What Is a 412(i) Plan? The Former Name for a 412(e)(3) Plan

Technical Summary: 412(i) and 412(e)(3) Are the Same Plan

A 412(i) plan is the former statutory name for what is now a section 412(e)(3) plan under the Internal Revenue Code: a fully insured defined-benefit plan funded exclusively by insurance contracts. The IRS states that the Pension Protection Act of 2006 retained the former section 412(i) provisions but relocated them to section 412(e)(3), effective for plan years beginning after December 31, 2007.

The regulation still uses the section 412(i) number, and so does IRS guidance issued before the change, such as Rev. Rul. 2004-20. "412(i) plan," "412i plan," "412 i plan," "section 412(i)," "412i pension plan" and "412i retirement plan" all refer to this same plan, not to a separate type of plan available today.

In summary:

• Name. "412(i)" was the Internal Revenue Code designation before the Pension Protection Act of 2006 (PPA '06). The IRS page on fully insured plans says the former provisions "were retained under PPA '06 but were relocated to IRC Section 412(e)(3), effective for plan years beginning after December 31, 2007."
• Regulation. The same IRS page states that regulations "were not updated after the enactment of PPA '06 and remain in Treas. Reg. Section 1.412(i)-1" (26 C.F.R. § 1.412(i)-1).
• Plan type. The plan is a defined-benefit plan funded exclusively by insurance contracts, and it must meet all six statutory conditions in 26 U.S.C. § 412(e)(3)(A)–(F).
• Compliance history. Rev. Rul. 2004-20 identified certain arrangements involving life insurance in these plans as "listed transactions," a designation that still appears on the IRS Listed Transactions page.
• Primary reference. The IRS page "Fully insured 412(e)(3) plans" is the agency's own summary of the requirements.

Definition: What a 412(i) Plan Is

The term begins with a business problem. An owner or owner-employee may want a retirement benefit set by formula, funded by the business, and sponsored as a qualified plan. The IRS page Retirement plans definitions states that a defined-benefit plan, "also known as a traditional pension plan, promises the participant a specified monthly benefit at retirement," while a defined-contribution plan "is a retirement plan in which the employee and/or the employer contribute to the employee's individual account under the plan." The same page describes a 401(k) plan as "a defined contribution plan." The two structures are compared on the page on 412(e)(3) plans vs a 401(k).

"Fully insured" refers to how the benefit is funded. Section 412(e)(3)(A) describes a plan "funded exclusively by the purchase of individual insurance contracts." The statute also treats a plan funded exclusively by group insurance contracts as described in that paragraph when regulations find that the contracts have the same characteristics. Treas. Reg. § 1.412(i)-1(c) addresses group annuity and group insurance contracts. Section 1.412(i)-1(d) treats a plan funded by a combination of individual and group contracts as described in the section if "the combination, in the aggregate, satisfies the requirements."

"412(i)" was the Code section number for these provisions until PPA '06 relocated them. The regulation's own text still refers to plans "described in section 412(i)," and the IRS describes the number change on its fully insured plans page. The insurance contracts are a funding mechanism inside the plan. Cash value is a feature of each contract. The life insurance is not itself a pension, a savings plan or an investment.

Applicable Rules: The Statutory and Regulatory Framework

Several federal sources govern the plan, and each one does a different job.

• 26 U.S.C. § 412(e)(3). This is the statutory home of the fully insured plan. Under section 412(e)(2)(B), section 412 "shall not apply to … any insurance contract plan described in paragraph (3)." The IRS states that these plans "are exempt from the minimum funding rules of IRC Section 412 pursuant to IRC Section 412(e)(2)(B)."
• 26 C.F.R. § 1.412(i)-1. This is the implementing Treasury Regulation. It sets out the conditions for individual contract plans (paragraph (b)), group contract plans (paragraph (c)) and combinations of the two (paragraph (d)), and the IRS states that it was not updated after PPA '06.
• 26 U.S.C. § 404. Section 404(a) provides that employer contributions to a pension plan "shall not be deductible under this chapter; but, if they would otherwise be deductible, they shall be deductible under this section," subject to its limits.
• 26 U.S.C. § 415(b). This section caps the annual benefit under a defined-benefit plan at the lesser of a dollar amount stated in the statute, which section 415(d) adjusts annually for cost of living, or "100 percent of the participant's average compensation for his high 3 years," with adjustments for benefits that begin before age 62 or after age 65.
• Rev. Rul. 2004-20. This ruling addresses when a plan holding life insurance cannot be a section 412(i) plan, when certain employer contributions for life insurance are deductible, and when such transactions are "listed transactions." A listed transaction is a transaction the IRS has identified under the Treasury's disclosure, registration and list-maintenance regulations that the ruling cites.
• Rev. Rul. 2004-21. This ruling addresses the Code's nondiscrimination requirements for plans funded with life insurance contracts.
• IRS Listed Transactions page. This official page lists Rev. Rul. 2004-20 under "Abusive Transactions Involving Insurance Policies in IRC 412(i) Retirement Plans."
• ERISA. Under 29 C.F.R. § 2510.3-3(a), "only employee benefit plans within the meaning of section 3(3) are subject to title I" of the Employee Retirement Income Security Act (ERISA), and under § 2510.3-3(b) that term does not include a plan "under which no employees are participants covered under the plan." The regulation's example is a so-called "Keogh" or "H.R. 10" plan: one "under which only partners or only a sole proprietor are participants covered under the plan will not be covered under title I," while one under which "one or more common law employees, in addition to the self-employed individuals, are participants covered under the plan, will be covered under title I." The specific ERISA requirements depend on the plan's facts.

