Using IRA Funds to Purchase Life Insurance

Many individuals desire to acquire insurance on their lives using funds held in a qualified retirement plan. The acquisition of insurance using funds within an IRA (Plan) is beneficial since the Plan uses tax deductible dollars (the Plan Funds) to acquire the insurance. Furthermore, the Plan Funds are not otherwise being directly used by qualified plan participant (Participant) for the Participant.

In general, the Internal Revenue Service (IRS) has prevented IRAs to be used for the acquisition of life insurance. Specifically, an improperly designed estate plan using Plan Funds to acquire life insurance will result in the individual's estate realizing estate taxes on the insurance proceeds and excise tax on the IRA for the purchase of life insurance. Also, a Participant must incur income taxes on the value of the death benefit acquired by a plan on behalf of the Participant. The Internal Revenue Code (Code) restricts the amount of life insurance that may be acquire to preserve the intended purpose of the Plan, i.e., to provide retirement benefits to the Plan participant and his or her dependents. The Code also prevents individual retirement accounts from owning
life insurance. Furthermore, when a Plan owns life insurance on a Participant at the time of the Participant's death and the Participant possesses an incident of ownership over the policy within three years of death, the life insurance proceeds will be subject to estate tax. These 'incidents of ownership,' which are important in an analysis of the topic discussed herein, include having the power to: designate the beneficiary of the policy; surrender or cancel the policy; assign the policy; or borrow against the policy. These are just some of the impediments imposed by the Code to prevent or discourage a Plan from using Plan Funds to acquire life insurance policies on the life of a Participant.

Insurance Limited Partnership

By using an Insurance Limited Partnership (ILP) format, an individual may indirectly use Plan Funds to acquire life insurance on his or her life (as a Participant) without triggering the negative effects of the Code. Under an ILP structure, a Participant, the Plan and an irrevocable life insurance trust (Trust) will create a limited partnership or LLC that complies with applicable state law and the prohibited transaction rules of the Code and the Employee Retirement Income Security Act of 1974 (ERISA). The Participant and Plan may be the designated limited partners of the ILP, and the Trust may serve as the general partner. Under most state laws, every partner (general and limited) must make a contribution to the capital of the ILP in consideration for receiving an ownership interest in the ILP. Thus, the Participant must initially make at least a nominal capital contribution (at least 2%) to the ILP; however, it is recommended that the Participant and the Plan make other contributions towards the primary business purpose of the ILP (discussed below). It is also extremely important under ERISA that the Plan own more than 50% of the interest in the ILP. See the discussion below.

It is recommended that the ILP utilize a traditional limited partnership or LLC approach with the limited partners receiving a guaranteed return on their investments. The Participant may contribute capital at least equal to the economic benefit established by the IRS to fund the acquisition of the life insurance. This contribution also helps to establish that the ILP has an insurable interest in the Participant. Otherwise, the life insurance policy may not be enforceable. The IRA must also make contributions to the ILP. These contributions will be sizeable and, thus, may be used to fund the acquisition of the life insurance policy insuring the Participant.

The ILP must have a demonstrable business purpose. The purpose of the ILP cannot be simply to acquire and hold life insurance. This is a key, and unavoidable, requirement of the ILP. If the ILP does not have a demonstrable business purpose, this strategy will not provide the benefits anticipated. An ILP that has a demonstrable business purpose, however, may engage in many activities, including the acquisition of life insurance policies insuring the lives of individuals in whom the ILP has an insurable interest. Once the ILP is established, it should operate its business in an ordinary and customary manner. The Trust, as general partner, may retain management authority over the management of the ILP's assets.

The ILP partnership agreement should contain certain provisions that are not typically possessed in a limited partnership agreement. These provisions are discussed below.

Basic Elements

The partnership agreement for the ILP must comply with applicable state law, the prohibited transaction rules of the Code and ERISA, specifically in connection with the investment of Plan contributions as regulated by '406 of ERISA and Code '4975(c). The partnership agreement must also be drafted so that the Participant is not able to exercise, directly or indirectly through the other partners, any incidents of ownership.

