[Federal Register Volume 70, Number 166 (Monday, August 29, 2005)]
[Rules and Regulations]
[Pages 50967-50972]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 05-17046]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9223]
RIN 1545-BC20


Value of Life Insurance Contracts When Distributed From a 
Qualified Retirement Plan

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations under section 402(a) 
of the Internal Revenue Code regarding the amount includible in a 
distributee's income when life insurance contracts are distributed by a 
qualified retirement plan and regarding the treatment of property sold 
by a qualified retirement plan to a plan participant or beneficiary for 
less than fair market value. This document also contains final 
regulations under sections 79 and 83 of the Internal Revenue Code 
regarding the amounts includible in income when an employee is provided 
permanent benefits in combination with group-term life insurance or 
when a life insurance contract is transferred in connection with the 
performance of services. These regulations will affect administrators 
of, participants in, and beneficiaries of qualified retirement plans. 
These regulations will also affect employers who provide permanent 
benefits in combination with group-term life insurance for their 
employees and employees who receive those permanent benefits, as well 
as service recipients who transfer life insurance contracts to service 
providers in connection with the performance of services, and service 
providers to whom those life insurance contracts are transferred.

DATES: These regulations are effective August 29, 2005.

FOR FURTHER INFORMATION CONTACT: Concerning the section 79 regulations, 
Betty Clary at (202) 622-6080; concerning the section 83 regulations, 
Robert Misner at (202) 622-6030; concerning the section 402 
regulations, Bruce Perlin or Linda Marshall at (202) 622-6090 (not 
toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

A. In General

    This document contains amendments to the Income Tax Regulations (26 
CFR part 1) under section 402(a) of the Internal Revenue Code (Code) 
relating to the amount includible in a distributee's income when a life 
insurance contract, retirement income contract, endowment contract, or 
other contract providing life insurance protection is distributed by a 
retirement plan qualified under section 401(a), and relating to the 
sale of property by a qualified retirement plan to a plan participant 
or beneficiary for less than the fair market value of the property. 
This document also contains amendments to the regulations under 
sections 79 and 83 relating, respectively, to permanent benefits that 
are provided to employees in combination with group-term life 
insurance, and to life insurance contracts that are transferred in 
connection with the performance of services.
    Section 402(a) generally provides that any amount actually 
distributed to any distributee by any employees' trust described in 
section 401(a) which is exempt from tax under section 501(a) is taxable 
to the distributee in the taxable year of the distributee in which 
distributed, in accordance with section 72. Distributions from a 
qualified employees' trust generally are subject to withholding and 
reporting requirements pursuant to section 3405 and regulations 
thereunder. Section 1.402(a)-1(a)(1)(iii) provides, in general, that a 
distribution of property by a section 401(a) plan is taken into account 
by the distributee at its fair market value. Prior to its amendment by 
this Treasury decision, Sec.  1.402(a)-1(a)(2) (which was originally 
published in 1956) provided, in general, that upon the distribution of 
a life insurance contract, the ``entire cash value'' of the contract 
must be included in the distributee's income.\1\ Section 1.402(a)-1(a) 
did not define fair market value or entire cash value, and questions 
have arisen regarding the interaction between these two provisions and 
regarding whether the term entire cash value includes a reduction for 
surrender charges.
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    \1\ Section 1.402(a)-1(a)(2) also provides rules regarding the 
taxation of the distribution of an annuity contract. In certain 
cases, the distribution of an annuity contract is not includible in 
the participant's gross income until distributions are made from the 
annuity contract.
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    On April 30, 1975, proposed regulations under section 402 regarding 
the taxation of certain lump sum

[[Page 50968]]

