Tax News As of 5/9/05              

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IRS Provides New Safe Harbor Formulas for Valuation

Revenue Procedure 2005-25

The IRS has published Revenue Procedure 2005-25 on the issue of valuing a life insurance contract, retirement contract, modified endowment contract or any other contract providing life insurance protection. This Revenue Procedure modifies and supersedes Revenue Procedure 2004-16, and the new safe harbor rules can be used retroactively to February 13, 2004, the date that the prior Revenue Procedure was published.

Revenue Procedure 2004-16 provided interim rules for when a contract's cash surrender value (without reduction for surrender charges) may be treated as the contract's fair market value, for purposes of the qualified plan rules (Section 402) and Sections 79 and 83 of the Code. The IRS received comments on the safe harbors after Revenue Procedure 2004-16 was issued and have now changed the formula for determining fair market value. This new revenue procedure is intended to address the IRS' concern that the value of life insurance policies should be calculated based on a standard formula and should not be understated.

Revenue Procedure 2005-25 provides the following "safe harbor" formula for valuation of non-variable contracts:

The fair market value of a non-variable contract may be measured as the greater of:

A) the sum of the interpolated terminal reserve (ITR) and any unearned premiums plus a pro rata portion of a reasonable estimate of dividends expected to be paid for that policy year based on company experience; or

B) the product of the PERC amount (PERC stands for premiums and earnings less reason-able charges) and the applicable Average Surrender Factor.

The PERC amount is the aggregate of: 1) the premiums paid from the date of issue through the valuation date (without reduction for dividends that offset those premiums) plus 2) dividends applied to purchase paid-up insurance prior to the valuation date plus 3) any other amounts credited to the policy holder with respect to premiums, including interest and similar income items, but not including dividends used to offset premiums and to purchase paid up insurance, minus 4) mortality and other charges that are not going to be reversed at a later date, minus 5) any distributions, withdrawals and surrenders prior to the valuation date.

The fair market value "safe harbor" for variable contracts follows the same formula as non-variable contracts, except that the PERC amount factors in all adjustments (plus or minus) that reflect the investment return and the market value of segregated asset accounts, instead of income items such as interest.

The Average Surrender Factor (ASF) for Sections 79, 83 and 402(b) (where no adjustment for potential surrender charges is permitted) is 1.00. For contracts that do provide for explicit surrender charges, the ASF is the unweighted average of the applicable surrender factors over the 10 years beginning with the policy year of distribution or sale. The ASF for a year with no surrender charge is 1.00 and a surrender charge can be taken into account only if it is specified at policy issue in the form of nonincreasing percentages or amounts.

Effective Dates. This Revenue Procedure applies to distributions or sales under Section 83 on or after February 13, 2004, to permanent benefits under Section 79 provided on or after February 13, 2004, and to qualified plans governed by Section 402(b) for periods on or after February 13, 2004. For valuations between February 13, 2004 and May 1, 2005, taxpayers may rely on either the safe harbors under Revenue Procedure 2004-16 or the formulas of Revenue Procedure 2005-25.

 

Joseph F. Blum, CLU, TEP