Ownership

The ILP partnership agreement should restrict the transferability of partnership interests. The agreement should also ensure that the Plan acquires and retain, under all circumstances, majority ownership in the ILP. Thus, the Plan will receive the majority of profits and losses.

Additional Contributions

The ILP partnership agreement may dictate the percentages of life insurance premium that each ILP partner will contribute to the ILP. The agreement should also confirm that these same percentages will be contributed by each partner in the event the ILP requires additional capital contributions.

Distributions

From Plan to Participant: After the Participant reaches the age of 59', the Plan's interest in the ILP may be distributed to the Participant without penalty, though it would be subject to income taxes. The Participant could then transfer his or her distribution to the Trust. This transfer of an interest in the ILP should be permissible under the limited partnership agreement. If so, the transfer should not activate the three-year in contemplation-of-death rule. By the time a Participant is old enough to receive the distribution of the ILP interest from the Plan, the Plan should have paid, using pre-tax dollars, the majority of acquisition costs of the insurance policy acquired by the ILP.

From ILP to Partners: The partnership agreement should state how assets will be distributed upon death of the Participant. The partnership agreement should provide that no policy dividends will be used to pay the obligation of the Trust to pay premiums since this would not be in the best interests of the Plan. Upon the death of the Participant, the Trustee of the Trust would collect, on behalf of the ILP, the proceeds of the insurance policy it owns insuring the life of the Participant. The ILP could distribute to the Participant and the Plan the amount advanced plus the guaranteed return. The remainder of the policy would be distributed to the Trust without being subject to estate or income taxes. The Trust could then distribute to the Participant's heirs the proceeds of the Trust.

If the ILP structure described above is implemented and the formalities are followed, the Participant, the Plan and the Trust may realize substantial benefits and cost savings. These benefits and savings include the following:

A. The Plan, using pre-tax dollars, by investing in the ILP will support the ILP, maintaining the life insurance policy and the Trust (General Partner), using favorable rates, and will pay the amount of the premium equal to the costs of just the insurance protection afforded by the policy (i.e., term insurance coverage).

B. The Plan can distribute to the Participant, when he or she reaches the age of 59', the Plan's interest in the ILP without penalty, and the Participant can then contribute such interest to the Trust or gift to family members without penalty.

C. After the death of the Participant, the Trust should receive the proceeds of the life insurance policy as described above, free of estate and income taxes. The proceeds could then be held or distributed pursuant to the terms of the Trust.

D. The Trust may purchase; if desirable, from the ILP the life insurance policy for an amount that may be substantially less than the aggregate of the premiums paid without triggering the 'transfer for value' rules. Where the life insurance policy has a springing cash value, the Trust may acquire the Plan's interest in the ILP with little income tax to the Participant.

E. In the event the Participant dies prior to the Plan distributing its interest in the ILP to the Participant, the Participant's estate will realize from the ILP only the return on the amount invested plus the guaranteed return.

As indicated above, in order to receive and preserve the benefits described above, it is imperative that: 1) the ILP have a demonstrable business purpose to support the position that it is a legitimate partnership for tax purposes; and 2) the limited partnership agreement be prepared in compliance with local law and in conformance with ERISA regulations to prevent the Participant from exercising incidents of ownership and engaging in certain prohibited transactions identified in '406 of ERISA and Code '4975(c). By following these requirements, the Trustee of the Trust, acting for the general partner, can mange the ILP's assets as though they were held within a qualified retirement plan regulated by ERISA.

The Department of Labor or the IRS could challenge the ILP structure on the basis that the Plan's investment in the ILP is a transfer of Plan assets for the benefit of a prohibited person in violation of '406(a)(l)(D) of ERISA and '4975(c)(l)(D) of the Code. In support of its position, the IRS would use as support for its position that: 1) the Trust is a party-in-interest for purposes of ERISA since the Participant's family members are beneficiaries of the Trust; 2) the investment of the Plan's assets in the ILP constitute a transfer or use of Plan assets; and 3) the Plan's investment in the ILP is actually being undertaken for the benefit of the beneficiaries of the Trust, as a party-in interest.

