Profit Sharing Plan distribution when participant has a life insurance

[maverick]

Situation: Former employee has a substantial account balance, which includes a life insurance policy (cash value = 20,000). He wants to roll the non-life insurance assets to an IRA, but does not want to take a distribution equal to the cash value of the ins. policy.

In addition to lump sum payouts, the plan document allows annual installments. Can he roll the non-life ins. assets to an IRA (2002 annual installment), then take the policy as his annual installment in 2003?

Other:

He does not have the cash to pay in to the plan to replace the cash value.

Yes, I know he might be able to take a policy loan and use the proceeds to pay the taxes.

I luv life insurance in qualified plans. Thanks.

Maverick

[mbozek]

Assuming that the plan permits a withdrawal of less than a lump sum distribution, the participant can make a tax free rollover of the cash to an IRA in 2002 and take distribution of the LI policy in 2003 as a taxable distribution. But why not cash out the LI policy and rollover the entire distribution to an IRA? Is employee uninsurable? If not than LI policy is probably an expensive investment.

There is one creative possibility: Tax free transfer of the LI policy and cash to a 0% money purchase plan established by ee for own business ,e.g., consulting. Employer can use protoype plan and only requirement would be that ee make some minimal after tax employee contribution or make er contribuion for one yr from consulting revenue. If ee anticpates profits from business establish a PS plan.

[maverick]

That's what I like about this site, someone always has a good idea. My brain must be addled, because I didn't even consider cashing out the life insurance policy. The participant did mention that he did not need the insurance, so that 's the way we will go. Thanks mjb.

[Belgarath]

Just for future reference if you ever have a similar situation where the participant WANTS to keep the insurance in force - assuming your plan document permits it, have the Trustee take a maximum loan on the life insurance policy. Then assign the policy to the participant. The policy will have little or no cash value - hence little or no taxable distribution. And the borrowed cash value can then be combined with the other funds for the participant, and the entire amount rolled to an IRA.

[mbozek]

Belgarath- Why isn't your proposed transaction a prohibited transaction between the plan and a party in interest which will result in the imposition of a 15/100% excise tax?? Also why should a plan participant pay interest to borrow his or her own money on a nondeductible basis when the employee can have the entire cash value without cost and roll it over tax free to an ira??? Please explain the economic rationale for for your concept.

[Belgarath]

mbozek - first, the transaction is between an insurance company and the Trustee/plan. It isn't a transaction between the plan and a party in interest. The Trustee is taking a loan from an insurance company. The insurance company would not generally be a party in interest, hence a perfectly legitimate transaction and not a PT.

As far as the economic rationale, remember this is addressing a specific situation, where a participant WANTS to keep a life insurance policy in force, but is either unable or unwilling to purchase it from the plan for the cash value. The plan can assign the policy to the participant, but the cash value will be taxable income, and possibly a premature distribution. So unless the participant is willing to purchase the policy for the cash value, the goals of keeping it in force yet not incurring a taxable distribution are mutually exclusive. In this situation, you're back to the policy loan solution discussed earlier. The participant receives no taxable distribution, rolls his ENTIRE account balance, including the borrowed funds, to an IRA, and now has a personally owned policy with a loan against it. Hope this helps.

[mbozek]

Belgarath- IRC 4975© provides that a prohibited transaction includes lending of of money between the plan and party in interest. A service provider such an an insurance company providing a policy to a plan participant where the policy is owned by the plan is a party in interest. I would not recommend that a plan trustee enter into a loan with an insurance co under these circumstances. Also would not UBIT apply on the sale of assets in the particpant's account which are purchased with the loaned funds because they are debt fianced property?? Isn't the bottom line that your proposal contains too many unclear/ complex tax issues to the plan and the participant to be worthwhile pursuing since outside advisors such as an attorney would have to be retained?

[Belgarath]

mbozek - where in the original post or subsequent discussion does it say that the insurance company is a service provider? I am basing my answer on the information provided. I agree with you completely that if the insurance company is a service provider, you have a party in interest and therefore a PT.

As far as UBIT, that's certainly an issue to be considered. But all of these situations that I've seen involve immediate assignment of the policy, and subsequent immediate distribution of the participant's account balance, which includes the policy loan proceeds. Highly unlikely that any earnings on the borrowed cash value would exceed the UBIT exemption amount.

This is a fairly standard procedure. We always tell Participants/Trustees/Employers to consult their tax or legal counsel. Nonetheless, as TPA's it is part of our job to point out possible solutions to everyday situations that arise. And I respectfully disagree that there are too many complexities to make it worth retaining outside counsel. Anytime you have an insurance policy with a high cash value in a plan (and believe me, there are lots of them) it should be well worth it in the fact situation given. It's a basic enough issue so I've never seen an attorney/CPA charge an exhorbitant fee, nor has a client ever complained about it.

Anyway, that's about all I have to say about it from my end. Hope this helps to clarify the issue.

[mbozek]

Belgarath- I have always thought that service providers include any company that provides investments to the plan, e.g, mutaul fund family- otherwise how would they be subject to the pT rules when plan uses their investments. Soloman Smith Barney was held to have violated the PT rules last year because because a plan indavertly purchased one of its investment funds.

[Belgarath]

mbozek - I'm not familiar with the Smith Barney case to which you refer. I'm assuming that there are some specific details that take it out of the situation we're discussing. ERISA 3(14) defines a party in interest, and includes a person providing services to the plan. However, an insurance company, mutual fund, etc. does not become a Service Provider merely because the plan invests funds with them. Or at least they never have been previously - if the case you reference did this, it's a well-kept secret.

You'd have to check with someone who is familiar with the Smith Barney case to see why they were found to be a Service Provider - perhaps the plan was using one of their prototype documents, for example? I'm only speculating... If you find a writeup or link that I could look at, I'd appreciate it if you could let me know - I'd be very interested to look at it. Thanks.

[Guest Harry O]

Although this is not my area of expertise, I thought there was a DOL prohibited transaction class exemption that would permit this type of transaction between an insurer who is a party in interest and a plan trustee.

[mbozek]

Harry O - that may be correct See PTE 77-9 and 84-24 which permit insurance companys that act as fiduciaries or service providers to plans to purchase insurance contracts from themselves. But i don't know if the insurance co can loan money to the plan from the cash value of the policy.

Belgarath- I still don't understand the economic advantage of taking the cash value as a loan (and paying a market interest rate of 8%+) plus the cost of paying an annual premium on the amount of insurance which will be used soley to pay back the loan balance at death. I don't see the leverage in this transaction for the insured. Economically it may be cheaper to rollover the cash value of the policy to an IRA and find a replacement policy on the internet e.g., 10 year term, if the employee needs death protection.

[Belgarath]

Note that there is a statutory PT exemption for parties in interest who provide services necessary for the establishment or operation of a plan as long as they don't receive more than reasonable compensation for providing that service. See Code § 4975(d)(2).

As far as the economic rationale - I'm not commenting on that, nor on the term vs. whole life issues, because these are issues that have been, and will continue to be, debated by legions of experts and non experts, all of whom have their own opinions, and in some cases, axes to grind. I'll only say that if you have a policy with a cash value of 100,000, there are many terminated participants who want to keep the insurance, for whatever reason, and who are completely unwilling to incur a taxable distribution of 100,000. They may also be unwilling to write a check to the plan for 100,000. I'm not commenting on the validity or intelligence of their financial choices - only to point out that this offers a solution, which is very frequently used, that seems to satisfy the needs of a lot of participants.

I'm signing off this thread for good, but I've appreciated the input, and hope the discussion may have been useful for some other people as well.