IRC

412(e)(3) Defined Benefit Plans (formerly 412(i) Defined Benefit Plans)

Under the Pension Protection Act of 2006 (PPA), Internal Revenue Code (Code) Section 412(i) was moved to Code Section 412(e)(3). A412(i)plan is now referred to a 412(e)(3) plan. A 412(e)(3) defined benefit plan is a regular defined benefit plan with special funding rules. This type of plan has existed for many years, but was not very popular in the past. In recent years, specifically since the enactment of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), 412(e)(3) plans have reemerged in the headlines. Unfortunately, there were some412(e)(3) arrangements that were purported to be able to circumvent traditional limitations, and the IRS has moved to shut those abusive arrangements down. However, a valid 412(e)(3) plan may still fit within an employer's goals, and this chapter explains how it works. (Throughout this chapter, an insurance contract plan that meets the requirements of Code Section 412(e)(3) is referred to as a 412(e)(3) plan.)

1: What are the requirements of Code Section 412(e)(3)?

A plan meets the requirements of Code Section 412(e)(3) if:

1. The plan is funded exclusively by the purchase of individual insurance contracts (see Q 14:3);
2. Such contracts provide for level annual premium payments to be made 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) (see Q 14:4);
3. Benefits provided by the plan are equal to the benefits provided under each contract at normal retirement age under the plan and are guaranteed by an insurance carrier (licensed under the laws of a state to do business with the plan) to the extent premiums have been paid;
4. 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 (see Q 14:5);
5. No rights under such contracts have been subject to a security interest at any time during the plan year (see Q 14:6); and
6. No policy loans are outstanding at any time during the plan year (see Q 14:7).

A plan can be funded exclusively by the purchase of group insurance contracts, but only if the contracts have the same characteristics as contracts described above (see Q 14:8). 

2: How does a 412(e)(3) plan meet the level premium requirements? 

The individual annuity or individual insurance contracts issued under the plan must provide for level annual (or more frequent) premium payments to be made under the plan for the period beginning with the date each individual began participating in the plan and ending not later than the normal retirement age for that individual or, if earlier, the date the individual ceases his or her participation in the plan.

Premium payments may be considered to be level even though items such as experience gains and dividends are applied against premiums.

In the case of an increase in benefits, the contracts must provide for level annual payments with respect to such increase to be paid for the period beginning at the time the increase becomes effective. If payment commences on the first payment date under the contract occurring after the date an individual becomes a participant or after the effective date of an increase in benefits, the level premium requirements will be satisfied even though payment does not commence on the date on which the individual's participation commenced or on the effective date of the benefit increase, whichever is applicable.

If an individual accrues benefits after his or her normal retirement age, the level premium requirements are satisfied if payment is made at the time such benefits accrue.

If the provisions for level premiums are set forth in a separate agreement with the issuer of the individual contracts, they need not be included in the individual contracts. [Treas. Reg. §1.412(i)-1(b)(2)(ii)]

3: May a contract under a 412(e)(3) plan be subject to a security interest?

No. No rights under the individual contracts may have been subject to a security interest at any time during the plan year. This requirement does not apply to contracts that have been distributed to participants if the security interest is created after the date of distribution.

4: May a 412(e)(3) plan allow loans?                                                              top

No. No policy loans, including loans to individual participants, on any of the individual contracts may be outstanding at any time during the plan year. This requirement does not apply to contracts that have been distributed to participants if the loan is made after the date of distribution.

An application of funds by the issuer to pay premiums due under the contracts shall be deemed not to be a policy loan if the amount of the funds so applied, and interest thereon, is repaid during the plan year in which the funds are applied and before distribution is made or benefits commence to any participant whose benefits are reduced because of such application. 

5: Can a 412(e)(3) plan be funded with a group insurance or annuity contract?

Yes. A 412(e)(3)plan can be funded with a group insurance or annuity contract instead of individual insurance or annuity contracts as long as the same requirements are met for the group contracts as are listed for the individual co  ntracts (i.e., funding from a licensed insurer, level premiums, and so forth). In addition, the following requirements must be satisfied by the group contracts:

1. If the plan is funded by a group annuity contract, the value of the benefits guaranteed by the insurance company issuing the contract under the plan with respect to each participant under the contract must not be less than the value of such benefits which would be provided by the cash surrender value for that participant under any individual annuity contract plan.
2. If the plan is funded by a group insurance contract, the value of the benefits guaranteed by the insurance company issuing the contract under the plan with respect to each participant under the contract must not be less than the value of such benefits which would be provided by the cash surrender value for that participant under any individual insurance contract plan.
3. Under the group annuity or group insurance contract, premiums or other consideration received by the insurance company (and, if a custodial account or trust is used, the custodian or trustee thereof) must be allocated to purchase individual benefits for participants under the plan.

A plan maintaining unallocated funds in an auxiliary trust fund or providing that an insurance company will maintain unallocated funds in a separate account (e.g., a group deposit administration contract) does not satisfy the requirements of Code Section 412(e)(3).

6: May a 412(e)(3) plan be funded with a combination of individual and group contracts?

Yes. A plan that is funded by a combination of individual contracts and a group contract does meet the requirements of Code Section 412(e)(3) if the combination, in the aggregate, satisfies the requirements of this Code section for the plan year.

7: From what requirements of Code Section 412 is a 412(e)(3) plan exempt?