distributions from qualified plans (the 1975 proposed regulations) were 
published in the Federal Register (40 FR 18798) to reflect changes to 
section 402 made by the Employee Retirement Income Security Act of 1974 
(ERISA) (Public Law 93-406, 88 Stat. 829). Under Sec.  1.402(a)-1(a)(2) 
of the 1975 proposed regulations, the distribution of an annuity 
contract must be treated as a lump sum distribution under section 
402(e) for purposes of determining the separate tax imposed under 
section 402(e)(1)(A),\2\ even if the distribution of the annuity 
contract itself is not currently taxable. The 1975 proposed regulations 
also expanded the situations in which the distribution of a retirement 
income, endowment, or other life insurance contract is not currently 
taxable to include the situation where, within 60 days after the 
distribution of such contract, the contract is treated as a rollover 
contribution under section 402(a)(5), as in effect after December 31, 
1973.
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    \2\ The tax imposed under section 402(e)(1)(A), as in effect at 
the time of the 1975 proposed regulations, generally was based on 
10-year averaging of the tax otherwise payable with respect to a 
lump-sum distribution.
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    Section 79 generally requires that the cost of group-term life 
insurance coverage provided by an employer on the life of an employee 
that is in excess of $50,000 of coverage be included in the income of 
the employee. Pursuant to Sec.  1.79-1(b), under specified 
circumstances, group-term life insurance may be combined with other 
benefits, referred to as permanent benefits. A permanent benefit is 
defined in Sec.  1.79-0 as an economic value extending beyond one 
policy year (for example, a paid-up or cash surrender value) that is 
provided under a life insurance policy. Section 1.79-0 further provides 
that certain features are not permanent benefits, including: (a) a 
right to convert (or continue) life insurance after group life 
insurance coverage terminates, (b) any other feature that provides no 
economic benefit (other than current insurance protection) to the 
employee, and (c) a feature under which term life insurance is provided 
at a level premium for a period of five years or less.
    Permanent benefits provided to an employee are subject to taxation 
under rules described in Sec.  1.79-1(d). Under those rules, the cost 
of the permanent benefits, reduced by the amount paid for those 
benefits by the employee, is included in the employee's income. Section 
1.79-1(d) provides that the cost of the permanent benefits cannot be 
less than an amount determined under a formula set forth in the 
regulations. Prior to its amendment by this Treasury decision, Sec.  
1.79-1(d) provided that one of the factors used in the formula for 
determining the cost of permanent benefits was ``the net level premium 
reserve at the end of that policy year for all benefits provided to the 
employee by the policy or, if greater, the cash value of the policy at 
the end of that policy year.''
    Section 83(a) generally provides that when property is transferred 
to any person in connection with the performance of services, the 
service provider must include in gross income (as compensation income) 
the excess of the fair market value of the property over the amount (if 
any) paid for the property. For this purpose, the fair market value of 
the property is determined without regard to lapse restrictions and is 
determined at the first time that the transferee's rights in the 
property are either transferable or not subject to a substantial risk 
of forfeiture. Prior to its amendment by this Treasury decision, Sec.  
1.83-3(e) generally provided that in the case of ``a transfer of a life 
insurance contract, retirement income contract, endowment contract, or 
other contract providing life insurance protection, only the cash 
surrender value of the contract is considered to be property.''
    In TD 9092, published in the Federal Register on September 17, 2003 
(68 FR 54336), relating to split-dollar life insurance arrangements, 
Sec.  1.83-3(e) was amended to add the following sentence: 
``Notwithstanding the previous sentence, in the case of a transfer of a 
life insurance contract, retirement income contract, endowment 
contract, or other contract providing life insurance protection, or any 
undivided interest therein, that is part of a split-dollar life 
insurance arrangement (as defined in Sec.  1.61-22(b)(1) or (2)) that 
is entered into, or materially modified (within the meaning of Sec.  
1.61-22(j)(2)), after September 17, 2003, the policy cash value and all 
other rights under such contract (including any supplemental agreements 
thereto and whether or not guaranteed), other than current life 
insurance protection, are treated as property for purposes of this 
section.''
    The prohibited transaction provisions of ERISA generally prohibit 
various transactions between plans covered by Title I of ERISA and 
certain parties in interest (including plan participants) with respect 
to such plans. Specifically, unless an exemption from the prohibited 
transaction rules applies, sections 406(a)(1)(A) and (D) of ERISA 
provide that a fiduciary with respect to a plan shall not cause the 
plan to engage in a transaction, if he knows or should know that such 
transaction constitutes a direct or indirect sale or exchange, or 
leasing, of any property between the plan and a party in interest; or 
transfer to, or use by or for the benefit of, a party in interest of 
any assets of the plan. Accordingly, unless a statutory or 
administrative exemption is applicable, the prohibited transaction 
rules are applicable to the sale of a life insurance contract, or 
annuity contract, by a plan to a party in interest.
    Section 4975 of the Code sets forth parallel rules that impose 
excise taxes on the amount involved with respect to prohibited 
transactions involving certain plans. The prohibited transaction 
provisions under section 4975, as well as the exemptions from the 
application of such rules, generally parallel the prohibited 
transaction provisions under Title I of ERISA.
    Prohibited Transaction Exemption (PTE) 77-8 (1977-2 C.B. 425), 
subsequently amended and redesignated as Prohibited Transaction 
Exemption 92-6, was jointly issued in 1977 by the Department of Labor 
and the IRS to provide an exemption from the restrictions of sections 
406(a) and 406(b)(1) and (b)(2) of ERISA and from the taxes imposed by 
sections 4975(a) and (b) of the Code for certain transactions. Under 
the exemption set forth in PTE 77-8 and PTE 92-6, an employee benefit 
plan is permitted to sell individual life insurance contracts and 
annuities for the cash surrender value of the contracts to certain 
specified parties, provided conditions are satisfied. Under PTE 77-8 
and PTE 92-6, such specified parties are: (1) A plan participant 
insured under such policies, (2) a relative of such insured participant 
who is the beneficiary under the contract, (3) an employer any of whose 
employees are covered by the plan, or (4) another employee benefit 
plan.
    The preamble to PTE 77-8 (citing Rev. Rul. 59-195, 1959-1 C.B. 18) 
noted that, for Federal income tax purposes, the value of an insurance 
policy is not the same as, and may exceed, its cash surrender value, 
and that a purchase of an insurance policy at its cash surrender value 
may therefore be a purchase of property for less than its fair market 
value. At the time PTE 77-8 was issued, the regulations under section 
402 did not address the consequences of a sale of property by a section 
401(a) plan to a plan participant or beneficiary for less than the fair 
market value of that property. In this regard, the preamble to PTE 77-8 
stated that the Federal income tax consequences of such a bargain 
purchase was required to be determined