The ILP should be able to prevail over such a challenge by the Department of Labor if the ILP is established in accordance with this Memorandum. The points raised by the Department of Labor are addressed as follows. First, the Trust will invest the ILP's assets in compliance with ERISA. Second, the investment of Plan assets in the ILP does not confer a personal benefit on the Participant or his or her heirs over the other partners. Rather, the actions of the ILP should benefit all of the different members of the ILP, as separate legal entities, in proportion to their ownership interest in the ILP, which was acquired with valuable consideration. Furthermore, the Plan will own more than 50% of the interest in the ILP so that the ILP will not be deemed a 'party in interest' under ERISA.

The case of Reich v. Compton, 57 F.3d 270 (3rd Cir. 1995), supports the conclusion that the ILP structure, when properly implemented and maintained, does not violate the prohibited transaction rules of ERISA. In this case, the Department of Labor asserted, among other things, that a transaction between a nonprofit corporation (Organization) and a retirement plan violated '406(a)(1)(D) of ERISA on the basis that the Organization was the alter ego of a party-in-interest. The court concluded that ERISA is specific as to its limitations, and the alter ego theory was not included by Congress in law. Therefore, the court would not examine whether one entity was an alter ego of another.

In addition, the court considered whether, under the facts and circumstances of the case, ERISA was violated by a fiduciary by virtue of the fiduciary causing a plan to engage in a transaction that the fiduciary knows or should know constitutes 'a direct or indirect … use … for the benefit of a party in interest, of any assets of the plan.' The court stated that the following five elements should be considered in making such determination of direct or indirect use:

1. The person or entity engaged in the transaction must be a fiduciary with respect to the retirement plan.
2. The fiduciary must cause the plan to engage in the transaction at issue.
3. The transaction must use plan assets.
4. The use of plan assets must be for the benefit of a party-in-interest.
5. The fiduciary knows or should have known that elements three and four are satisfied.

With respect to the use of plan assets being for the benefit of a party-in-interest, the court stated: '[W]e conclude that element four requires proof of a subjective intent to benefit a party-in-interest.' Thus, the subjective intent standard, based on the facts and circumstances of the case, rather than an objective standard of analysis should be used.

The application of the subjective standard will benefit an ILP. Reich requires the DOL to demonstrate that the Plan's investment in the ILP was performed with the subjective intent of benefiting the Trust rather than the Plan. This argument should not succeed against an ILP implemented using the split dollar approach described above since the Trust will be contributing to the ILP the cost of the death benefit provided by the policy and the partnership agreement. Furthermore, any increases in the cash value of the ILP's insurance policy will inure to the benefit of the Plan. The same results can be achieved using a variable life policy. There are sound business reasons for the ILP to acquire an interest in the life insurance policy since there will ultimately be a reasonable return on its investment. Therefore, the ILP structure should withstand the scrutiny of the IRS and the Department of Labor. Additionally, Department of Labor announced in 2000 that an IRA could invest in a family limited partnership, and it was not a prohibited transaction.

Conclusion

This article is not intended as a substitute for careful tax planning by any prospective participants in an ILP. The tax consequences associated with the ILP structure are complex. Certain of these consequences will not be the same for all taxpayers and not all tax consequences have been definitively addressed by statute, regulations, rulings or court decisions. Each prospective participant in an ILP should seek and rely on the advice of his, her or its tax counsel or accountant with specific reference to his, her or its own tax situation and to potential changes in the applicable law. Moreover, with respect to some of these matters, existing precedents provide little guidance.

Lawrence L. Bell, JD, LTM, CLU, ChFC, CFP', AEP, a member of this newsletter's Board of Editors, has served as Tax Bar liaison to the IRS for 10 years. He has received patents in actuarial product fields dealing with COLI, GASB, FASB, IASB and OPEB solutions.