Requirements: The Six Statutory Conditions Under § 412(e)(3)

Section 412(e)(3) of the Internal Revenue Code describes a plan as fully insured only if every one of the following conditions is met:

• (A) Exclusive funding. "The plan is funded exclusively by the purchase of individual insurance contracts." Group contracts may also qualify under the statute's second sentence and Treas. Reg. § 1.412(i)-1(c).
• (B) Level premiums. The contracts "provide for level annual premium payments to be paid extending not later than the retirement age for each individual participating in the plan, and commencing with the date the individual became a participant in the plan (or, in the case of an increase in benefits, commencing at the time such increase becomes effective)."
• (C) Benefits equal to contract benefits. The benefits provided by the plan "are equal to the benefits provided under each contract at normal retirement age under the plan," and the statute requires those benefits to be backed by an insurance carrier "licensed under the laws of a State to do business with the plan," to the extent premiums have been paid.
• (D) Premiums paid. "Premiums payable for the plan year, and all prior plan years, under such contracts have been paid before lapse or there is reinstatement of the policy."
• (E) No security interest. "No rights under such contracts have been subject to a security interest at any time during the plan year."
• (F) No policy loans. "No policy loans are outstanding at any time during the plan year."

These conditions apply plan year by plan year, and the statute does not limit them to a set number of early years. A plan that is not described in paragraph (3) does not fall within the section 412(e)(2)(B) exception, so section 412 generally applies to it unless another exception does. Whether a particular plan and its contracts meet each condition needs individual review of the plan document and the contracts by qualified tax, legal and insurance professionals. Each condition is explained further on the page on 412(e)(3) plan requirements.

How the Rules Work: Funding, Deductions and Benefit Limits

The employer makes contributions to the plan, and the plan holds the insurance contracts and pays their premiums. Under Treas. Reg. § 1.412(i)-1(b)(2)(i), the contracts may be purchased "either directly by the employer or through the use of a custodial account or trust." Contract values and proceeds are used to provide the defined benefit that the plan document promises. In Situation 2 of Rev. Rul. 2004-20, the participant's beneficiary receives the death benefit payable under the plan, and the proceeds above it are "applied to the payment of premiums under the plan with respect to other participants." The mechanics are explained further on the page on how a 412(e)(3) plan works.

The premium-deduction rule comes first. Section 264(a)(1) of the Internal Revenue Code provides that "no deduction shall be allowed for … premiums on any life insurance policy, or endowment or annuity contract, if the taxpayer is directly or indirectly a beneficiary under the policy or contract." The same rule appears in the context of whether key person insurance is deductible. In a fully insured plan, the employer's claimed deduction is for contributions to a qualified plan under section 404, not for premiums on a policy the employer itself owns. How section 264(a)(1) interacts with a particular plan's structure depends on its documents and contracts.

Deduction limits. Section 404(a) allows contributions to be deducted only within its limits. Rev. Rul. 2004-20 states that contributions "used to purchase life insurance coverage for a participant in excess of the participant's death benefit provided under the plan are not fully deductible when contributed." Instead, they are carried over and become deductible in future years only when other contributions fall below the section 404 maximum.

Benefit limits. The benefit equals the contract benefits at normal retirement age under section 412(e)(3)(C). That benefit remains subject to the annual benefit limitation of section 415(b).

Death benefit. Section 101(a)(1) generally excludes from gross income amounts paid under a life insurance contract "by reason of the death of the insured." That exclusion is limited by the transfer-for-value rule in section 101(a)(2) and, for an employer-owned contract, by section 101(j), which caps the exclusion at "the sum of the premiums and other amounts paid by the policyholder for the contract" unless a section 101(j)(2) exception applies and the written notice and consent were given "before the issuance of the contract." Those limits are explained on the page on business life insurance tax treatment.

Listed-transaction exposure. Rev. Rul. 2004-20 concerns plans holding contracts whose benefits exceed the plan's benefits, either at normal retirement age (its Situation 1) or as life insurance above the participant's death benefit under the plan (its Situation 2). It identifies arrangements the same as, or substantially similar to, Situation 2 as listed transactions when the employer has deducted amounts used to pay premiums on a life insurance contract for a participant with a death benefit under the contract that exceeds the participant's death benefit under the plan by more than $100,000.

Who This Is For: Businesses and Owners That May Consider This Plan

This page is written for owners of closely held businesses, partners, owner-employees of professional practices and finance leads who are considering a qualified defined-benefit plan, or who are administering one, and who come across the 412(i) label. Section 412(e)(3)(B) requires level annual premium payments for each participant from the date the individual became a participant until no later than retirement age, and section 412(e)(3)(D) requires the premiums for the plan year and all prior plan years to have been paid before lapse or the policy reinstated. For a participant closer to retirement age, the same benefit is funded over fewer level payments.

Professional practices raise their own ownership and succession questions, which are covered on the page on life insurance for law firms. The plan is not limited to owners. Rev. Rul. 2004-21 applies the Code rule "prohibiting discrimination in favor of highly compensated employees" to plans funded with life insurance. Whether the structure suits a given business turns on facts including the business form, the stability of its income, its employee census and any existing plans.