Life Insurance in Profit-Sharing Plan Process

This guide discusses our internal process for life insurance in a profit-sharing plan. This guide assumes that the following is already completed:

Incidental benefit rule has been addressed
Client has selected the insurance policy and determined amount to be funded

Here’s the technical detail on each of the remaining to do’s.

What the plan document must contain

Authority to acquire and hold life insurance as a plan investment. The document (or the underlying trust agreement) must affirmatively permit the trustee to apply for, own, and pay premiums on life insurance contracts insuring participants. The provision should also grant the trustee full incidents of ownership over the contracts.
In-service distribution provision keyed to seasoned money. Because the policy typically needs to come out before or at the eventual distribution, the document should permit in-service distributions (Rev. Rul. 68-24, 71-295).
Directed/earmarked (segregated) investment provision. The document should allow individually directed or earmarked accounts so the policy is allocated to and charged against the insured participant’s account only, with premiums drawn from that account.
In-kind distribution. The plan must expressly permit distribution of the actual insurance contract (not just cash), since an in-kind rollout of the policy is one of the primary exit routes.
Authority to sell the contract to the participant/insured. To support a PTE 92-6 sale (the tax-efficient rollout), the document should authorize the trustee to sell a contract to the insured participant, a relative, the employer, or another plan for adequate consideration.
Beneficiary and spousal-rights provisions. The document needs a beneficiary designation mechanism consistent with §401(a)(11)/417. Even in a profit-sharing plan structured to be exempt from QJSA/QPSA, the surviving spouse must be the beneficiary unless the spouse consents in writing to another beneficiary.

Policy owner and beneficiaries

Owner and applicant: the plan trust. The trustee, in its capacity as trustee of the qualified plan, must be the owner and applicant of the policy and must hold all incidents of ownership. The participant is only the insured (the life covered). If the participant is listed as owner, the contract is not a plan asset and the entire structure fails.
Primary beneficiary: the plan trust. Best practice is to name the trust as beneficiary of the death proceeds so the proceeds flow back into the participant’s account and are then distributed under the plan’s beneficiary rules. Routing proceeds through the plan is the clean administrative path and preserves the correct tax treatment (pure insurance portion tax-free under §1.72-16(c) where economic benefit costs were reported; cash-value portion taxable as a plan distribution/IRD).
Participant designates the plan beneficiary for the account (including the insurance proceeds once received by the trust). This is the designation subject to the spousal-consent rules above — the spouse is the default recipient absent written consent to someone else.
Avoid naming the participant’s personal beneficiary directly on the policy as a default. A split designation (trust for the cash-value equivalent, personal beneficiary for the pure at-risk amount) is technically possible and occasionally used, but it adds complexity and administrative risk; most designs keep it simple with the trust as sole policy beneficiary and let the plan distribute.

Economic benefit reporting (annual process)

This runs every plan year for as long as the contract sits in the trust, and it’s what builds the participant’s basis and preserves the tax-free character of the pure death benefit down the road. Treat it as its own recurring administrative task, separate from any actual distribution reporting.

Determining the annual economic benefit

Isolate the net amount at risk. Take the contract’s total death benefit and subtract the cash surrender value as of the measurement date. The difference is the “pure insurance” / amount at risk — the only portion that generates a current economic benefit. The cash-value buildup itself is not currently taxed inside the plan.
Select the applicable rate. For years after 2001, use the Table 2001 rate for the participant’s attained age, expressed per $1,000 of coverage (Table 2001 replaced the old PS-58 rates under Notice 2001-10 and Notice 2002-8). PS-58 still applies to certain pre-2002 or grandfathered arrangements.
Consider the insurer’s term rate substitution. You may use the carrier’s own published term rates in place of Table 2001 only if they clear the Notice 2002-8 conditions — the insurer must make those rates generally available to standard-risk applicants and must actually sell term coverage at them through its normal distribution channels. This was tightened specifically to shut down artificially low “published” rates, so document that the rates qualify before relying on them.
Compute the benefit. (Net amount at risk ÷ 1,000) × the age-based rate = the annual economic benefit. Reduce it by any portion of the premium the participant personally pays out of pocket (in this structure that’s usually zero, since the trustee pays from the participant’s account).
Recalculate every year. The attained-age rate rises as the participant gets older, while the cash value typically grows and shrinks the net amount at risk — so the number moves annually and cannot be set once and reused.
Watch survivorship contracts. If the policy is second-to-die, the standard single-life Table 2001 rates don’t apply; use the appropriate survivorship rates (or qualifying insurer rates), which are far lower while both insureds are living.