Since a 412(e)(3) plan is not subject to the rest of the requirements of Code Section 412, the following are not applicable:

1. Full-funding limitations
2. Quarterly contribution requirements
3. Additional funding charges
4. Current liability testing
5. Schedule B requirement or enrolled actuary certifications (unless there is an additional contribution needed to meet top-heavy requirements)
6. Investment risk

8: Is a 412(e)(3) plan subject to the Pension Benefit Guaranty Corporation (PBGC) requirements?

Yes, in part. A 412(e)(3) plan is subject to the per participant premium of $19, but is exempt from the variable rate premium.

9: What Code requirements are still applicable to a 412(e)(3) plan?         top

Since a 412(e)(3) plan is a regular defined benefit plan that has special funding rules, the rest of the Code sections applicable to any qualified defined benefit plan remain applicable to 412(e)(3) plans. These include the maximum benefit limitations of Code Section 415, the minimum coverage rules of Code Section 410, the nondiscrimination regulations of Section 401(a)(4), the minimum participations rules of Code Section 401(a)(26), the minimum vesting rules of Code Section 411, the deduction rules of Code Section 404 (excluding Code Section 404(a)(1)(A)(i), and the top-heavy regulations of Code Section 416.

10: How is the accrued benefit determined in a 412(e)(3) plan?

A participant's accrued benefit in a 412(e)(3) plan must be no less than the cash surrender value of his or her insurance contract. [I.R.C. §411(b)(1)(F)]

11: Does Code Section 417 apply to 412(e)(3) plans in determining lump-sum payments?

Generally, no. If the 412(e)(3) plan defines the accrued benefit as the cash surrender value of the insurance contract, then no, there is no requirement to apply Code Section 417 to the distribution of the annuity, including avoiding the GATT interest rate and mortality assumptions of Code Section 417(e). However, if the plan defines the accrued benefit using the fractional rule, the provisions of Code Section 417 do apply. In addition, if there are top-heavy minimums in the 412(e)(3) plan, the participant will have a portion of the accrued benefit defined as an annuity that is subject to Code Section 417 provisions. [IRS Q&A 2005 ASPPA Annual Conference]

12: Is the accrued benefit under a 412(e)(3) plan definitely determinable?

Yes. Treasury Regulations Section 1.401-1(b)(1)(i) provides that a plan designated to provide benefits to be paid upon retirement will, for purposes of Code Section 401(a), be considered a pension plan if the employer contributions under the plan can be determined actuarially on the basis of definitely determinable benefits. In a 412(e)(3) plan, an employee's accrued benefit cannot be less than the cash surrender value of the individual's contracts. This is considered definitely determinable.

However, it is the practice of some life insurance companies to provide a larger retirement benefit if, at the time the cash surrender value of the insurance policy (or annuity contract) is applied to purchase an annuity, the company's then-current annuity purchase rate is more favorable than the annuity purchase rate guaranteed in the policy. Many policies contain a provision that specifies how the calculations of the larger benefit would be made in such circumstances. Where no such provision is incorporated in the policy, the insurance company will provide the larger benefit administratively based on the established practice of the company at the time the cash surrender value is so applied. In either case, the increased benefit arises simply by the substitution of one (lower) purchase rate for the guaranteed rate, and the amount of the increased benefit is thereby uniquely determinable at the time the benefit is to be purchased. In Revenue Ruling 78-56 [1978-1 C.B. 116], the IRS ruled that, if this is the case, the fact that the cash value of a participant's policy may provide a benefit in excess of the benefit intended by the plan document will not necessarily mean that the benefit is not definitely determinable. The benefit will be considered to be definitely determinable so long as:

1. The participant's accrued benefit at all times is determinable under the insurance contract;
2. A plan benefit is uniquely determinable, based on (a) such accrued benefit, (b) the procedures stated in the insurance contract or established insurance company practice, and (c) the current annuity purchase rate offered by the insurance company;
3. The current annuity purchase rate is not affected by forfeitures under the plan; and
4. None of these factors is within the discretion of the employer (other than by plan amendment). 

13: Is there a special safe harbor rule for nondiscrimination testing of 412(e)(3) plans? 

Yes. Under Treasury Regulations Section 1.401(a)(4)-3(b)(5), a plan satisfies the safe harbor for 412(e)(3) plans if it satisfies each of the following requirements:

1. The accrued benefit must be no less than the cash surrender value of each participant's contract as required under Code Section 411(b)(1)(F).
2. The plan must meet all of the requirements of Code Section 412(e)(3).
3. The benefit formula under the plan must be one that would satisfy the requirements of the fractional accrual rule of Treasury Regulations Section 1.401(a)(4)-3(b)(4), using only participation as plan service. Thus, the benefit formula may not recognize years of service before an employee commenced participation in the plan because, otherwise, the definition of years of service for determining the normal retirement benefit would differ from the definition of years of service for determining the accrued benefit. Notwithstanding the foregoing, a 412(e)(3) plan adopted and in effect on September 19, 1991, may continue to recognize years of service prior to an employee's participation in the plan for an employee who is a participant in the plan on that date to the extent provided by the benefit formula in the plan on such date.
4. The scheduled premium payments under an individual or group insurance contract used to fund an employee's normal retirement benefit must be level annual payments to normal retirement age. Thus, payments may not be scheduled to cease before normal retirement age.
5. The premium payments for an employee who continues benefiting after normal retirement age must be equal to the amount necessary to fund additional benefits that accrue under the plan's benefit formula for the plan year.
6. Experience gains, dividends, forfeitures, and similar items must be used solely to reduce future premiums.
7. All benefits must be funded through contracts of the same series. Among other requirements, contracts of the same series must have cash values based on the same terms (including interest and mortality assumptions) and the same conversion rights. A plan does not fail to satisfy this requirement, however, if any change in the contract series or insurer applies on the same terms to all employees. However, an amendment to the plan to change the insurer may need to be tested to make sure it does not discriminate. [Treas. Reg. §1.401(a)(4)-5(a)(4), Ex. 12]
8. If permitted disparity is taken into account, the normal retirement benefit stated under the plan's benefit formula must satisfy Treasury Regulations Section 1.401(l)-3. For this purpose, the 0.75-percent factor in the maximum excess or offset allowance in Treasury Regulations Section 1.401(l)-3(b)(2)(i) or (b)(3)(i), respectively, adjusted in accordance with Treasury Regulations Section 1.401(l)-3(d)(9) and , is reduced by multiplying the factor by 0.80. 

