Death Benefit Limits

[Gary]

A plan sponsor implemented a 412i insurance funded plan, thought the fact that it is intended to be a 412i plan should not be relevant as the matter pertains to death benefit limits.

The plan includes the husband and wife as the only employees/participants.

For each participant a total contribution of $200k was made, where $100k was for the life insurance premium and the additional $100k was to an annuity poicy. If the participant lives until NRA then the amounts in the two policies is to fund the retirement benefit. And if the employee dies prior to NRA then the life insurance and value in the annuity policy is the death benefit.

This seems to comply with the incidental death benefit limits of rev rul 74-307.

My understanding of 74-307 is that less than 50% must be applied to life insurance. So that would mean if the annuity policy contribution was instead $100,001 it would technically mean that the life insurance premium is less than 50% of total contribution. Not sure if such a technicality is truly meaningful or relevant, but just an observation.

I've even seen where a DB plan could have as much as 66% of contribution be applied to the life insurance policy.

Any views on the compliance of such a death benefit provision?

Thanks.

[SoCalActuary]

A plan sponsor implemented a 412i insurance funded plan, thought the fact that it is intended to be a 412i plan should not be relevant as the matter pertains to death benefit limits.

The plan includes the husband and wife as the only employees/participants.

For each participant a total contribution of $200k was made, where $100k was for the life insurance premium and the additional $100k was to an annuity poicy. If the participant lives until NRA then the amounts in the two policies is to fund the retirement benefit. And if the employee dies prior to NRA then the life insurance and value in the annuity policy is the death benefit.

This seems to comply with the incidental death benefit limits of rev rul 74-307.

My understanding of 74-307 is that less than 50% must be applied to life insurance. So that would mean if the annuity policy contribution was instead $100,001 it would technically mean that the life insurance premium is less than 50% of total contribution. Not sure if such a technicality is truly meaningful or relevant, but just an observation.

I've even seen where a DB plan could have as much as 66% of contribution be applied to the life insurance policy.

Any views on the compliance of such a death benefit provision?

Thanks.

The type of policy matters here. If you are buying UL or a term policy, then the life policy gets only 1/4 of the total.

If you are buying an endowment at NRA, or possibly a whole life policy, then your example has some play - done carefully.

[Gary]

It is a whole life policy.

[Gary]

IRS is reviewing a plan with 50% premium for whole life policy and 50% premium for annuity contract to fund the projected retirement benefit under 412i plan.

The projected ret benefit being funded is 100k per year at age 65.

The participant's compensation for the first two years was only 80k and then the next three years is 100k for a 3 year avg of 100k. So initially it seems the flaw would be funding for a benefit in excess of 415 limit, but this is corrected when they increase their compensation.

Today agent said that the death benefits are excessive and the entity is subject to a listed transaction, but gave no further details.

Based on the facts presented, anyone care to opine as to what grounds the IRS may arrive at such a conclusion?

Thanks.

[JAY21]

I'd be surprised if the IRS is doing the death benefit limit using the Rev. Ruling 74-307 themselves. You might need to do that calc for them, provide the Rev. Ruling, and have them reconsider. We have a handful of 412i plans and the few audited it seems like the IRS considers them "guilty" until proven "innocent", and innocence is considered extremely unlikely.

[Gary]

The IRS acknowledges that 74-307 allows for a death benefit where 50% of the total premium is for a whole life policy and the other 50% premium is for an annuity contract.

However, at the same tiime they say the death benefit is excessive. They say that the insurance policies provide for an excessive retirement benefit thus the death benefit is excessive.

As I mentioned before it is true that the compensation was a little low for the benefits produced by the policies, but by the third year compensation was significantly increased and thus the projected benefit by the end of the fourth year was more than what the policies were guaranteed to provide.

The IRS is going to prepare a written report and then we will have to respond to each aspect.

If in fact the IRS chooses to disqualify the plan based on the first year compensation being too low than it seems there isn't much to do about it, but if they are willing to look at the big picture it should be clear that the benefits aren't excessive.

Any interpretations are welcome.

Thank you.

[rcline46]

I don't know a lot about 412(i) plans, but don't forget one could always use a Salary Scale to provide funding for an anticipated benefit.

[Belgarath]

One option that the IRS has frequently been allowing is to "unwind" the 412(e)(3) plan, retroactive to the starting date, and treat as a regular DB plan. Have they offered this as an acceptable solution?

Even if you have an approved prototype, and did everything right, it's still a rare client who is willing to pay the legal fees to fight even a stupid or incorrect auditor (and I'm not saying the auditor is wrong in this case - may be right, may not be) so unwinding it is often more palatable then the remaining choices, which are rarely good.

[Gary]

I believe unwinding plan will be an option, but not a very good one since the deduction limits will be much less than the actual premiums paid.

Thanks and we'll see.

[SoCalActuary]

I don't know a lot about 412(i) plans, but don't forget one could always use a Salary Scale to provide funding for an anticipated benefit.

For a normal plan that makes sense, but not the fully insured plan. Remember that the accrued benefit is the cash value. By using a policy that buys too much benefit, you have an incorrect accrued benefit.

The provider of the work in the first plan year is responsible for this failure, IMO, and they should review their E/O coverage.

[JAY21]

Belgrath's comment is what I'm seeing the IRS do also (treat it as if it's a traditional DB plan from the get go and use the cash-value or interpolated reserve of the policy as being the side-fund assets).

Don't be afraid to use low interest rates like maybe 4% when re-calculating on this basis. There isn't a magical 5% limit on funding assumptions and I do think they (IRS) might even allow a salary scale if benefit formula is pay related. They truly almost seem to be ignoring the 412i plan document and just treating it (for funding) as a traditional DB plan with all the normal funding assumptions you might use.