Life and Death Planning for Retirement Benefits

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Table of Contents 463
the “three year rule” of while avoiding a “transfer for value” or “prohibited
transaction.”
11.4.07 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 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. If the tax-exempt entity has UBTI, it must pay income tax on that
income.
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. “Debt-financed property” is property
acquired with borrowed funds and held to produce income.
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).
11.4.08 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 The plan death benefit for this purpose includes proceeds of any life insurance
policy held in the plan. Reg. A-12(b).
11.5 Planning Ideas with Life Insurance and Retirement Benefits
This discusses various planning ideas that have been advanced for use of life
insurance in connection with retirement benefits.