14: Can a 412(e)(3) plan meet the nondiscrimination rules in any manner other
than using the safe harbor?

Yes. As with other defined benefit plans, a 412(e)(3) plan may meet the general testing requirements of Code Section 401(a)(4). However, this can be problematic due to a 412(e)(3) plan's definition of accrued benefit being the cash surrender value of the insurance. Under general testing requirements of Code Section 401(a)(4), compliance is tested by comparing the normal and most valuable benefit accrual rates of the non-highly compensated employees to the highly compensated employees. Therefore, the surrender values will need to be converted to an annuity in order to determine the accrual rates. Common practice in determining the normal accrual rate under the annual method appears to be using the guaranteed rates under the contract in order to project the increase in the cash surrender value for the current plan year to the testing age. In determining the most valuable accrual rate, the increase in the cash surrender value is projected to the earliest permissible annuity starting date using the contract rates and then normalized to testing age using standard assumptions. Similar methodology is used for the accrued-to-date method or for testing involving fresh-starts.

Yes. Under Treasury Regulations Section 1.401(a)(4)-5(a), a change in the insurance company providing the contracts for the plan is an amendment to the plan that must be tested to make sure it does not discriminate in favor of highly compensated employees. Treas. Reg. §1.401(a)(4)-5(a)(4), Ex. 12]

Example: The Play It Safe defined benefit plan is a 412(e)(3) plan. For all plan years before 2002, the plan purchases insurance contracts from the Insural insurance company. In 2002, the plan shifts future purchases of insurance contracts to Insural At Any Cost insurance company. The shift in insurance companies is a plan amendment subject to testing for nondiscrimination.

In addition, if the benefits, rights, or features of the life insurance contracts held by highly compensated employees are of inherently greater value than the benefits, rights, or features of contracts held by non-highly compensated employees, then the plan is considered discriminatory. [Rev. Rul. 2004-21, 2004-10 I.R.B. 544] These benefits, rights, or features can include optional forms of benefit, ancillary benefits, and other rights and features that can be expected to have meaningful value. Differences in insurance contracts, including differences in cash value growth terms or different exchange features that may be purchased from a plan can create distinct other rights or features even if the terms under which the contracts are purchased from the plan are the same. [Rev. Rul. 2004-21, 2004-10 I.R.B. 544]

Example: The PayAllLess defined benefit plan provides an incidental death benefit for each participant (this is not necessarily a 412(e)(3) plan). The plan holds a life insurance contract on the life of each participant to fund this incidental death benefit. Prior to distributions from the plan, each participant is offered the opportunity to purchase his or her contract for the cash surrender value in accordance with Prohibited Transaction Exemption 92-6 [57 Fed. Reg. 5,189 (Feb. 12, 1992)]; thus the purchase is not a prohibited transaction under Code Section 4975. The contracts for the highly compensated participants are different from the ones for the non-highly compensated participants in that the cash values grow faster and the other purchase rights are different. Since the benefits, rights, or features of the contract are of inherently greater value to the highly compensated employees and are not currently made available in a nondiscriminatory manner to the non-highly compensated employees, this plan fails the requirements of Code Section 401(a)(4).

15: How is an employee considered as benefiting under Code Section 410(b)?

Under Code Section 410(b), a participant in a 412(e)(3) plan is considered benefiting only if a premium is paid on behalf of the participant for the plan year. However, an employee is treated as benefiting under a 412(e)(3) plan for a plan year if the sole reason that a premium is not paid on behalf of the employee is one of the following:

1. The employee's benefit would otherwise exceed a limit that is applicable on a uniform basis to all employees in the plan.
2. The benefit previously accrued by the employee is greater than the benefit that would be determined under the plan if the benefit previously accrued were disregarded.
3. The plan offsets the employee's current benefit accrual under an offset arrangement described in Treasury Regulations Section 1.401(a)(4)-3(f)(9)(without regard to whether the offset is attributable to pre-participation service or past service).
4. The employee has attained normal retirement age under a deemed benefit plan and fails to accrue a benefit because of the provisions of Code Section 411(b)(1)(H)(iii) regarding adjustments for delayed retirement.
5. The insurance contracts that have previously been purchased on behalf of the employee guarantee to provide for the employee's projected normal retirement benefit without regard to future premium payments.

16: How does a 412(e)(3) plan meet the top-heavy requirements of Code Section 416?

