SECTION 2. BACKGROUND

.01 Relevance of Fair Market Value. (1) Distributions from Qualified Plans Under § 402(a). Section 402(a) provides generally that any amount actually distributed to any distributee by any employees’ trust described in § 401(a) (which is exempt from tax under § 501(a)) is taxable to the distributee, in the taxable year of the distributee in which distributed. Section 1.402(a)–1(a)(1)(iii) of the Income Tax Regulations provides, in general, that a distribution of property by a qualified plan is taken into account by the distributee at its “fair market value.” Section 1.402(a)–1(a)(2) provides, in general, that upon distribution of a retirement income, endowment, or other life insurance contract, the “entire cash value” at the time of distribution must be included in the distributee’s income. Amendments to the regulations under § 402 were proposed on February 13, 2004 (REG–126967–03, 2004–10 I.R.B. 566 [69 FR 7384]) to clarify that the fair market value standard controls when such a contract is distributed. The same valuation standard applies when such a contract is sold by the plan to a participant. This fair market value standard under the proposed regulations would apply to distributions or sales that occur on or after February 13, 2004.

(2) Permanent Benefits Provided Under § 79. Section 79 generally requires that the cost of group-term life insurance coverage on the life of an employee that is in excess of $50,000 of coverage be included in the income of the employee. Pursuant to

§ 1.79–1(b) of the regulations, under specified circumstances, group-term life insurance may be combined with other benefits, referred to as permanent benefits. Under § 1.79–1(d), the employee’s income includes the cost of those permanent benefits, reduced by the amount the employee paid for the benefits. The cost of the permanent benefits is determined under a formula provided in the regulations that is based in part on the increase in the employee’s deemed death benefit during the year. One of the factors used for determining the deemed death benefit is “the net level premium reserve at the end of that policy year for all benefits provided to the employee by the policy or, if greater, the cash value of the policy at the end of that policy year.” Amendments to the regulations under § 79 were proposed on February 13, 2004 (69 FR 7384) that would delete the term “cash value” from the formula for determining the cost of permanent benefits in § 1.79–1(d) and substitute the term “fair market value.” The proposed regulations would apply to permanent benefits provided on or after February 13, 2004. (3) Transfers Under § 83(a). Section 83(a) provides that, when property is transferred to any person in connection with the performance of services, the service provider must include in gross income (as compensation income) the excess of the fair market value of the property, determined without regard to lapse restrictions (such as life insurance contract surrender charges), and determined at the first time that the transferee’s rights in the property are either transferable or not subject to a substantial risk of forfeiture ( i.e., when those rights become “substantially vested”), over the amount (if any) paid for the property. Section 1.83–3(e) of the regulations provides that, in the case of a transfer of a life insurance contract, retirement income contract, endowment contract, or other contract providing life insurance protection, only the cash surrender value of the contract is considered to be property. Amendments to the regulations under § 83 were proposed on February 13, 2004 (69 FR 7384) that would provide that, in the case of a transfer of an insurance contract, retirement income contract, endowment contract, or other contract providing life insurance protection, the policy cash value and all

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made with respect to those premiums during that period (whether under the contract or otherwise) that reflect investment return and the current market value of segregated asset accounts, minus (3) reasonable mortality and other reasonable charges actually charged by the date of determination ( e.g., date of the transfer or distribution) that are expected to be paid.

.03 Need For Further Guidance. After the issuance of Rev. Proc. 2004–16, the Service received comments concerning the safe harbors set forth in that revenue procedure. Commentators asserted that the formulas did not function well for certain types of traditional policies. In addition, commentators were concerned about the possible double-counting of dividends under the formulas, and the fact that the formulas did not make an explicit adjustment for surrender charges, withdrawals, or distributions. The Service has determined that adjustments to the safe harbors are appropriate.