[[Page 50969]]

in accordance with generally applicable Federal income tax rules but 
that any income realized by a participant or relative of such 
participant upon such a purchase under the conditions of PTE 77-8 would 
not be deemed a distribution from the plan to such participant for 
purposes of subchapter D of chapter 1 of subtitle A of the Internal 
Revenue Code (i.e., sections 401 to 424 relating to qualified pension, 
profit-sharing, and stock bonus plans).

B. The 2004 Proposed Regulations

    In February 2004, the IRS issued proposed amendments to the 
regulations under section 402(a) (69 FR 7384) to clarify that the 
requirement that a distribution of property be included in the 
distributee's income at fair market value is controlling in those 
situations where the regulations provided for the inclusion of the 
entire cash value of a retirement income, endowment, or other life 
insurance contract. The 2004 proposed regulations provided that the 
fair market value of a life insurance contract is determined taking 
into account the value of all rights under the contract, including any 
supplemental agreements thereto and whether or not guaranteed. The 
proposed regulations also provided that, if a qualified retirement plan 
transfers property to a plan participant or beneficiary for 
consideration that is less than the fair market value of the property, 
the transfer would be treated as a distribution by the plan to the 
participant or beneficiary to the extent the fair market value of the 
distributed property exceeds the value of the consideration received. 
Thus, under the proposed regulations, such a transfer would be treated 
as a distribution for purposes of applying the plan qualification 
requirements of section 401(a).
    The 2004 proposed regulations also contained proposed amendments to 
existing regulations under section 83 to clarify that fair market value 
is also controlling with respect to a life insurance contract, 
retirement income contract, endowment contract, or other contract 
providing life insurance protection and thus all of the rights under 
the contract (including any supplemental agreements thereto and whether 
or not guaranteed) must be considered in determining that fair market 
value. The proposed regulations contained proposed amendments to Sec.  
1.83-3(e), which generally apply the definition of property for new 
split-dollar life insurance arrangements to all situations subject to 
section 83 involving the transfer of life insurance contracts. The 
proposed regulations also contained proposed amendments to Sec.  1.79-
(d) to replace the term ``cash value'' in the formula for determining 
the cost of permanent benefits with the term ``fair market value.''