Under Code Section 416, a top-heavy defined benefit plan requires a minimum accrual of 2 percent per year of service (limited to 10 years) for each non-key employee (see chapter 5). Unfortunately, the accrued benefits provided for a non-key employee under most level premium insurance contracts might not provide a benefit satisfying this defined benefit minimum because of the lower cash values in early years under most level premium insurance contracts, and because such contracts normally provide for level premiums until normal retirement age. Therefore, in order to satisfy the requirements of Code Section 41, a 412(e)(3) plan may be required to provide either an auxiliary fund or deferred annuity contracts to provide extra benefits to those employees whose current benefits are not sufficient to satisfy the top-heavy minimum. However, a plan will not be considered to violate the requirements of Code Section 412(e)(3) merely because it funds these extra benefits in this manner if the following conditions are met:

1. The targeted benefit at normal retirement age under the level premium insurance contract is determined, taking into account the defined benefit minimum that would be required assuming the current top-heavy (or non top-heavy) status of the plan continues until normal retirement age;
   and
2. The benefits provided by the auxiliary fund or deferred annuity contracts do not exceed the excess of the defined benefit minimum benefits over the benefits provided by the level premium insurance contract.

If the above conditions are satisfied, then the portion of the plan funded by the level premium annuity contract is still exempt from the minimum funding requirements under Code Section 412 and may still utilize the special accrued benefit rule in Code Section 411(b)(1)(F) (see Q 14:13); however, the portion funded by an auxiliary fund is subject to Code Section 412. Thus, a funding standard account must be maintained, and a Schedule B must be filed with the annual report. The accrued benefit for any participant may be determined using the rule in Code Section 411(b)(1)(F), but must not be less than the defined benefit minimum as required under Code Section 416

17: Can a regular defined benefit plan be converted into a 412(e)(3) plan?

Yes. One of the requirements of Code Section 412(e)(3) is that a plan must provide for level annual premium payments to be made 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 the increase becomes effective) and extending not later than the retirement age for each individual participating in the plan. [I.R.C. §412(e)(3)(B)] If an existing defined benefit plan is converted to a plan under which future accruals are funded in the manner prescribed by Code Section 412(e)(3), level premium payments will begin with the year of conversion. The level annual premium payments will, therefore, start after the dates on which existing participants became participants in the plan. Therefore, the plan would not satisfy Code Section 412(e)(3)(B) following the conversion and would not be exempt under Code Section 412(h)(2) from the minimum funding requirements of Code Section 412. However, Revenue Ruling 94-75 [1994-2 C.B. 59] provides an exception to the requirement that premiums commence with participation by deeming defined benefit plans that have not been 412(e)(3) plans to satisfy Code Section 412(e)(3)(B) if certain requirements are met.

An existing defined benefit plan subject to Code Section 412 that, in accordance with the requirements specified below, is converted to a plan funded in the manner prescribed by Code Section 412(e)(3) will not be deemed to fail the requirements of Code Sections 412(e)(3)(B), 403(a), and 404(a)(2)merely because of the conversion, or merely because of participation in the plan before level annual premiums commence. The date on which the conversion is deemed to occur (the conversion date) is the first day of the first plan year for which the plan satisfies these requirements:

1. The plan otherwise satisfies the requirements of Code Sections 412(e)(3), 403(a), and 404(a)(2) for the plan year containing the conversion date.
2. All benefits accruing for each participant on and after the conversion date are funded by level annual premium contracts that satisfy the requirements of Code Section 412(e)(3)(B).
3. All benefits accrued for each participant before the conversion date are guaranteed through insurance or annuity contracts, the purchase price of which equals the minimum amount required by the life insurance company for a contract that guarantees, on and after the conversion date, to provide the participant's accrued benefits, including any optional forms of payment at each retirement age available under the plan.
4. There are meaningful continuing benefit accruals under the plan after the conversion date. A plan is considered to satisfy this requirement if there are meaningful benefit accruals under the plan for at least three plan years ending after the conversion date. [See Letter Ruling 9234004 for an example of a plan that did not satisfy this requirement and the minimum funding requirements continued to apply.]
5. The following actions are taken on or before the conversion date: (a) contracts are purchased guaranteeing the benefits accrual before the conversion date; (b) any remaining plan assets are applied to the payment or prepayment of premiums for level annual premium contracts described in item #2 above; and (c) any plan amendments necessary to satisfy these requirements for conversion and the requirements of Code Sections 412(e)(3), 403(a), and 404(a)(2) are adopted and made effective. Contracts purchased within one month after the first day of a plan year are deemed to be purchased on the first day of the plan year for purposes of this requirement.

If these requirements for conversion are not satisfied on or before the first day of a plan year, the minimum funding requirements and funding standard account of the plan continue to apply to the plan for that plan year.

18: Are any contributions made that are necessary to fund existing benefits
under a conversion deductible?

Yes. When a defined benefit plan that has been subject to Code Section 412 is deemed converted to a 412(e)(3) plan, the deduction limitations under Section 404(a)(1)(A) with respect to plan years ending prior to the conversion date are derived from the funding standard account requirements. Accordingly, with respect to any plan year ending prior to the conversion date, the deductible limit under Code Section 404(a)(1)(A) with respect to the plan is the greater of (1) the amount necessary to satisfy the minimum funding requirement under Code Section 412, as provided in Code Section 404(a)(1)(A)(i), or (2) the deductible limit calculated under Code Section 404(a)(1)(A)(ii) or (iii), whichever applies to the plan.