Reporting it on the 1099-R

The economic benefit is a currently taxable distribution to the participant, reported on Form 1099-R — one per insured participant, every year, in addition to any 1099-R for an actual distribution.
Box 1 (gross distribution) and Box 2a (taxable amount): the annual economic benefit figure.
Box 7 (distribution code): Code 9 — “cost of current life insurance protection.” This is the code that specifically identifies the amount as the economic benefit rather than a normal distribution.
The Code 9 amount is not an eligible rollover distribution and is not subject to the 10% early-distribution penalty under §72(t). The participant simply picks it up as ordinary income on the 1040 for the year.
Standard 1099-R deadlines apply: furnish to the participant by January 31, and file with the IRS by the end of February on paper or March 31 if filing electronically.

Tracking the basis it creates

Keep a running total of every economic benefit amount reported. The cumulative reported costs become the participant’s investment in the contract (basis).
That basis does two things: it reduces the taxable fair market value on a later in-kind distribution of the policy, and — provided the costs were actually reported each year — it secures income-tax-free treatment of the pure insurance (at-risk) portion of the death benefit under §1.72-16(c). Skipping or under-reporting the annual benefit is what jeopardizes that tax-free death benefit, so the annual discipline matters.

Final distribution options and the rollout process

The policy generally should not remain in the plan indefinitely, and — importantly — it cannot be rolled to an IRA, because IRAs are barred from holding life insurance under §408(a)(3). So at the relevant distributable event (retirement, separation, or an in-service event once the seasoned-money rules are met), the contract has to be dealt with by one of three routes before any IRA rollover of the remaining cash can occur.

The first option is an in-kind distribution of the contract to the participant. The participant is taxed on the policy’s fair market value at distribution under Rev. Proc. 2005-25, reduced by basis from the aggregate economic benefit (Table 2001/PS-58) costs already taxed over the years. It’s reported on a 1099-R, and if the participant is under 59½ the taxable amount can carry the 10% early-distribution penalty. After distribution the policy is personally owned and its future death benefit passes income-tax-free.

The second — and usually the most tax-efficient — is a sale of the contract to the participant under PTE 92-6. Rather than take the policy as a taxable distribution, the participant buys it from the plan for cash equal to its fair market value (the exemption requires the plan receive at least what it would have realized on surrender). Because it’s a purchase and not a distribution, there is no income tax on the policy’s value. The cash the participant pays in stays in their account, continues to grow tax-deferred, and can later be rolled to an IRA; the participant walks away owning the policy personally. This is the route most owner-participants prefer when they want to keep the coverage but get it out of the plan without an immediate tax hit.

The third is surrender inside the plan. The trustee simply surrenders the contract for cash surrender value, which remains in the account as cash. No insurance leaves the plan, the coverage is gone, and the now-all-cash account can be distributed or rolled to an IRA normally. This is the cleanest option when the coverage is no longer wanted.

Mechanically, the process in each case is: confirm the distributable event; obtain the insurer’s fair market value statement (Form 712/Rev. Proc. 2005-25 valuation); choose distribute, sell, or surrender; execute the insurer’s change-of-ownership or assignment paperwork transferring the contract out of the trust (or the surrender); and report correctly — a 1099-R for an in-kind distribution (FMV net of basis), no 1099-R on a PTE 92-6 sale since it isn’t a distribution.

Death is the other terminal event: the trust collects the proceeds, and the plan distributes the account to the participant’s plan beneficiary — the pure at-risk amount coming through income-tax-free where economic benefit costs were reported, and the cash-value component taxable as a plan distribution.