C. Determination of Fair Market Value

    As noted under the heading In General, Sec.  1.402(a)-1(a)(1)(iii) 
does not define the term fair market value. In Rev. Rul. 59-195, the 
IRS addressed the determination of fair market value of a life 
insurance contract in situations similar to those in which an employer 
purchases and pays the premiums on an insurance policy on the life of 
one of its employees for several years and on which further premiums 
must be paid, and subsequently sells such policy. The IRS held that the 
value of such a policy for purposes of computing taxable gain to the 
employee in the year of purchase should be determined under the method 
of valuation prescribed in Sec.  25.2512-6 of the Gift Tax Regulations. 
Under this method, the value of such a policy is not its cash surrender 
value but the interpolated terminal reserve at the date of sale plus 
the proportionate part of any premium paid by the employer prior to the 
date of the sale which is applicable to a period subsequent to the date 
of the sale. Section 25.2512-6 also provides that if ``because of the 
unusual nature of the contract such approximation is not reasonably 
close to the full value, this method may not be used.'' Thus, this 
method may not be used to determine the fair market value of an 
insurance policy where the reserve does not reflect the value of all of 
the relevant features of the policy.
    Q&A-10 of Notice 89-25 (1989-1 C.B. 662) described a distribution 
from a qualified plan of a life insurance policy with a value 
substantially higher than the cash surrender value stated in the 
policy. The notice concluded that the practice of using cash surrender 
value as fair market value is not appropriate where the total policy 
reserves, including life insurance reserves (if any) computed under 
section 807(d), together with any reserves for advance premiums, 
dividend accumulations, etc., represent a much more accurate 
approximation of the policy's fair market value.
    Since Notice 89-25 was issued, life insurance contracts have been 
marketed that are structured in a manner which results in a temporary 
period during which neither a contract's reserves nor its cash 
surrender value represent the fair market value of the contract. For 
example, some life insurance contracts may provide for large surrender 
charges and other charges that are not expected to be paid because they 
are expected to be eliminated or reversed in the future (under the 
contract or under another contract for which the first contract is 
exchanged), but this future elimination or reversal is not always 
reflected in the calculation of the contract's reserve. If such a 
contract is distributed prior to the elimination or reversal of those 
charges, both the cash surrender value and the reserve under the 
contract could significantly understate the fair market value of the 
contract. Thus, in some cases, it would not be appropriate to use 
either the net surrender value (i.e., the contract's cash value after 
reduction for any surrender charges) or, because of the unusual nature 
of the contract, the contract's reserves to determine the fair market 
value of the contract. Accordingly, Q&A-10 of Notice 89-25 should not 
be interpreted to provide that a contract's reserves (including life 
insurance reserves (if any) computed under section 807(d), together 
with any reserves for advance premiums, dividend accumulations, etc.) 
are always an accurate representation of the contract's fair market 
value.
    The IRS and Treasury recognized that taxpayers could have 
difficulty determining the fair market value of a life insurance 
contract for which the contract's reserves (including life insurance 
reserves (if any) computed under section 807(d), together with any 
reserves for advance premiums, dividend accumulations, etc.) are not an 
accurate representation of the contract's fair market value. 
Accordingly, the IRS issued Rev. Proc. 2004-16 (2004-10 I.R.B. 559), 
which provided interim rules under which the cash value (without 
reduction for surrender charges) of a life insurance contract 
distributed from a qualified plan may be treated as the fair market 
value of that contract, provided that certain requirements are 
satisfied. This safe harbor for determining fair market value was also 
available for purposes of sections 79 and 83.

D. Comments and Public Hearing on the 2004 Proposed Regulations and 
Rev. Proc. 2004-16

    The IRS received comments on the 2004 proposed regulations, and a 
public hearing was held on June 9, 2004. While none of the commentators 
objected to the proposed amendments to the regulations, a number of 
commentators raised concerns regarding the safe harbor formula for fair 
market value set forth in Rev. Proc. 2004-16. Several commentators 
recommended that final guidance provide more than one safe harbor for 
determining the fair market value of a policy and asserted that the 
safe harbor formulas under Rev. Proc.

[[Page 50970]]

2004-16 produce a value that is too high and does not reflect market 
realities. Suggestions were made that the interpolated terminal reserve 
(ITR) and tax reserve valuation methods under section 807(d) be used as 
alternatives to the interim safe harbor formula.
    Some commentators claimed that the interim safe harbor provided by 
Rev. Proc. 2004-16 was not usable for all types of life insurance 
policies. In particular, these commentators asserted that the formulas 
did not function well for traditional whole life policies. In addition, 
commentators were concerned about the possible double-counting of 
certain dividends under the formulas, and the fact that the formulas 
did not make an explicit adjustment for withdrawals or distributions, 
nor did they provide for any recognition of the possibility that a 
surrender charge would apply in the future.