Except for the funding of any additional top-heavy benefits, for the conversion year and succeeding plan years in which the plan is deemed a Code Section 412(e)(3) plan, Code Section 404(a)(1)(A)(i) no longer applies because the minimum funding requirements of Code Section 412 no longer apply to the plan.

After a defined benefit plan is deemed converted to a 412(e)(3) plan, all benefits accrued as of the conversion date will have been guaranteed through contracts issued by an insurance company without any required future premiums. Therefore, only the costs of future benefit accruals (including future benefit increases) are allocated to future service. All other costs are allocated to prior years. This type of allocation is consistent with the cost allocation under a reasonable funding method for a defined benefit plan that is subject to Code Section 412, with an accrued liability equal to the actuarial present value of accrued benefits and to which Code Section 404(a)(1)(A)(iii)applies. Therefore, to determine the deductible limit with respect to plan years beginning on or after the conversion date, Code Section 404(a)(i)(A)(iii) is applicable.

The employer's deductible limit with respect to the conversion year and succeeding plan years, other than for any contribution to fund additional top-heavy benefits is the sum of (1) the normal cost for a 412(e)(3)plan established on the conversion date for post-conversion benefit accruals; (2) the limit adjustments, if any, for any 10-year amortization bases remaining unamortized as of the conversion date that are maintained for purposes of Code Section 404(a)(1)(A)(iii); and (3) the limit adjustment, if any, for any 10-year amortization base created on account of treating the plan as if terminated for purposes of Code Section 412as of the last day of the plan year immediately preceding the conversion year (pre-conversion year). Normal cost under Code Section 404(a)(1)(A) and Treasury Regulations Section 1.404(a)-14 is based on the annual premiums for level annual premium contracts providing for the post-conversion benefit accruals (and any increases in benefits) that are reasonable in view of the funding medium and reasonable expectations as to the effects of mortality, interest, and other pertinent factors. Ten-year amortization bases under Treasury Regulations Section 1.404(a)-14 remain or are established based on treating the conversion as a change to the unit credit funding method (if that was not the funding method of the plan for the pre-conversion year), with the accrued liability as of the conversion date deemed to be equal to the reasonable cost of single premium contracts guaranteeing benefits accrued prior to the conversion date (conversion accrued liability).

If, as of the conversion date, there are no unamortized 10-year amortization bases under Code Section 404(a)(1)(A)(iii) and Treasury Regulations Section 1.404(a)-14 with respect to the plan, a new 10-year amortization base is established on conversion equal to the excess, if any, of (1) the conversion accrued liability over (2) the value of plan assets minus the sum of (a) any carryover under Code Section 404(a)(1)(E) from the prior taxable year plus (b) any contribution made for the current taxable year that is included in plan assets. The sum of (a) and (b) is referred to as undeducted contributions.

If, as of the conversion date, there is at least one unamortized 10-year amortization base under Code Section 404(a)(1)(A)(iii) and Treasury Regulations Section 1.404(a)-14 with respect to the plan and the conversion accrued liability is greater than the value of plan assets minus any undeducted contributions, a new 10-year amortization base is established on conversion equal to (1) the conversion accrued liability minus (2) the sum of (a) the value of plan assets less any undeducted contributions and (b) the net unamortized balance of any existing 10-year amortization bases under Code Section 404(a)(1)(A)(iii) (treating negative bases as having negative unamortized amounts). This new 10-year amortization base may be negative. Any existing 10-year amortization base under Code Section 404(a)(1)(A)(iii) for a plan that remains unamortized as of the conversion date must continue to be maintained. These new and existing 10-year amortization bases are maintained in the same manner as bases maintained following the termination of a plan subject to Code Section 412. The bases may be combined or replaced in accordance with the general method or the fresh-start alternative under Treasury Regulations Section 1.404(a)-14(i).

If, as of the conversion date, a plan's conversion accrued liability is not greater than the value of plan assets minus any undeducted contributions, no new base is established and all existing bases are considered fully amortized.

Example: The COM pension plan is a qualified defined benefit pension plan and trust with a calendar plan year and a valuation date of January 1. The plan is maintained by a calendar year taxpayer. As of January 1, 2004, the fair market value of the plan's assets was $1 million. There were no outstanding loans to participants under the plan. The plan is not a top-heavy plan. Before 2004, the plan was not a 412(e)(3) plan.

On December 10, 2003, the plan was amended effective as of January 1, 2004, to become a 412(e)(3) plan. Under these amendments, the terms of the plan satisfy the requirements of Code Sections 412(e)(3)(A), (C), (D), (E), and (F) beginning on January 1, 2004. Under the plan as amended, all benefit accruals on and after January 1, 2004, will be funded exclusively by insurance or annuity contracts that provide for level annual premium payments. The plan provides that level annual premium payments for each participant are to be paid for the period commencing with the later of the 2004 plan year or the first plan year of the participant's participation in the plan and ending with the plan year the participant attains normal retirement age. Benefit accruals after normal retirement age are to be funded by insurance or annuity contracts as they accrue.

On January 1, 2004, a single premium deferred annuity contract was purchased for each plan participant. Beginning on January 1, 2004, each contract was guaranteed by a life insurance company to provide the payment of the participant's benefits accrued prior to January 1, 2004, including any optional forms of payment at each retirement age available under the plan. The premium for each participant's single premium contract was the minimum amount required by the insurer to guarantee the payment of that participant's accrued benefit, beginning on January 1, 2004. The total purchase price of the single premium contracts was $1,300,000.

