412(e)(3) Plan Tax Deductions: What Section 404 Allows and What It Does Not

Technical Summary: How the 412(e)(3) Deduction Works

Employer contributions to a qualifying section 412(e)(3) plan can be deductible, but only as pension plan contributions within the limits of section 404(a), not as an ordinary insurance expense. Amounts above those limits are nondeductible and subject to the section 4972 excise tax, and certain arrangements with excess life insurance are IRS listed transactions.

The question usually comes from owners of closely held companies and professional practices who are weighing a retirement plan funded with insurance. This site covers it because the plan buys insurance contracts as its funding mechanism. The business goal is retirement funding for the owner and staff, and the insurance contracts sit inside a qualified pension plan.

The deduction runs through a chain of rules. Section 264(a)(1) of the Code provides that "No deduction shall be allowed for— (1) 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." For plan contributions, the deduction path is section 404(a). Section 415(b) caps the benefit the plan may promise, and section 404(j)(1)(A) provides that benefits above the section 415 limit are not taken into account in computing the deduction. Section 4972 reaches nondeductible contributions. Rev. Rul. 2004-20 treats certain arrangements with excess insurance as listed transactions. The IRS states that these plans were called "412(i) plans" before the Pension Protection Act of 2006.

What a Section 412(e)(3) Plan Is

A section 412(e)(3) plan is a fully insured defined-benefit pension plan. "Fully insured" means the plan is funded only by insurance contracts. "Defined-benefit" means the plan promises a stated retirement benefit, and the employer's funding obligation follows from that promise rather than from a fixed contribution amount. Section 412(e)(3)(A) requires that "the plan is funded exclusively by the purchase of individual insurance contracts." Group contracts with the same characteristics, as determined under Treasury regulations, are also treated as qualifying.

The contracts may be annuity contracts, life insurance contracts, or both. In this setting, cash value is a feature of the contract held by the plan. The insurance itself is not a retirement plan.

According to the IRS, the former section 412(i) provisions "were relocated to IRC Section 412(e)(3), effective for plan years beginning after December 31, 2007." The IRS also notes that the regulations were not updated after that change and still sit under the former section 412(i) numbering. The site's page on the former 412(i) name covers the history.

The plan also has to qualify under section 401(a). That qualified status is what brings employer contributions within section 404(a).

The Applicable Rules: Section 404(a), Section 415(b) and Section 264(a)(1)

Section 404(a) is the starting point. It provides that contributions to "a stock bonus, pension, profit-sharing, or annuity plan ... shall not be deductible under this chapter; but, if they would otherwise be deductible, they shall be deductible under this section, subject, however, to the following limitations as to the amounts deductible in any year." For a defined-benefit plan other than a multiemployer plan, section 404(a)(1)(A) sets the deductible amount by cross-reference to subsection (o). The computation is actuarial and plan-specific.

Section 415(b) limits benefits. A benefit exceeds the limit if the annual benefit is greater than the lesser of a statutory dollar amount and "100 percent of the participant's average compensation for his high 3 years." Section 415(d) requires the Secretary to adjust the statutory dollar amount annually for cost-of-living increases, so the dollar amount printed in the Code is not the limit for any given year. In computing the deduction for a defined benefit plan, section 404(j)(1)(A) provides that "there shall not be taken into account any benefits for any year in excess of any limitation on such benefits under section 415 for such year."

Section 264(a)(1) is the rule for a premium deduction claimed outside a plan. Treasury regulations state that a taxpayer who takes out a policy for the purpose of protecting itself "from loss in the event of the death of the insured" is considered a beneficiary (26 C.F.R. § 1.264-1(b)). Where the taxpayer is a beneficiary, section 264(a)(1) allows no deduction for the premium. In a fully insured plan, the plan contribution pays the premium, but the legal basis for any deduction is section 404(a). The site's page on key person insurance deductibility applies section 264(a)(1) outside a plan.

Requirements a Plan Must Meet

Section 412(e)(3) describes a plan only if all six of the following conditions hold:

• (A) Funding. The plan "is funded exclusively by the purchase of individual insurance contracts."
• (B) 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." The payments begin when the individual became a participant, or when a benefit increase takes effect.
• (C) Benefits. Plan benefits "are equal to the benefits provided under each contract at normal retirement age." The statute also requires that these benefits be backed by a state-licensed insurance carrier to the extent premiums have been paid. That backing is a contract feature the statute describes, not a promise about any plan's result.
• (D) Premium payment. Premiums for the plan year and all prior plan years "have been paid before lapse or there is reinstatement of the policy."
• (E) Security interests. "No rights under such contracts have been subject to a security interest at any time during the plan year."
• (F) Loans. "No policy loans are outstanding at any time during the plan year."

A plan meeting these conditions is excepted from the minimum funding rules under section 412(e)(2)(B), as the IRS notes. A plan that fails any one condition is not described in section 412(e)(3), and the funding and deduction analysis changes. Separately, the plan must meet the qualification requirements of section 401(a).

Section 412(e)(3) plan design, contributions and deductions need individual review of the contracts involved by the insurers and a qualified tax professional.

How the Deduction Rules Work in Practice

The mechanics follow the ownership structure:

1. The employer sponsors the plan.
2. The plan holds the contracts on each participant.
3. The employer's contribution pays the premiums.
4. Plan benefits are paid to participants and their beneficiaries under the plan's terms.

In a plan funded exclusively through insurance contracts, the employer's contribution pays for the contracts, and section 404(a)(1)(A) and (o) set the limit on the employer's deduction for that contribution.

Section 4972(c) defines "nondeductible contributions" as the excess of the amount the employer contributed for the year "over ... the amount allowable as a deduction under section 404." The definition adds prior-year nondeductible amounts, reduced by any portion returned to the employer or deducted in the current year. Under section 4972(c)(2), the deduction allowable in a year is treated as coming first from carryforwards, in order of time, and then from current contributions.

Rev. Rul. 2004-20 applies this to excess insurance. It states that contributions used to buy life insurance coverage "in excess of the participant's death benefit provided under the plan are not fully deductible when contributed, but are carried over" to later years, when other contributions are below "the maximum amount deductible for the year pursuant to the limits of § 404." The IRS page on fully insured plans states that if the employer deducts premiums on a contract whose death benefit exceeds the plan death benefit "by more than $100,000, the arrangement is a 'listed transaction'."

Who This Is For

This structure typically draws interest from closely held businesses and professional practices whose owners want funding for a defined retirement benefit. Such businesses often have cash flow steady enough to support the level annual premiums that section 412(e)(3)(B) requires.

Several facts tend to shape the analysis:

• Age at adoption. The participant's age and the years remaining to normal retirement age affect how large the actuarially determined contribution is.
• Workforce. The size and makeup of the workforce matter, because section 401(a)(3) ties qualification to minimum participation standards, and section 401(a)(4) bars discrimination in favor of highly compensated employees. Benefits for non-owner employees are part of the cost.
• Other plans. Existing plans and how they interact with this one also matter.

This describes a factual profile, not a recommendation. Whether the plan fits a given business depends on facts this page does not have. Comparisons with other plan designs are covered elsewhere on this site.