412(e)(3) Plan Pros and Cons: Advantages and Disadvantages of a Fully Insured Defined-Benefit Plan

When It May Not Fit: Conditions That Create Difficulty

Several of the disadvantages of a 412e3 plan show up most clearly in specific fact patterns:

• Variable income. Level premiums under condition (B) do not move with cash flow. A missed premium that leads to a lapse without reinstatement fails condition (D).
• A larger workforce. Covering rank-and-file employees on a nondiscriminatory basis adds premium cost for each covered participant.
• A young owner. With a long period to retirement, the level premium for a given benefit is spread over more years. Each year's premium is therefore smaller for a given benefit.
• Anticipated policy loans or pledges. Conditions (E) and (F) require that no rights under the contracts have been subject to a security interest and that no policy loans are outstanding at any time during the plan year.
• Excess life insurance. Rev. Rul. 2004-20 describes arrangements in which life insurance death benefits exceed the plan's death benefit. The IRS Listed Transactions page lists that ruling under the title "Abusive Transactions Involving Insurance Policies in IRC 412(i) Retirement Plans."
• A short planning horizon. Ending a plan early raises tax and plan-law questions that turn on the plan document and the contracts involved.

Tax Treatment: Contributions, Benefits and the Insurance Element

Section 404(a) of the Internal Revenue Code 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 stated limits. Under 26 U.S.C. § 4972(c)(1), "nondeductible contributions" generally means the excess of the amount the employer contributes over "the amount allowable as a deduction under section 404," plus carried-over amounts. Section 4972 imposes a tax on those amounts. For a defined benefit plan, section 4972(c)(7) lets the employer elect, for a year, not to take the plan's contributions into account in determining nondeductible contributions, except that for a multiemployer plan the contributions above the full-funding limitation still count. The site's page on 412(e)(3) plan tax deductions covers these limits.

Benefits are capped separately. Under 26 U.S.C. § 415(b)(1), a benefit exceeds the limit if the annual benefit is greater than the lesser of a dollar amount stated in the statute or "100 percent of the participant's average compensation for his high 3 years." The statute adjusts that dollar amount for benefits beginning before age 62 or after age 65.

Treas. Reg. § 1.72-16(b)(2) provides that, for a life insurance contract described in paragraph (b)(1), when amounts allowed as a deduction under section 404 or trust earnings are applied toward its purchase, "the cost of the life insurance protection under such contract shall be included in the gross income of the participant." Paragraph (b)(1) covers a contract purchased as part of a section 403(a) plan, or purchased by a section 401(a) trust if the proceeds are payable directly or indirectly to a participant or the participant's beneficiary. Under paragraph (c)(2)(ii), for a life insurance contract with a reserve accumulation intended to fund pension or other deferred benefits, the portion of the death proceeds equal to the cash value immediately before death "is not excludable from gross income under section 101(a)," and the amount above the cash value "is excludable under section 101(a)." Section 101(a)(1) excludes amounts paid "by reason of the death of the insured," subject to exceptions that include section 101(a)(2) and subsection (j). Whether either exception applies to a particular contract depends on the facts of that contract. The site's page on life insurance inside the plan develops these points.

Potential Advantages: What the Structure Provides

Among the 412e3 plan benefits supported by the statute and IRS guidance:

• No minimum funding calculation. Under section 412(e)(2)(B), a plan described in section 412(e)(3) is outside section 412's minimum funding rules. The level premium sets the funding.
• Potentially large contributions. Because the plan funds a defined benefit through level premiums, the premium for an older owner over a short period can be sizable. The section 415(b) limit and section 404 still apply, as explained on the site's page on the contribution limits.
• Contract-backed benefits. Condition (C) ties plan benefits to contract benefits backed by an insurance carrier only to the extent premiums have been paid. That is a feature of the contracts and depends on premiums being paid.
• Deductibility within limits. Contributions may be deductible within section 404 limits, which section 404(a)(1)(A) applies to a pension trust that is tax-exempt for the relevant year.