In addition, a level annual premium deferred annuity contract was purchased for each plan participant on January 1, 2004, to provide for the excess, if any, of the participant's projected normal retirement benefit over the portion of the normal retirement benefit provided by the single premium contract purchased for that participant. For purposes of determining the projected normal retirement benefit, it was assumed that the amount of each participant's current compensation would not change before the participant's normal retirement age. For 2004, the total of the level annual premiums needed to provide the additional normal retirement benefits under the terms of the plan (post-conversion benefit accruals) was $50,000.

The costs of the single premium annuity contracts purchased to fund participants' benefits accrued prior to January 1, 2004, and the level annual premium contracts purchased to fund participants' post-conversion benefit accruals, were reasonable in view of the funding medium and reasonable expectations as to the effects of mortality, interest, and other pertinent factors.

On January 1, 2004, in addition to the $1 million in existing plan assets that was paid to the insurance company, the employer paid a plan contribution of $350,000 (the total premium due of $1,350,000 less plan assets of $1 million) to the insurer to meet the 2004 premium requirement for all annuity contracts.

As of January 1, 2004, no additional amounts contributed to the plan could be deducted by the employer for the 2003 plan year. As of the end of 2003, there were no unamortized 10-year amortization bases with respect to the plan for purposes of Code Section 404(a)(1)(A), and no nondeductible contributions were carried over to 2004 under Code Section 404(a)(1)(E).

The single premium deferred annuity contracts guaranteeing the payment of prior benefit accruals were purchased for $1,300,000 during the first month of the 2004 plan year; all remaining plan assets ($50,000) were applied to purchase level annual premium contracts during the first month of that plan year; and plan amendments were made before and effective on the first day of that plan year. The plan meets the requirements to be converted to a 412(e)(3) plan, and January 1, 2004 is, therefore, the conversion date. Accordingly, the minimum funding requirements of Code Section 412 do not apply to the plan for the 2004 plan year and later years. This is based on the assumption that the plan will continue to provide meaningful continuing benefit accruals after the conversion date and that the plan will satisfy all the requirements of Code Sections 403(a), 404(a)(2), and 412(e)(3)(A), (C), (D), (E), and (F) on and after the conversion date.

In determining how the extra contribution is to be deducted, it is important to note that the plan was deemed converted to a 412(e)(3) plan as of the first day of the 2004 plan year. Accordingly, the funding standard account for the plan was terminated as of December 31, 2003. In connection with the conversion of the plan, the employer contributed $350,000 to the plan on January 1, 2004. This amount, combined with existing plan assets of $1 million, was used to purchase single premium deferred annuity contracts for $1,300,000 and to pay the level annual premium of $50,000 for 2004.

The deductible limit under Code Section 404(a)(1)(A) with respect to the plan for the conversion year and thereafter is determined under Code Section 404(a)(1)(A)(iii). The conversion process is treated under Code Section 404(a)(1)(A)(iii) and Treasury Regulations Section 1.404(a)-14 as creating a 10-year amortization base of $300,000. This is equal to (1) the conversion accrued liability ($1,300,000) minus (2) the sum of (a) the value of plan assets less any undeducted contributions ($1,350,000 in plan assets, less $350,000 in undeducted contributions) and (b) the net unamortized balance of any existing 10-year amortization bases under Code Section 404(a)(1)(A)(iii)($0). This 10-year amortization base of $300,000 is maintained under Code Section 404(a)(1)(A)(iii)and Treasury Regulations Section 1.404(a)-14 in the same manner as a base would be maintained following the termination of a plan subject to Code Section 412.

The deductible limit under Code Section 404(a)(1) with respect to the plan was calculated solely under Code Section 404(a)(1)(A).

The contributions paid by the employer as premiums for the annuity contracts that are not deductible under Code Section 404(a)(1)(A) for the 2004 taxable year are nondeductible contributions for 2004 and are subject to the excise tax on nondeductible contributions under Code Section 4972. However, they will become deductible as the 10-year base continues to be amortized. In addition, the excise tax on nondeductible contributions will apply only for the 2004 plan year. [Rev. Rul. 94-75, 1994-2 C.B. 59].

19: Can a 412(e)(3) plan be converted to a traditional defined benefit plan?

Yes. It is necessary to break only one of the requirements of Code Section 412(e)(3) to force it back into following the funding requirements of Code Section 412.

20: What are some of the advantages proponents offer from a 412(e)(3) plan?

Proponents of 412(e)(3) plans offer the following as advantages of these arrangements:

1. Retirement benefit is fully guaranteed.
2. Insurance company bears all investment risk.
3. Investments are not subject to market fluctuation.
4. There is no full-funding limitation or current liability test to limit deductions.
5. There can be no over funding, and thus no reversion penalty (assuming annuity payouts).
6. There can be no under funding.
7. No enrolled actuary is required, since there is no Schedule B (Form 5500) to file (as long as there is no top-heavy accumulation fund).
8. There are no quarterly contribution requirements.
9. Generally, much larger contributions (deductions) are available.
10. Employer funding of the plan can be more readily understood.
11. Administration fees may be lower.

21:What are some of the disadvantages of 412(e)(3) plans?

Some of the disadvantages of these arrangements are:

1. No flexibility in investments.
2. It is not possible to take advantage of any market gains.
3. Premiums must be paid as they come due.
4. There is no flexibility in timing or amount of contributions.
5. Premiums are determined by insurance company rates.
6. No policy loans are allowed.
7. No participant loans are allowed.
8. Plan can become over funded if a lump sum is desired. 

