Rev. Proc. 2008-27: Safe Harbor Valuation Rules

An IRS Revenue Procedure is a formal statement that provides instructions on how to follow tax law, offering a clear path for specific situations. Revenue Procedure 2005-25 provides this guidance as a “safe harbor,” which is a pre-approved method for calculating a value that, if followed precisely, guarantees compliance. This procedure establishes specific formulas for determining the fair market value of certain life insurance and annuity contracts. Using this safe harbor simplifies reporting and provides certainty for taxpayers dealing with these financial instruments.

Scope of the Safe Harbor

The valuation methods in Rev. Proc. 2005-25 are restricted to specific types of contracts and tax events. The guidance applies to life insurance contracts, retirement income contracts, endowment contracts, and other contracts that provide life insurance protection.

One application is for distributions from qualified retirement plans under Internal Revenue Code Section 402. This guidance applies when a retirement plan, such as a 401(k), distributes or sells a life insurance policy to a participant. The safe harbor is used to determine the policy’s fair market value, which is necessary to calculate the taxable income. If a plan sells a policy for less than this value, the shortfall is considered a taxable distribution.

Another area is the transfer of these contracts without valuable consideration, which has implications for income and gift taxes. For income tax purposes under Section 83, if a contract is transferred for the performance of services, its value must be determined. For gift tax purposes, when a policy is gifted to another person, its value must be reported on a gift tax return. The guidance also extends to situations involving employer-provided group-term life insurance under Section 79.

When the Safe Harbor Does Not Apply

The safe harbor’s application is limited, and several situations fall outside its scope. The procedure is designed for contracts with predictable reserves and values, and it excludes those that do not fit this mold.

While some Section 83 transfers are covered, the safe harbor generally does not apply if the contract is subject to specific restrictions that affect its value. For example, if a contract transferred to an employee is not substantially vested, meaning the employee’s right to it is conditional, its valuation is more complex and falls outside this guidance.

The guidance is also not intended for valuing contracts in contexts outside of those explicitly mentioned. This includes business valuations or for certain estate tax purposes not covered by the procedure.

Calculating the Fair Market Value

The methodology for the calculation differs depending on whether the contract is non-variable or variable. Each has a distinct formula to arrive at its fair market value for tax reporting purposes.

Non-Variable Contracts

For non-variable contracts, which have cash values that grow based on a fixed interest rate, the fair market value is the greater of two calculated amounts. The first amount is the sum of the interpolated terminal reserve and any unearned premiums, plus a proportional share of any dividends expected for that policy year. The interpolated terminal reserve is an insurance company calculation that estimates the policy’s reserve value between anniversary dates.

The second amount is derived from the PERC (Premiums, Earnings, and Reasonable Charges) formula. This calculation starts with the aggregate of all premiums paid into the contract from its issue date. This total is then increased by any dividends applied to the contract and decreased by the sum of reasonable mortality charges and other reasonable charges actually assessed against the policy. The resulting PERC amount is then multiplied by an Average Surrender Factor provided by the insurance carrier.

To illustrate, assume the interpolated terminal reserve plus unearned premiums is $50,000. Separately, the PERC calculation shows $60,000 in total premiums paid, less $5,000 in charges, resulting in a net of $55,000. If the Average Surrender Factor is 0.95, the second value would be $52,250. In this example, the fair market value reported would be $52,250, as it is the greater of the two calculated amounts.

Variable Contracts

The calculation for variable contracts, where the cash value is invested in sub-accounts, follows a similar “greater of” logic but with different components for the second amount. The first amount is calculated using the same interpolated terminal reserve formula as for non-variable contracts.

The second part of the calculation is based on the variable PERC amount. This starts with the aggregate premiums paid, which is then adjusted for all investment returns, both positive and negative, credited to the policyholder’s account. From this amount, reasonable mortality and other charges are subtracted. The resulting figure is then multiplied by the Average Surrender Factor to arrive at the final value for this part of the test.

For example, consider a variable contract where the interpolated terminal reserve calculation yields a value of $70,000. For the second calculation, assume total premiums paid are $65,000, and the account has experienced $15,000 in positive investment returns. After subtracting $4,000 for mortality and other fees, the net amount is $76,000. If the Average Surrender Factor is 1.0, the second value is $76,000, and the fair market value would be reported as $76,000, since it is greater than the $70,000 reserve amount.