SECTION 3. GUIDANCE FOR

DETERMINING FAIR MARKET VALUE

.01 Safe Harbor Formulas for Fair Market Value. This revenue procedure provides two safe harbor formulas that, if used to determine the value of an insurance contract, retirement income contract, endowment contract, or other contract providing life insurance protection that is distributed or otherwise transferred from a qualified plan, will meet the definition of fair market value for purposes of § 402(a). These safe harbor formulas will also meet the definition of fair market value for purposes of §§ 79, 83, and 402(b) and, in addition, will meet the definition of vested accrued benefit for purposes of § 402(b)(4)(A).

.02 Safe Harbor for Non-Variable Contracts. Except as provided in section 3.03 of this revenue procedure (which applies only to variable contracts), the fair market value of an insurance contract, retirement income contract, endowment contract, or other contract providing life insurance protection may be measured as the greater of: A) the sum of the interpolated terminal reserve and any unearned premiums plus a pro rata portion of a reasonable estimate of dividends expected to be paid for that policy year based on company experience, and B) the product of

market value of all the assets in the trust is the total amount of the fair market values (determined without regard to any lapse restriction, as defined in § 1.83–3(h)) of all the assets in the trust, less the amount of all the liabilities to which such assets are subject or which the trust has assumed (other than the rights of any employee in such assets), as of the date on which some or all of the employee’s interest in the trust becomes substantially vested.

Section 402(b)(2) and § 1.402(b)–1(c) provide that any amount actually distributed or made available to any distributee by an employee’s trust in a taxable year in which it is not exempt under § 501(a) is taxable under § 72 (relating to annuities) to the distributee in the taxable year in which it is so distributed or made available. If, for example, the distribution consists of an annuity contract, the amount of the distribution is considered to be the entire value of the contract at the time of the distribution. Such value is includible in the gross income of the distributee to the extent that such value exceeds the investment in the contract, determined by applying § 72. The distributions are included in income under the rules of § 72 whether or not the employee’s rights in the contributions become substantially vested beforehand.

Section 402(b)(4)(A) provides that, if one of the reasons a trust is not exempt from tax under § 501(a) is the failure of the plan of which it is a part to meet the requirements of § 401(a)(26) or 410(b), then a highly compensated employee shall, in lieu of the amount determined under § 402(b)(1) or under § 402(b)(2), include in gross income for the taxable year with or within which the taxable year of the trust ends an amount equal to the vested accrued benefit of such employee (other than the employee’s investment in the contract) as of the close of such taxable year of the trust.

.02 Prior Guidance Regarding Fair Market Value.

(1) Rev. Rul. 59–195 - Interpolated Terminal Reserve. Rev. Rul. 59–195, 1959–1 C.B. 18, addressed the determination of the fair market value of a policy in a situation in which an employer sold to an employee a life insurance contract on which premiums were still due. The revenue ruling held that, for purposes of computing the employee’s taxable gain in the year of the purchase, the value of the con

tract should be determined using the approach of § 25.2512–6 of the Gift Tax Regulations. Under that regulation, the value of a life insurance contract that has been in force for some time and on which further premium payments are to be made is not its cash surrender value, but, rather, the interpolated terminal reserve as of the date of sale plus the proportionate part of any employer-paid unearned premiums. Section 25.2512–6 also provides that if “because of the unusual nature of the contract such approximation is not reasonably close to the full value, this method may not be used.” Thus, this method is appropriate only where the reserve reflects the value of all of the relevant features of the policy.

(2) Notice 89–25 - Tax Reserves. Q&A–10 of Notice 89–25, 1989–1 C.B. 662, described a distribution from a qualified plan of a life insurance policy with a value substantially higher than the cash surrender value stated in the policy. The notice concluded that the practice of using cash surrender value as fair market value is not appropriate where the total policy reserves, including life insurance reserves (if any) computed under § 807(d), together with any reserves for advance premiums, dividend accumulations, etc., represent a much more accurate approximation of the policy’s fair market value.

(3) Rev. Proc. 2004–16 — Safe Harbor for Determining Fair Market Value. Rev. Proc. 2004–16, 2004–10 I.R.B. 559, provided a safe harbor for determining fair market value of variable and non-variable contracts for purposes of applying the rules under the proposed regulations issued under §§ 79, 83, and 402(a). The safe harbor for non-variable contracts set forth in Rev. Proc. 2004–16 permitted the use of the contract’s cash value without reduction for surrender charges as the fair market value so long as this cash value is at least equal to the sum of: (1) the premiums paid, plus (2) interest, dividends or other credits, 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. In those cases where the contract is a variable contract (as defined in § 817(d)), cash value without reduction for surrender charges may be treated as the fair market value of the contract provided such cash value is at least equal to the sum of: (1) the premiums paid, plus (2) all adjustments

2005–17 I.R.B. 963 April 25, 2005

of the formulas, even if the income can only be realized through an exchange right that gives rise to a springing cash value under another policy. Similarly, if a mortality charge or other amount charged under a contract can be expected to be directly or indirectly returned to the contractholder (whether through the contract, a supplemental agreement, or under a verbal understanding and regardless of whether there is a guarantee), the charge is not permitted to be subtracted under item (4) in the formulas. In addition, a surrender charge cannot be taken into account in determining an average surrender factor if it may be waived or otherwise avoided or was created for purposes of the transfer or distribution. Furthermore, at no time are these rules to be interpreted in a manner that allows the use of these formulas to understate the fair market value of the life insurance contracts and associated distributions or transfers. For example, if the insurance contract has not been in force for some time, the value of the contract is best established through the sale of the particular insurance contract by the insurance company ( i.e., as the premiums paid for that contract).

.06 Date as of Which Fair Market Value is Determined. In the case of a distribution or sale of a contract from a qualified plan, the date as of which the fair market value is to be determined is the date of that distribution or sale. The date of determination in the case of the provision of permanent benefits subject to § 79 is the date those benefits are provided. The date of determination in the case of a transfer of an insurance contract subject to § 83 is the date on which fair market value must be determined under the rules of § 83. The date of determination in the case of a non-exempt employees’ trust under § 402(b) is the date on which fair market value must be determined under the rules of § 402(b).