E. Rev. Proc. 2005-25--Safe Harbors for Determining Fair Market Value

    After reviewing the comments to the prior guidance, the IRS and 
Treasury concluded that the safe harbor formulas in Rev. Proc. 2004-16 
did not function well for certain types of traditional policies, and 
also should be revised to reflect a discount for the possibility that a 
surrender charge would apply in certain situations. Accordingly, Rev. 
Proc. 2005-25 (2005-17 I.R.B. 962) was issued to modify and supersede 
Rev. Proc. 2004-16 in order to make adjustments to the safe harbor 
formulas. These new safe harbor formulas replace the formulas in Rev. 
Proc. 2004-16 for distributions, sales, and other transfers made on or 
after February 13, 2004, and for permanent benefits provided on or 
after February 13, 2004. For all periods, including periods before May 
1, 2005, taxpayers may rely on the safe harbors in Rev. Proc. 2005-25. 
In addition, for periods on or after February 13, 2004, and before May 
1, 2005, taxpayers may rely on the safe harbors in Rev. Proc. 2004-16.

Explanation of Provisions

    These final regulations retain the rules set forth in the 2004 
proposed regulations under section 402(a) providing that the 
requirement that a distribution of property be included in the 
distributee's income at fair market value is controlling in those 
situations where the former regulations provided for the inclusion of 
the entire cash value of a retirement income, endowment, or other life 
insurance contract. Thus, these final regulations clarify that, in 
those cases where a qualified plan distributes a life insurance 
contract, retirement income contract, endowment contract, or other 
contract providing life insurance protection, the fair market value of 
such a contract (i.e., the value of all rights under the contract, 
including any supplemental agreements thereto and whether or not 
guaranteed) is generally included in the distributee's income, and not 
merely the entire cash value of the contract. However, these final 
regulations retain the rules from existing final regulations setting 
forth the situations under which a distribution of such a contract is 
not currently includible in income.
    These final regulations also set forth a portion of the rules 
included in the 1975 proposed regulations. Under those rules, the 
distribution of an annuity contract must be treated as a lump sum 
distribution for purposes of determining the amount of tax under the 
10-year averaging rule of section 402(e) (as in effect prior to the 
amendment by the Tax Reform Act of 1986, Public Law 99-514, 100 Stat. 
2085), even if the distribution of the annuity contract itself is not 
currently taxable. The distribution of a retirement income, endowment, 
or other life insurance contract is not taxable in the situation where 
within 60 days after the distribution of such contract, the contract is 
treated as a rollover contribution under section 402(a)(5), as in 
effect after December 31, 1973. Although the final regulations reject 
the use of the term entire cash value as found in the 1975 proposed 
regulations, no inference should be made that other rules in the 1975 
proposed regulations that have not been included in these final 
regulations have also been rejected.
    These final regulations retain the rules provided in the 2004 
proposed regulations that, if a qualified plan transfers property to a 
plan participant or beneficiary for consideration that is less than the 
fair market value of the property, the transfer is treated as a 
distribution under the plan to the participant or beneficiary to the 
extent the fair market value of the distributed property exceeds the 
value of the consideration. Thus, in contrast to the statement to the 
contrary in the preamble to PTE 77-8, these regulations provide that 
any bargain element in the sale is treated as a distribution under 
section 402(a). In addition, any such bargain element is treated as a 
distribution under the plan for all other purposes of the Code, 
including the qualification requirements of section 401(a). Thus, for 
example, this bargain element is treated as a distribution for purposes 
of applying the limitations on in-service distributions from certain 
qualified retirement plans and the limitations of section 415. The rule 
treating the bargain element in a sale as a distribution from a 
qualified plan applies to transfers that occur on or after August 29, 
2005. For transfers before that date, the bargain element in the sale 
must be included in the plan participant's income under section 61. 
However, such a transfer of a life insurance contract, retirement 
income contract, endowment contract, or other contract providing life 
insurance protection occurring before that date is deemed not to give 
rise to a distribution for purposes of applying the requirements of 
subchapter D of chapter 1 of subtitle A of the Code.
    These final regulations also retain the rules set forth in the 2004 
proposed regulations under sections 79 and 83 that clarify that fair 
market value is also controlling with respect to life insurance 
contracts under those sections and, thus, that all of the rights under 
the contract (including any supplemental agreements thereto and whether 
or not guaranteed) must be considered in determining that fair market 
value. These final regulations amend Sec.  1.79-1(d) to replace the 
term cash value in the formula for determining the cost of permanent 
benefits with the term fair market value. These final regulations also 
amend Sec.  1.83-3(e) generally to apply the definition of property for 
new split-dollar life insurance arrangements to all situations 
involving the transfer of a life insurance contract, retirement income 
contract, endowment contract, or other contract providing life 
insurance protection. Section 83(a) requires that the excess of the 
fair market value of the property over the amount paid for the property 
be included in income. The purpose of the changes to the regulations is 
to clarify that, unless specifically excepted from the definition of 
permanent benefits or fair market value, the value of all features of a 
life insurance policy providing an economic benefit to a service 
provider (including, for example, the value of a springing cash value 
feature) must be included in determining the employee's income.
    These final regulations do not affect the relief granted by the 
provisions of Section IV, paragraph 4 of Notice 2002-8 (2002-1 C.B. 
398) to the parties to any insurance contract that is part of a pre-
January 28, 2002, split-dollar life insurance arrangement. Also, 
consistent with the effective date of the final split-dollar life 
insurance regulations at Sec.  1.61-22(j), these final regulations do 
not apply to the transfer of a life insurance contract which is part of 
a split-dollar life insurance arrangement entered into on or before 
September 17, 2003, and not materially modified after

