Incidental Limits for Life Insurance in Profit Sharing Plan Exceeded. What to do?

[PRS5500!]

What are the implications of exceeding the incidental limits for life insurance in a Profit Sharing Plan? Are there corrective mechanisms, penalties, excise tax, govenernment forms to report the excess?

[Bill Presson]

If you exceed the incidental limits, it's considered an in-service distribution and the entire premium is taxable.

[Belgarath]

But make sure you first confirm incidental limits were actually exceeded. Plan may utilize 2/5 rule if participant was eligible for it.

[PRS5500!]

Bill do you have a cite for the entire premium being taxable as an in-service distribution?

[Belgarath]

I don't think you will find statutory or regulatory authority for this position. Waaay back, maybe in the late 1990's or early 2000's, an IRS representative put forth this theory at an ASPPA conference, but as far as I know, there is no supporting guidance, and opinions from the podium are just that - opinions. Official guidance appears to only require taxable term cost be paid, even on the excess. Now, I don't know whether the IRS does, indeed, take this position and whether it has ever been litigated. Hasn't to my knowledge.

The worse outcome is that exceeding the incidental limits is a qualification issue, and the IRS COULD disqualify the entire plan. However, I believe this can be corrected under EPCRS (Revenue Procedure 2016-51) but I thankfully haven't had to deal with life insurance in pans for several years now, so you'd want to look that up.

[Bill Presson]

But make sure you first confirm incidental limits were actually exceeded. Plan may utilize 2/5 rule if participant was eligible for it.

We've (meaning this board) discussed this over the years. I'm firmly convinced that exceeding the incidental limits using this rule still requires the entire premium to be taxable as an inservice distribution. But many dont' agree.

Bill do you have a cite for the entire premium being taxable as an in-service distribution?

I filed a general information request a number of years ago. I also had several discussions with Jim Holland regarding that request. Those two things combined gave me the information I needed to know I was correct. Don't think many will be able to use it as a cite.

[Belgarath]

Bill - certainly not saying you are wrong. There's a good argument for that position being technically correct. But I will say this - in a prior life with an insurance company, that company and many, many others didn't agree with what we termed "The Holland approach." As far as I know, Holland's interpretation was never adopted as official policy by the IRS, and I never saw imposition of taxation in that situation on audit where the 2/5 rule had been utilized. Maybe just lucky...

Of course, I've been out of that for a long time, and it may have changed. I thankfully no longer deal with these issues, and I don't miss it!!

[Bird]

I'm with Bill on this. IMO the only reason taxes aren't imposed in these situations is that a) they aren't audited, or b) if audited, the agent didn't know enough. This is what Walters Kluwer says about using seasoned money:

If we have seasoned profit sharing money in the plan, to avoid the incidental death benefit restrictions, must we have a provision allowing distribution of seasoned assets, or is simply having seasoned money in the plan enough to get around the limitation?

The plan would have to include a provision allowing for the in-service distribution of seasoned money. Note that the entire premium would be taxable to the participant if paid from seasoned money, if the premium exceeds the ancillary benefit limit.

[ETA Consulting LLC]

I'm will Belgarath on this issue. WOW. We have us a live one!!! LOL Over my years, everything here is a repeat of all interpretations I've seen in the past.

With Belgarath's approach, we acknowledge that the ancillary limit does one thing; prove that those benefits (e.g. insurance) is not why the plan exists int he first place. The whole notion here is to ensure that the retirement plan, itself, exists for the purpose of providing a retirement benefit (and not insurance). I think we should all agree on that as a matter of principle; despite our disagreements on the 'what next' issue.

When it comes to 'what next': 1) Does the premium get taxed as if it were a distribution? If so, what happens if that individual was not eligible for a distribution from the plan; does that disqualify the plan?
When it comes to a qualification issue (Belgarath): How to you address the fact that you have a transaction that basically undermine the entire premise of your plan being established to provide a retirement benefit?

Consequences aside, I'm with Belgarath This does not mean I believe other suggestions are not valid; I just need it to fit in my neat little jigsaw puzzle

Ultimately, the only authority I see on a taxable event from life insurance is the economic benefit in section 72(m)(3) which basically says that if you want then "pure death benefit" to be paid from the plan income-tax free, then you must pay the economic benefit up front. Even that rule does not mandate the economic benefit tax be paid; it seems to merely state that if you don't pay it, then the entire death benefit goes back to the trust and the ultimate distribution from it will be taxed.

With that said, I clearly see no precedent for taxing premiums on life insurance policies merely because they were purchased with 'season (or even seeded)' money.

Good Luck!

[Belgarath]

"When it comes to a qualification issue (Belgarath): How to you address the fact that you have a transaction that basically undermine the entire premise of your plan being established to provide a retirement benefit?"

This is probably the only piece of this whole issue that I think is simple and straightforward - the IRS absolutely permits the use of "seasoned" money, and it is still routinely found in IRS pre-approved prototypes/VS documents. As far as I'm concerned, it isn't a qualification issue. The IRS will not disqualify a PS plan if you properly applied the 2/5 rule. As to the philosophical discussion of what the proper purpose of a PS plan should be, I decline to enter that debate.

As to the rest, not necessarily so simple (at least as far as I'm concerned) and as I said, I don't have to deal with it any more. I think we have maybe three old takeover plans where life insurance is even permitted as an investment, and only one plan with a very old policy still remaining. Hurray!!!

Signing off this one, as I have nothing useful to say (not that this is any change from normal...)

[ETA Consulting LLC]

As for me, I worked for a Life & Annuity firm for years and had to research every single life insurance rule ever written (even the Norris vs. Arizona case). While a good part of the industry as moved away from the entire notion of having a life policy inside a qualified plan; it's still a practice that is alive and well. I continue to get questions on it from many of the advisors I support.

At the end of the day, it will be up to the client to obtain the services of someone who is comfortable with providing those services. When providing those services, the plan document is, indeed, an appropriate reference; especially with respect to life policies within a plan written onto that document.

As a professional, I try to instill comfort to my clients in the positions I communicate to them by adding as much perspective as possible. So, I think it is entirely fitting to have a discussion of the 'purpose of a retirement plan' anytime you're speaking of incident benefit limits. Doing so would be an equivalent of discussing the plan being in existence for 5 years when addressing a permanency issue. I think that type of perspective and insight is important, and often missing, when speaking on contentious issues

With that said, I think I'm signing off as well.

Good Luck!