Life and Death Planning for Retirement Benefits

Chapter 11: Insurance, Annuities, and Retirement Plans

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the “three year rule” of § 2035 , while avoiding a “transfer for value” or “prohibited transaction.”

Plan-owned insurance and the tax on UBTI

Normally, retirement plans are tax-exempt entities; however, like other tax-exempt entities, plans are subject to tax under § 511 on “unrelated business taxable income” (UBTI). The idea of the UBTI tax is that a tax-exempt organization (such as a charity or retirement plan) is granted its tax exemption to foster its exempt purposes, not to enable the entity to compete with tax-paying businesses. Reg. § 1.513-1(b) . If the tax-exempt entity has UBTI, it must pay income tax on that income. § 511 . Don’t be fooled by the term “unrelated business taxable income” into thinking that the UBTI tax applies only if the IRA runs a business. An IRA can have UBTI even without owning or operating a business, because income from “debt-financed property” is UBTI regardless of whether there is a trade or business. § 512(b)(4) , § 514 . “Debt-financed property” is property acquired with borrowed funds and held to produce income. § 514(b) . The UBTI tax does not apply if the indebtedness is incurred in furtherance of the plan’s exempt purpose. One could argue that the purpose of a retirement plan is to invest and accumulate funds for the owner’s future retirement, and therefore any debt incurred to increase investment return is in furtherance of the plan’s exempt purpose. However, this argument was rejected in Elliot Knitwear Profit-Sharing Plan , 614 F. 2d 347 (3d Cir. 1980), which was followed in Henry E. & Nancy Horton Bartels Trust , 209 F. 3d 147 (2d Cir. 2000); Cert. Denied 531 U.S. 978 (2000), on the basis that “in furtherance” of the exempt purpose means inherent in or essential to the fulfilment of the exempt purpose; while borrowing for investment purposes may be useful for the accumulation of funds, it is not essential. If a QRP carries a life insurance policy to provide incidental death benefits, and the plan borrows on the policy in order to invest the loan proceeds in a different investment, the policy loan generates debt-financed income that is taxable as UBTI, according to PLR 7918095. On the other hand, if the borrowing against the policy is solely for the purpose of financing the policy premiums , presumably the loan thus incurred would not create debt-financed income because it is incurred in an essential function of the exempt purpose of the plan. However, there is no ruling on this point. For more on the UBTI tax, see IRS Publication 598, Tax on Unrelated Business Income of Exempt Organizations ; or Freitag, C.N., Unrelated Business Income Tax (T.M. 874-2) and Debt- Financed Income (T.M. 875).

Plan-owned life insurance subject to spousal ERISA rights

Under a qualified retirement plan, the surviving spouse of a deceased employee/participant is given certain inheritance rights, which may be as much as 100 percent of the death benefit under the plan. See ¶ 3.4 . The plan death benefit for this purpose includes proceeds of any life insurance policy held in the plan. Reg. § 1.401(a)-20 , A-12(b).

11.5 Planning Ideas with Life Insurance and Retirement Benefits

This ¶ 11.5 discusses various planning ideas that have been advanced for use of life insurance in connection with retirement benefits.