[[Page 50971]]

that date. However, taxpayers are reminded that, in determining the 
fair market value of property transferred under section 83, lapse 
restrictions (such as life insurance contract surrender charges) are 
ignored.

Effective Date

    These regulations are effective August 29, 2005. The amendments to 
Sec.  1.402(a)-1(a) apply to any distribution of a retirement income, 
endowment, or other life insurance contract occurring on or after 
February 13, 2004. The amendment to Sec.  1.79-1 is applicable to 
permanent benefits provided on or after February 13, 2004. The 
amendment to Sec.  1.83-3(e) is applicable to any transfer occurring on 
or after February 13, 2004.

Special Analyses

    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in Executive Order 12866. 
Therefore, a regulatory assessment is not required. It has also been 
determined that section 553(b) of the Administrative Procedure Act (5 
U.S.C. chapter 5) does not apply to these regulations. In addition, 
because no collection of information is imposed on small entities, the 
provisions of the Regulatory Flexibility Act (5 U.S.C. chapter 6) do 
not apply, and therefore, a Regulatory Flexibility Analysis is not 
required. Pursuant to section 7805(f) of the Code, the notice of 
proposed rulemaking preceding these regulations was submitted to the 
Small Business Administration for comment on its impact on small 
business.

Drafting Information

    The principal authors of these regulations are Bruce Perlin and 
Linda Marshall, Office of Division Counsel/Associate Chief Counsel (Tax 
Exempt and Government Entities). However, other personnel from the IRS 
and Treasury participated in the development of these regulations.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Amendments to the Regulations

0
Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

0
Paragraph 1. The authority citation for part 1 continues to read, in 
part, as follows:

    Authority: 26 U.S.C. 7805 * * *


0
Par. 2. In Sec.  1.79-1, paragraph (d)(3) is revised to read as 
follows:


Sec.  1.79-1  Group-term life insurance--general rules.

* * * * *
    (d) * * *
    (3) Formula for determining deemed death benefit. The deemed death 
benefit (DDB) at the end of any policy year for any particular employee 
is equal to--

R/Y

Where--

R is the net level premium reserve at the end of that policy year 
for all benefits provided to the employee by the policy or, if 
greater, the fair market value of the policy at the end of that 
policy year; and
Y is the net single premium for insurance (the premium for one 
dollar of paid-up, whole life insurance) at the employee's age at 
the end of that policy year.
* * * * *

0
Par. 3. In Sec.  1.83-3, paragraph (e), the fourth and fifth sentences 
are revised to read as follows:


Sec.  1.83-3  Meaning and use of certain terms.

