponsoring a 401(k) plan sought to allow participants the ability to acquire longterm care insurance coverage under the plan. Various contributions were being made to the participants' accounts under the plan: 401(k) contributions, matching contributions, employer non-elective profit sharing contributions, and qualified non-elective contributions. The employer proposed to amend the plan to allow the participants to direct the investment of their accounts in long-term care insurance coverage, subject to limitations to comply with the incidental benefit rule. The plan would be the purchaser and holder of the policies, although the policy would be held for the benefit of the electing participant and the participant's account would be charged for the applicable premium. The employer further proposed to allow in-service distribution of the policy when the participant incurred long-term care expenses which qualified as a hardship. All policies would be qualified long-term care insurance contracts under IRC § 7702B.

Rulings Requested

Several rulings were requested. Foremost, a ruling was requested that the participants would not be currently taxed on the cost of the long-term care coverage. Secondary requests concerned whether the acquisition of the policy satisfied the "incidental benefit" requirement, whether the benefits received by the plan would be annual additions subject to IRC § 415(c), whether benefits received by the participant would be excludable from gross income under IRC § 105(b), whether in-service distribution of the policy would be permissible, and whether the policy could be rolled over to an individual retirement arrangement.

IRS Analysis

IRS looked back to Revenue Ruling 61-164, which held that the purchase of hospitalization insurance by a profit sharing plan will not cause the plan to be disqualified where the insurance is deemed to be "incidental," although the use of plan funds to pay for the coverage would be a distribution. IRS pointed out that this rationale is carried forward in the recently proposed regulations under IRC § 402, which clarify that a payment from a qualified plan for accident or health insurance premiums -- including long-term care coverage -- would constitute a taxable distribution to the participant in the year the premium is paid.

According to IRS, both the elective contributions and non-elective employer contributions under the plan were made "pursuant to section 401(k)(2)(A) of the Code." It is unclear how this conclusion was reached since the letter ruling stated that the employer non-elective contributions were held in the participant's "Employer Non-Elective Contribution Account" separate and apart from the participant's "Elective Contribution Account" which reportedly held, but separately accounted for, the participant's elective deferrals, matching contributions and qualified nonelective contributions. The employer's proposal nonetheless clearly sought to use employee 401(k) contributions to pay the long-term care premiums, and IRS ruled that such use would violate the restrictions imposed by IRC § 401(k)(2)(B) which prohibits distribution earlier than severance from employment, death, disability, plan termination, age 59-1/2, hardship, or the date a qualified reservist distribution is permitted. Failure to comply with the IRC § 401(k) distribution restrictions would adversely affect the qualified status of the plan under IRC § 401(a).

Having decided that the proposed features would cause the plan to fail to comply with the qualification requirements of IRC § 401(a), IRS concluded that the other issues were moot and did not address them.

Observations

If structured another way, the employer's proposal may have caused the IRS to persevere further into the analysis of whether it would be possible to provide long-term care coverage under such plans. For example, if the employer sought to utilize only contributions that were not subject to the IRC § 401(k)(2)(B) restrictions -- or, if the option to invest in long-term care insurance was to be made available only to participants age 59-1/2 and older -- IRS might have taken its analysis beyond the first request for ruling. Perhaps employer non-elective profit sharing contributions could be paid out in-service in a manner that would not trigger an early distribution tax under IRC § 72(t) (e.g., as a series of substantially equal periodic payments) but which can be utilized to pay the long-term care premiums. From the IRS's brief synopsis of the law, however, a proposal by which benefits will be paid from the policy to the plan and then distributed to the participant would seem to raise compliance issues with IRC § 415(c) which, in turn, would place a premium on distributing the policy before it becomes payable.

The information in this Washington Bulletin is general in nature only and not intended to provide advice or guidance for specific situations. If you have any questions or need additional information about articles appearing in this or previous versions of Washington Bulletin, please contact: Robert Davis 202.879.3094, Elizabeth Drigotas 202.879.4985, Mary Jones 202.378.5067, Stephen LaGarde 202.879-5608, Erinn Madden 202.572.7677, Bart Massey 202.220.2104, Mark Neilio 202.378.5046, Martha Priddy Patterson 202.879.5634, Tom Pevarnik 202.879.5314, Sandra Rolitsky 202.220.2025, Tom Veal 312.946.2595, Deborah Walker 202.879.4955. Copyright 2008, Deloitte.