Many individuals desire to acquire insurance on their lives using funds held in a qualified retirement plan. The acquisition of insurance using funds within an IRA (Plan) is beneficial since the Plan uses tax deductible dollars (the Plan Funds) to acquire the insurance. Furthermore, the Plan Funds are not otherwise being directly used by qualified plan participant (Participant) for the Participant.

In general, the Internal Revenue Service (IRS) has prevented IRAs to be used for the acquisition of life insurance. Specifically, an improperly designed estate plan using Plan Funds to acquire life insurance will result in the individual's estate realizing estate taxes on the insurance proceeds and excise tax on the IRA for the purchase of life insurance. Also, a Participant must incur income taxes on the value of the death benefit acquired by a plan on behalf of the Participant. The Internal Revenue Code (Code) restricts the amount of life insurance that may be acquire to preserve the intended purpose of the Plan, i.e., to provide retirement benefits to the Plan participant and his or her dependents. The Code also prevents individual retirement accounts from owning
life insurance. Furthermore, when a Plan owns life insurance on a Participant at the time of the Participant's death and the Participant possesses an incident of ownership over the policy within three years of death, the life insurance proceeds will be subject to estate tax. These 'incidents of ownership,' which are important in an analysis of the topic discussed herein, include having the power to: designate the beneficiary of the policy; surrender or cancel the policy; assign the policy; or borrow against the policy. These are just some of the impediments imposed by the Code to prevent or discourage a Plan from using Plan Funds to acquire life insurance policies on the life of a Participant.

Insurance Limited Partnership

By using an Insurance Limited Partnership (ILP) format, an individual may indirectly use Plan Funds to acquire life insurance on his or her life (as a Participant) without triggering the negative effects of the Code. Under an ILP structure, a Participant, the Plan and an irrevocable life insurance trust (Trust) will create a limited partnership or LLC that complies with applicable state law and the prohibited transaction rules of the Code and the Employee Retirement Income Security Act of 1974 (ERISA). The Participant and Plan may be the designated limited partners of the ILP, and the Trust may serve as the general partner. Under most state laws, every partner (general and limited) must make a contribution to the capital of the ILP in consideration for receiving an ownership interest in the ILP. Thus, the Participant must initially make at least a nominal capital contribution (at least 2%) to the ILP; however, it is recommended that the Participant and the Plan make other contributions towards the primary business purpose of the ILP (discussed below). It is also extremely important under ERISA that the Plan own more than 50% of the interest in the ILP. See the discussion below.

It is recommended that the ILP utilize a traditional limited partnership or LLC approach with the limited partners receiving a guaranteed return on their investments. The Participant may contribute capital at least equal to the economic benefit established by the IRS to fund the acquisition of the life insurance. This contribution also helps to establish that the ILP has an insurable interest in the Participant. Otherwise, the life insurance policy may not be enforceable. The IRA must also make contributions to the ILP. These contributions will be sizeable and, thus, may be used to fund the acquisition of the life insurance policy insuring the Participant.

The ILP must have a demonstrable business purpose. The purpose of the ILP cannot be simply to acquire and hold life insurance. This is a key, and unavoidable, requirement of the ILP. If the ILP does not have a demonstrable business purpose, this strategy will not provide the benefits anticipated. An ILP that has a demonstrable business purpose, however, may engage in many activities, including the acquisition of life insurance policies insuring the lives of individuals in whom the ILP has an insurable interest. Once the ILP is established, it should operate its business in an ordinary and customary manner. The Trust, as general partner, may retain management authority over the management of the ILP's assets.

The ILP partnership agreement should contain certain provisions that are not typically possessed in a limited partnership agreement. These provisions are discussed below.

Basic Elements

The partnership agreement for the ILP must comply with applicable state law, the prohibited transaction rules of the Code and ERISA, specifically in connection with the investment of Plan contributions as regulated by '406 of ERISA and Code '4975(c). The partnership agreement must also be drafted so that the Participant is not able to exercise, directly or indirectly through the other partners, any incidents of ownership.