* * * * *
    (e) * * * In the case of a transfer of a life insurance contract, 
retirement income contract, endowment contract, or other contract 
providing life insurance protection, or any undivided interest therein, 
the policy cash value and all other rights under such contract 
(including any supplemental agreements thereto and whether or not 
guaranteed), other than current life insurance protection, are treated 
as property for purposes of this section. However, in the case of the 
transfer of a life insurance contract, retirement income contract, 
endowment contract, or other contract providing life insurance 
protection, which was part of a split-dollar arrangement (as defined in 
Sec.  1.61-22(b)) entered into (as defined in Sec.  1.61-22(j)) on or 
before September 17, 2003, and which is not materially modified (as 
defined in Sec.  1.61-22(j)(2)) after September 17, 2003, only the cash 
surrender value of the contract is considered to be property. * * *
* * * * *

0
Par. 4. Section 1.402(a)-1 is amended by:
0
1. Revising paragraph (a)(1)(iii).
0
2. Revising paragraph (a)(2).
    The revisions read as follows:


Sec.  1.402(a)-1  Taxability of beneficiary under a trust which meets 
the requirements of section 401(a).

    (a) * * *
    (1) * * *
    (iii) Except as provided in paragraph (b) of this section, a 
distribution of property by a trust described in section 401(a) and 
exempt under section 501(a) shall be taken into account by the 
distributee at its fair market value. In the case of a distribution of 
a life insurance contract, retirement income contract, endowment 
contract, or other contract providing life insurance protection, or any 
interest therein, the policy cash value and all other rights under such 
contract (including any supplemental agreements thereto and whether or 
not guaranteed) are included in determining the fair market value of 
the contract. In addition, in the case of a transfer of property that 
occurs on or after August 29, 2005 where a trust described in section 
401(a) and exempt under section 501(a) transfers property to a plan 
participant or beneficiary in exchange for consideration and where the 
fair market value of the property transferred exceeds the value of the 
consideration, then the excess of the fair market value of the property 
transferred by the trust over the value of the consideration received 
by the trust is treated as a distribution to the distributee under the 
plan for all purposes under the Internal Revenue Code. Where such a 
transfer occurs before that date, the excess of the fair market value 
of the property transferred by the trust over the value of the 
consideration received by the trust is includible in the gross income 
of the participant or beneficiary under section 61. However, such a 
transfer of a life insurance contract, retirement income contract, 
endowment contract, or other contract providing life insurance 
protection occurring before that date is not treated as a distribution 
for purposes of applying the requirements of subchapter D of chapter 1 
of subtitle A of the Internal Revenue Code.
* * * * *
    (2) If a trust described in section 401(a) and exempt under section 
501(a) purchases an annuity contract for an employee and distributes it 
to the employee in a year in which the trust is exempt, and the 
contract contains a cash surrender value which may be available to an 
employee by surrendering the contract, such cash surrender value will 
not be considered income to the employee unless and until the contract 
is surrendered. For the rule as to nontransferability of annuity 
contracts issued after 1962, see Sec.  1.401-9(b)(1). For additional 
requirements regarding distributions of annuity contracts, see, e.g., 
Sec. Sec.  1.401(a)-20, Q&A-2, 1.401(a)(31)-1, Q&A-17, and 1.401(a)(9)-
6, Q&A-4. However, the distribution of an annuity contract must be 
treated as a lump sum distribution for purposes of determining the 
amount of tax under the 10-year averaging rule of section 402(e) (as in 
effect prior to amendment by the Tax Reform Act of

[[Page 50972]]

1986, Public Law 99-514, 100 Stat. 2085). If, however, the contract 
distributed by such exempt trust is a life insurance contract, 
retirement income contract, endowment contract, or other contract 
providing life insurance protection, the fair market value of the 
contract at the time of distribution must be included in the 
distributee's income in accordance with the provisions of section 
402(a), except to the extent that, within 60 days after the 
distribution of the contract, all or any portion of such value is 
irrevocably converted into a contract under which no part of any 
proceeds payable on death at any time would be excludable under section 
101(a) (relating to life insurance proceeds), or the contract is 
treated as a rollover contribution under section 402(c). If the 
contract distributed by such trust is a transferable annuity contract, 
or a retirement income, endowment, or other life insurance contract and 
such contract is not treated as a rollover contribution under section 
402(c), then, notwithstanding the preceding sentence, the fair market 
value of the contract is includible in the distributee's gross income 
unless, within such 60 days, such contract is made nontransferable.
* * * * *

Mark E. Matthews,
Deputy Commissioner for Services and Enforcement.
Approved: August 9, 2005.

Eric Solomon,
Acting Deputy Assistant Secretary for Tax Policy.
[FR Doc. 05-17046 Filed 8-26-05; 8:45 am]
BILLING CODE 4830-01-P