22:How can a 412(e)(3) plan become over funded?                                   top

If a 412(e)(3) plan is funded to the maximum assuming an annuity payout, the low interest rate assumptions used by the insurance company may cause there to be more money in the plan than is necessary, and allowed, if the principal retires and selects a lump-sum payout.

Example: Dr. Freddy installs a 412(e)(3) plan at age 60 with a retirement age of 65. The insurance company uses a guaranteed rate of return of 3 percent, both preretirement and postretirement. Dr. Freddy is excited that he will be able to fund nearly $229,000 into the plan for each of the next five years --which is much more than the $150,000 that he received as a proposal under a traditional defined benefit plan. At Dr. Freddy's retirement, the 412(e)(3) plan has assets of $1,250,000 to pay his annuity benefit. However, Dr. Freddy believes he can do a better job of managing the money during his retirement than the insurance company and decides he would like a lump-sum distribution. The Code Section 415 maximum lump sum based on his annuity payment is only $925,000, leaving $325,000 as excess assets in the plan.

23:Can a lump sum be paid from a 412(e)(3) plan and the plan not be over funded?

Yes. However, planning is required in order to avoid this problem. Three different approaches are suggested:

1. Make an assumption as to what the 30-year Treasury rate will be at the principal's retirement date. Then use the insurance company's guaranteed rate to determine what the equivalent guaranteed annuity amount of the GATT maximum would be. Use this lower monthly amount in determining the formula for the 412(e)(3) plan.
2. Fund for the maximum annuity, but fund for only a certain number of years until the maximum lump-sum amount is reached based on a projected 30-year Treasury rate. Freeze the plan at that time. (The plan becomes subject to Code Section 412.)
3. Fund for the maximum annuity, as in option 2, but terminate the plan once the maximum lump-sum amount is reached.

24:Can death benefits be provided in a 412(e)(3) plan?                              

Yes, subject to the same limitations as in a traditional defined benefit plan. Therefore, the death benefit provided by the insurance must be incidental to the primary purpose of providing retirement income and may not exceed the greater of the following two limits:

1. The face amount cannot exceed 100 times the projected monthly benefit; or
2. The premium used to purchase the policy may not be more than 25 percent of the total cost of providing retirement benefits in the case of term insurance, or 50 percent in the case of ordinary life insurance.

[Rev. Rul. 74-307, 1974-2 C.B. 126]

Death benefits are often added to a 412(e)(3) plan to provide insurance coverage and increase the tax deduction.

25:How should a life insurance contract be valued when distributed to a participant?

The IRS previously ruled in Notice 89-25, Q&A 10 [1981-1 C.B. 662] that the cash surrender value may not always be the best way to value an insurance policy when determining taxable income of a participant. Treasury Regulations Section 1.402(a)-1(a)(1)(iii) provides that the amount includible in a plan participant's gross income by reason of the distribution of property by the plan shall be the fair market value of such property. Life insurance contracts constitute property within the meaning of this section. Treasury Regulations Section 1.402(a)-1(a)(2) provides that a distributee must include in gross income the cash value of any retirement income, endowment, or other life insurance contract at the time of the distribution. Treasury Regulations Section 1.72-16(c)(2)(ii) indicates that the reserve accumulation in a life insurance contract constitutes the source of and approximates the amount of such cash value.

Individuals who receive an insurance policy as a distribution from a qualified plan use the stated cash surrender value of the policy as its fair market value for purposes of determining the amount includible in their gross income under Code Section 402(a). However, the IRS stated that this practice is not appropriate where the total policy reserves, including life insurance reserves (if any) computed under Code Section 807(d), together with any reserves for advance premiums, dividend accumulations, and so forth, represent a much more accurate approximation of the fair market value of the policy than does the policy's stated cash surrender value.

The IRS has issued proposed regulations Prop. Treas. Reg. §1.402(a)-1(a)(1)(iii) and (a)(2)] to clarify that, where the Code Section 402(a) regulations refer to entire cash value of a contract, such terms should be interpreted as fair market value. Thus, when 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 contract is to be included in the distributee's income, not merely the cash value as defined in the contract. Fair market value for this purpose is defined as the value of all rights under the contract, including any supplemental agreements thereto, whether or not guaranteed.

In addition, the IRS issued Revenue Procedure 2004-16 [2004-10 I.R.B 559], prescribing an interim method of valuing insurance contracts, pending the issuance of the proposed regulations in final form. The IRS is issuing this procedure in recognition that, under its current guidance regarding the valuation of insurance contracts distributed from a plan, taxpayers may have difficulty in determining fair market value of these contracts.

Under the interim valuation method, the cash value (without reduction for surrender charges) may be treated as the fair market value of a contract, provided the cash value is no less than the amount determined under the following formula:

-x + y - z

where x, y and z are determined as follows:                                           top

• x equals the premiums paid from the date of issue through the date of determination.
• y equals any amounts credited (or otherwise made available) to the policyholder with respect to those premiums, including interest, dividends, and similar income items (whether under the contract or otherwise). In the case of variable contracts, y equals all adjustments made with respect to the premiums paid from the date of issue through the date of determination (whether under the contract or otherwise) that reflect investment return and the current market value of segregated asset accounts.
• z equals reasonable mortality charges and other reasonable charges that are actually charged on or before the date of determination and are expected to be paid.

The date of determination is the date of a distribution, in the case of valuing a contract distributed from a qualified plan.