Ownership

The ILP partnership agreement should restrict the transferability of partnership interests. The agreement should also ensure that the Plan acquires and retain, under all circumstances, majority ownership in the ILP. Thus, the Plan will receive the majority of profits and losses.

Additional Contributions

The ILP partnership agreement may dictate the percentages of life insurance premium that each ILP partner will contribute to the ILP. The agreement should also confirm that these same percentages will be contributed by each partner in the event the ILP requires additional capital contributions.

Distributions

From Plan to Participant: After the Participant reaches the age of 59', the Plan's interest in the ILP may be distributed to the Participant without penalty, though it would be subject to income taxes. The Participant could then transfer his or her distribution to the Trust. This transfer of an interest in the ILP should be permissible under the limited partnership agreement. If so, the transfer should not activate the three-year in contemplation-of-death rule. By the time a Participant is old enough to receive the distribution of the ILP interest from the Plan, the Plan should have paid, using pre-tax dollars, the majority of acquisition costs of the insurance policy acquired by the ILP.

From ILP to Partners: The partnership agreement should state how assets will be distributed upon death of the Participant. The partnership agreement should provide that no policy dividends will be used to pay the obligation of the Trust to pay premiums since this would not be in the best interests of the Plan. Upon the death of the Participant, the Trustee of the Trust would collect, on behalf of the ILP, the proceeds of the insurance policy it owns insuring the life of the Participant. The ILP could distribute to the Participant and the Plan the amount advanced plus the guaranteed return. The remainder of the policy would be distributed to the Trust without being subject to estate or income taxes. The Trust could then distribute to the Participant's heirs the proceeds of the Trust.

If the ILP structure described above is implemented and the formalities are followed, the Participant, the Plan and the Trust may realize substantial benefits and cost savings. These benefits and savings include the following:

A. The Plan, using pre-tax dollars, by investing in the ILP will support the ILP, maintaining the life insurance policy and the Trust (General Partner), using favorable rates, and will pay the amount of the premium equal to the costs of just the insurance protection afforded by the policy (i.e., term insurance coverage).

B. The Plan can distribute to the Participant, when he or she reaches the age of 59', the Plan's interest in the ILP without penalty, and the Participant can then contribute such interest to the Trust or gift to family members without penalty.

C. After the death of the Participant, the Trust should receive the proceeds of the life insurance policy as described above, free of estate and income taxes. The proceeds could then be held or distributed pursuant to the terms of the Trust.

D. The Trust may purchase; if desirable, from the ILP the life insurance policy for an amount that may be substantially less than the aggregate of the premiums paid without triggering the 'transfer for value' rules. Where the life insurance policy has a springing cash value, the Trust may acquire the Plan's interest in the ILP with little income tax to the Participant.

E. In the event the Participant dies prior to the Plan distributing its interest in the ILP to the Participant, the Participant's estate will realize from the ILP only the return on the amount invested plus the guaranteed return.

As indicated above, in order to receive and preserve the benefits described above, it is imperative that: 1) the ILP have a demonstrable business purpose to support the position that it is a legitimate partnership for tax purposes; and 2) the limited partnership agreement be prepared in compliance with local law and in conformance with ERISA regulations to prevent the Participant from exercising incidents of ownership and engaging in certain prohibited transactions identified in '406 of ERISA and Code '4975(c). By following these requirements, the Trustee of the Trust, acting for the general partner, can mange the ILP's assets as though they were held within a qualified retirement plan regulated by ERISA.

The Department of Labor or the IRS could challenge the ILP structure on the basis that the Plan's investment in the ILP is a transfer of Plan assets for the benefit of a prohibited person in violation of '406(a)(l)(D) of ERISA and '4975(c)(l)(D) of the Code. In support of its position, the IRS would use as support for its position that: 1) the Trust is a party-in-interest for purposes of ERISA since the Participant's family members are beneficiaries of the Trust; 2) the investment of the Plan's assets in the ILP constitute a transfer or use of Plan assets; and 3) the Plan's investment in the ILP is actually being undertaken for the benefit of the beneficiaries of the Trust, as a party-in interest.