Important Considerations: Constraints and Risks

The trade-offs are concrete:

• Rigid premiums. Conditions (B) and (D) require level premiums with no lapse unless the policy is reinstated. A cash-flow disruption can take the plan outside section 412(e)(3).
• No policy loans. Condition (F) bars any policy loan outstanding during the plan year.
• No pledges. Condition (E) bars any security interest in contract rights during the plan year, so the contracts cannot serve as collateral for a business loan.
• Excess insurance and listed transactions. Rev. Rul. 2004-20 identifies transactions that are "the same as, or substantially similar to, the transaction described in Situation 2" as listed transactions, provided that the employer has deducted premiums on a life insurance contract with a death benefit that "exceeds the participant's death benefit under the plan by more than $100,000." The ruling also states that employer contributions used to buy life insurance coverage above the participant's death benefit under the plan "are not fully deductible when contributed"; they are carried over to future years and are deductible in a future year only when other contributions for that year are less than the maximum amount deductible under section 404. A listed transaction is not a planning strategy.
• Excise tax. Section 4972 taxes nondeductible contributions, subject to the election in section 4972(c)(7) for a defined benefit plan.
• Participant income. Under Treas. Reg. § 1.72-16(b), the cost of life insurance protection under a covered contract is included in the participant's gross income.
• Benefit ceiling. Section 415(b) caps the benefit regardless of the premiums paid.
• Administration and termination. A written plan, any required annual reporting and plan-law compliance continue each year, and early termination raises its own questions.

Tax and Legal Coordination: What Professionals Review

Coordination is part of the structure itself. A tax professional typically addresses the section 404 deduction limit, the section 415(b) benefit limit and section 4972 exposure. Benefits counsel typically addresses the written plan document and the plan's ongoing compliance and annual reporting. The insurers involved confirm the contract terms, the premium schedule and the reinstatement provisions, which vary from insurer to insurer.

The IRS describes its examination focus for these plans, including whether "all insurance and annuity contracts are effective and adopted timely for the plan year(s) under examination." The IRS also notes that the regulations "were not updated after the enactment of PPA '06 and remain in Treas. Reg. Section 1.412(i)-1."

For listed transactions, the IRS cites the Treasury disclosure regulations. Disclosure obligations and penalties attach to listed transactions. Whether a given arrangement is a listed transaction, and what disclosure applies, needs individual review of the plan and contracts by the insurers and a qualified tax professional. State insurance rules governing the contracts vary by state.

Alternatives: Other Structures That Address Similar Objectives

Businesses with this objective usually compare several structures:

• A traditional defined-benefit plan that is not funded exclusively by insurance contracts is subject to the minimum funding rules of section 412.
• A cash balance plan is a defined-benefit design that expresses the benefit as a hypothetical account. The site compares it with a 412(e)(3) plan on its own comparison page.
• A 401(k) or profit-sharing plan is a defined-contribution plan. Section 412(e)(2)(A) excludes profit-sharing plans from section 412.
• An executive bonus arrangement is an industry term. It is not a qualified plan and is not defined in the Code. In this arrangement, the employer pays premiums on a policy the executive owns as taxable compensation, as the site explains in its discussion of executive bonus tax treatment.

The site's 412(e)(3) comparison pages cover the defined-benefit, cash balance and 401(k) alternatives.

Example (Hypothetical): Illustrating the Trade-Offs

This example is hypothetical, and every figure in it is an invented round number.

Assumptions: a 55-year-old owner of a professional corporation, no other employees, retirement at 65, and a level annual premium of $100,000 set by the insurer.

1. Level premium. Under conditions (B) and (D), $100,000 is paid each year for 10 years: 10 × $100,000 = $1,000,000 in total premiums. If one year is skipped and the policy is not reinstated, the plan fails condition (D).
2. Insurance element. Suppose part of the funding buys life insurance under a contract described in Treas. Reg. § 1.72-16(b)(1), and an assumed $2,000 per year is the cost of life insurance protection included in the participant's gross income. Over 10 years, that is 10 × $2,000 = $20,000 of income to the owner.
3. Deduction limit. Suppose that in one year the employer contributes $100,000 but section 404 allows only $90,000. Then $100,000 − $90,000 = $10,000 is a nondeductible contribution for section 4972 purposes, unless the employer makes the defined benefit plan election in section 4972(c)(7).
4. Benefit cap. If the contracts would produce a benefit above the section 415(b) limit, the plan cannot promise the excess, whatever the premiums paid.

The example is an educational illustration only. Actual amounts depend on the contracts, the participant's age and compensation, and the plan's assumptions.