The Treasury has issued new regulations (TD 9223) dealing with "springing" cash-value life insurance and other issues in valuing insurance contracts. The regulations respond to a variety of ploys to artificially lower insurance values temporarily for income and estate tax planning.
In the past, a life policy's cash value was often considered the same as it's "fair market value." To take advantage of this, policies were created that had a low cash value for a few years, before the cash value "springs" to a big number.
A number of tax planning defices were built around this concept. In income-tax planning, a small pension plan would buy a springing policy and transfer it to a beneficiary -- say, the business owner -- at thelow "unsprung" value. The plan would then "spring" to life, and the owner could borrow against the policy tax free. The Treasury press release for the regs explains:
The contract is structured so that the cash surrender value increases significantly after it is transferred to the employee. The use of this springing cash value life insurance results in a mismatch between the employer's deduction and the employee's recognition of income. The employer takes a deduction for the entire value of the premiums paid into the insurance plan and the employee pays taxes only on the artificially depressed value of the contract allowing the employee to avoid taxes on the true value of the contract while the employer taxes the full deduction for the premiums paid.
The new regulations say that "fair market value" means, well, fair value, unreduced for gimmicks like springing cash value. The regulations apply to policy transfers starting February 13, 2004.
Links: Treasury Press Release
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