The ILP should be able to prevail over such a challenge by the Department of Labor if the ILP is established in accordance with this Memorandum. The points raised by the Department of Labor are addressed as follows. First, the Trust will invest the ILP's assets in compliance with ERISA. Second, the investment of Plan assets in the ILP does not confer a personal benefit on the Participant or his or her heirs over the other partners. Rather, the actions of the ILP should benefit all of the different members of the ILP, as separate legal entities, in proportion to their ownership interest in the ILP, which was acquired with valuable consideration. Furthermore, the Plan will own more than 50% of the interest in the ILP so that the ILP will not be deemed a 'party in interest' under ERISA.

The case of Reich v. Compton, 57 F.3d 270 (3rd Cir. 1995), supports the conclusion that the ILP structure, when properly implemented and maintained, does not violate the prohibited transaction rules of ERISA. In this case, the Department of Labor asserted, among other things, that a transaction between a nonprofit corporation (Organization) and a retirement plan violated '406(a)(1)(D) of ERISA on the basis that the Organization was the alter ego of a party-in-interest. The court concluded that ERISA is specific as to its limitations, and the alter ego theory was not included by Congress in law. Therefore, the court would not examine whether one entity was an alter ego of another.

In addition, the court considered whether, under the facts and circumstances of the case, ERISA was violated by a fiduciary by virtue of the fiduciary causing a plan to engage in a transaction that the fiduciary knows or should know constitutes 'a direct or indirect … use … for the benefit of a party in interest, of any assets of the plan.' The court stated that the following five elements should be considered in making such determination of direct or indirect use:

1. The person or entity engaged in the transaction must be a fiduciary with respect to the retirement plan.
2. The fiduciary must cause the plan to engage in the transaction at issue.
3. The transaction must use plan assets.
4. The use of plan assets must be for the benefit of a party-in-interest.
5. The fiduciary knows or should have known that elements three and four are satisfied.

With respect to the use of plan assets being for the benefit of a party-in-interest, the court stated: '[W]e conclude that element four requires proof of a subjective intent to benefit a party-in-interest.' Thus, the subjective intent standard, based on the facts and circumstances of the case, rather than an objective standard of analysis should be used.

The application of the subjective standard will benefit an ILP. Reich requires the DOL to demonstrate that the Plan's investment in the ILP was performed with the subjective intent of benefiting the Trust rather than the Plan. This argument should not succeed against an ILP implemented using the split dollar approach described above since the Trust will be contributing to the ILP the cost of the death benefit provided by the policy and the partnership agreement. Furthermore, any increases in the cash value of the ILP's insurance policy will inure to the benefit of the Plan. The same results can be achieved using a variable life policy. There are sound business reasons for the ILP to acquire an interest in the life insurance policy since there will ultimately be a reasonable return on its investment. Therefore, the ILP structure should withstand the scrutiny of the IRS and the Department of Labor. Additionally, Department of Labor announced in 2000 that an IRA could invest in a family limited partnership, and it was not a prohibited transaction.

Conclusion

This article is not intended as a substitute for careful tax planning by any prospective participants in an ILP. The tax consequences associated with the ILP structure are complex. Certain of these consequences will not be the same for all taxpayers and not all tax consequences have been definitively addressed by statute, regulations, rulings or court decisions. Each prospective participant in an ILP should seek and rely on the advice of his, her or its tax counsel or accountant with specific reference to his, her or its own tax situation and to potential changes in the applicable law. Moreover, with respect to some of these matters, existing precedents provide little guidance.

Lawrence L. Bell, JD, LTM, CLU, ChFC, CFP', AEP, a member of this newsletter's Board of Editors, has served as Tax Bar liaison to the IRS for 10 years. He has received patents in actuarial product fields dealing with COLI, GASB, FASB, IASB and OPEB solutions.