Example: Dr. John is a participant in the John's defined benefit plan. On January 1, 2001, $400,000 of plan assets was used to purchase an insurance policy. The policy was distributed to John on January 1, 2003, two years after the date of purchase. The policy provides a stated cash surrender value for each of the first five policy years, as set forth in the table below. The total end-of-year reserves held by the insurance company for the policy also are set forth in the table. These reserves may include life insurance reserves and any other reserves such as for advance premiums and dividend accumulations. Life insurance reserves, if any, are calculated using the rules in Code Section 807(d), which provides rules for determining the amount of those reserves for purposes of calculating the tax liability of the insurance company issuing the policy.

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As the total reserves for the policy at the end of year two, $426,597, substantially exceed the policy's cash surrender value, $112,360, the reserves represent a much more accurate approximation of the fair market value of the policy when distributed than does the policy's cash surrender value. Accordingly, the amount includible in John's gross income by reason of the distribution of the policy at the end of year two is an amount equal to the $426,597 reserve, not the $112,360 stated cash surrender value at that date.

In the case of a distribution in excess of John's accrued benefit, as defined in Treasury Regulations Section 1.411(a)-7(a)(1), resulting from valuing the policy at $112,360 rather than $426,547, the distribution would not be treated as a distribution to John from a qualified plan and, depending upon the facts and circumstances of the case, could be treated as a reversion to the employer. Of course, depending on the facts and circumstances, such distributions could disqualify the plan for exceeding the limitations of Code Section 415.

26:Can a death benefit for a participant be provided in excess of the incidental limitations?

Yes, but pursuant to Revenue Ruling 2004-20, the amount of the contribution used to fund the death benefit in excess of plan limits is not deductible in the current year, is most likely subject to a 10 percent excise tax, and will only be deductible in future years pursuant to the rules of Code Section 404(a)(1)(E). This ruling serves to shut down another abusive arrangement that was being sold on the basis of being able to provide a death benefit well in excess of the incidental limitations, but whereby the beneficiary would receive only the amount that is considered incidental. Any remaining death benefit would remain in the pension plan. This extra money would be used to fund other participants' benefits, or would revert to the employer at substantial excise taxes.

However, the goal of this plan was to distribute the policy to the participant at a depressed value (see Q 14:30), which later grew to a very large value without additional funding. Then, since this is an insurance contract, the policyholder could borrow from the policy up to the cash value tax free. This option has now been closed down as a result of Revenue Ruling 2004-20 [2004-10 I.R.B. 550] and Revenue Procedure 2004-16 [2004-10 I.R.B. 559].

Revenue Ruling 2004-20 also designates any transaction where the face amount of a policy exceeds the participant's death benefit under the plan by more than $100,000 as a "listed transaction." If a plan is involved in a "listed transaction," the plan sponsor must notify the IRS that it is involved in such a transaction by including a statement with its income tax return.

Example: Dr. Brown is a doctor who operates her medical practice as a solely owned corporation. She participates in the 412(e)(3) pension plan maintained by her corporation. The pension plan provides a $1,000,000 death benefit, payable upon the death of Dr. Brown, to her beneficiaries. Although the death benefit is equal to $1,000,000, the plan purchased a life insurance policy with a face value of $5,000,000. The plan provides that if she dies while she is employed by the corporation, $1,000,000 is payable to her beneficiaries but the remaining $4,000,000 is to be applied to pay premiums under the plan for other participants. This is considered a "listed transaction" and as such the corporation must include a statement with its tax return detailing this transaction. In addition, any premiums paid in excess of what are needed to cover the $1,000,000 death benefit are nondeductible to the corporation.

27:Are there any other possible consequences if the sponsor pays more for the premium than what is necessary to provide for the retirement benefit?

Yes. Pursuant to Revenue Ruling 2004-20, if the insurance policies are structured within what purports to be a "fully-insured" plan, and:

1. If premiums are paid through a participant's normal retirement age;
2. If the annuity purchase rates guaranteed under the contract are applied; and
3. If the benefits payable at normal retirement age under the contract as a result of item #1 or #2 above will exceed the participant's benefit under the terms of the plan

Then the plan fails to satisfy the requirement of Code Section 412(e)(3)(C) and is not treated as a fully-insured plan. Code Section 412(e)(3)(C) requires that: "benefits provided by the plan are equal to the benefits provided under each contract at normal retirement age under the plan and are guaranteed by an insurance carrier (licensed under the laws of a State to do business with the plan) to the extent premiums have been paid." Therefore, if a contract provides for premiums that, when guaranteed rates are applied, create benefits that exceed plan stated benefits, this requirement is not satisfied.

If a plan does not satisfy this requirement, then it is no longer a 412(e)(3) plan and certain exceptions that apply to 412(e)(3) plans are no longer applicable. These exceptions include minimum funding exceptions, special nondiscrimination testing options, PBGC exceptions, etc. (See Q 14:25 for a more complete list.) Thus, the plan is subject to the minimum funding requirements of Code Section 412, with charges and credits to the funding standard account determined using the reasonable funding method selected for the plan and using reasonable actuarial assumptions. The actuarial method and assumptions so determined also affect the deductibility of employer contributions under Code Section 404. In addition, the special accrual rule permitted under Code Section 411(b)(1)(F), which deems a fully-insured plan to satisfy the minimum accrual requirements under Code Section 411(b), is not applicable (see Qs 14:14-14:22).

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