Final regulations issued under section 402(a) regarding the amount includible in a distributee's income when life insurance contracts are distributed by a qualified retirement plan, and how property sold by a qualified retirement plan to a plan participant or beneficiary for less than fair market value will be treated. (T.D. 9223)

The IRS and Treasury concluded that the safe harbor formulas in Rev. Proc. 2004-16 did not function well for certain types of traditional policies, and also should be revised to reflect a discount for the possibility that a surrender charge would apply in certain situations. Accordingly, Rev. Proc. 2005-25, 2005-17 I.R.B. 962, was issued to modify and supersede Rev. Proc. 2004-16 in order to make adjustments to the safe harbor formulas.

These new safe harbor formulas replace the formulas in Rev. Proc. 2004-16 for distributions, sales, and other transfers made on or after February 13, 2004, and for permanent benefits provided on or after February 13, 2004. For all periods, including periods before May 1, 2005, taxpayers may rely on the safe harbors in Rev. Proc. 2005-25. In addition, for periods on or after February 13, 2004, and before May 1, 2005, taxpayers may rely on the safe harbors in Rev. Proc. 2004-16.

The regulations also retain the rules set forth in the 2004 proposed regulations under sections 79 and 83 that clarify that fair market value is also controlling with respect to life insurance contracts under those sections and, thus, that all of the rights under the contract (including any supplemental agreements thereto and whether or not guaranteed) must be considered in determining that fair market value.

These final regulations amend §1.79-1(d) to replace the term cash value in the formula for determining the cost of permanent benefits with the term fair market value .

The Service specifically focused on the valuation of life insurance contracts that are structured in a manner which results in a temporary period during which neither a contract's reserves nor its cash surrender value represent the fair market value of the contract.

"For example, some life insurance contracts may provide for large surrender charges and other charges that are not expected to be paid because they are expected to be eliminated or reversed in the future (under the contract or under another contract for which the first contract is exchanged), but this future elimination or reversal is not always reflected in the calculation of the contract's reserve. If such a contract is distributed prior to the elimination or reversal of those charges, both the cash surrender value and the reserve under the contract could significantly understate the fair market value of the contract."

Thus the Service concludes that, in some cases, it would not be appropriate to use either the net surrender value ( i.e. , the contract's cash value after reduction for any surrender charges) or, because of the unusual nature of the contract, the contract's reserves to determine the fair market value of the contract.

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