Completing a two-year project to shutter abusive transactions of 412(i) plans and other arrangements, the Treasury and the Internal Revenue Service have issued final regulations clarifying that any life insurance contract transferred from an employer or a tax-qualified plan to an employee must be taxed at full fair market value.

The final regulations are aimed at arrangements that attempt to avoid taxes via the use of "artificial devices" to understate the value of insurance contracts.

A 412(i) plan" is a tax-qualified retirement plan that is funded by a life insurance contract. An employer is entitled to claim tax deductions for contributions that are used by the plan to pay premiums on an insurance contract covering an employee. The plan may hold the contract until the employee dies, or it may distribute or sell the contract to the employee at a specific point -- like retirement.

Some companies however, have promoted a tax-avoidance scheme where an employer establishes a section 412(i) plan under which the contributions made to the plan -- which are deducted by the employer -- are used to purchase a specially designed life insurance contract. Under that arrangement, the cash surrender value (the amount that the contract states the policy is worth if it were cashed in), is lowered to a level significantly below the paid premiums. The contract is then distributed or sold to the employee for the amount of the depressed cash surrender value.

The contract is structured so that the cash surrender value increases significantly after it is transferred to the employee.

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