Life Insurance in qualified plans - Policy Loan

[Guest allanH]

I have a new client who has had his Qualified Plan Trust take loans against policies owned by the Trust. The loan proceeds were then invested by the Trustee in other assets. It seems to me there may be two problems: First, is there an excise tax for the income generated from this leveraged asset of the plan, and Secondly is there a prohibited transaction associated with this borrowing? Any Thoughts?

[mbozek]

There is no prohibition against a plan using plan assets to make loans to an unrelated third party at a reasonable rate of intereest and treating the interest as a plan asset. Only loans to a party in interest who is related to the plan create a prohibited transaction subject to the 15% tax. See IRC 4975. However, using borrowed funds secured by plan assets to purchase additional plan assets will generate unrelated business income tax at a marginal rate of up to 38.6% of the gains when the leveraged assets are sold by the plan. See IRC 512-14. Also some types of qualified plans (e.g., IRC 412(i)) do not permit borrowing on LI policies. I think your client needs to speak to a tax /benefit specialist to determine the propriety of borrowing on the plan assets.

[Kirk Maldonado]

MBozek:

Assuming that (1) the participant directed the plan to take out the policy loan and (2) the proceeds of that loan are invested as directed by the participant, are you comfortable that it would not be treated as a loan to the participant. In that regard, note the following language from Section 72(p)(5):

any amount received as a loan under a contract purchased under a qualified employer plan (and any assignment or pledge with respect to such a contract) shall be treated as a loan under such employer plan.

I'm not convinced that there is a loan here, but I wanted to raise the issue.

[Belgarath]

I clearly do not think that there is a participant loan. However, I agree with Mbozek that thre is a UBTI issue. It also seems to me that there was some level of exemption, as long as the UBTI didn't exceed some figure, which from my failing memory was 1,000. Is this still true?

[mbozek]

UBIT is imposed only if the tax exceeds $1000.