Rev. Rul. 55-193

Advice has been requested whether (1) a business deduction is allowed for life insurance premiums paid by an employer under a nontrusteed combination group insurance and group annuity contract, (2) such premiums are taxable to the employee, (3) insurance benefits paid under the insurance provisions of the group contract by reason of the death of an employee prior to retirement are taxable to the beneficiary, and (4) death benefits under the retirement annuity portion of the contract paid by reason of the death of an employee prior to retirement are taxable to the beneficiary.

An employer established a nontrusteed pension and insurance plan for the benefit of his employees under which annuity benefits are provided retired employees and insurance benefits are provided active employees. All benefits are funded under a single contract issued by a life insurance company. The employees do not contribute to the contract.

The retirement benefit features of the contract are similar to those generally found in group annuities. In addition, as in some group annuity contracts, a death benefit is paid from the accumulation of premiums paid for the retirement annuity benefit, upon the death of an employee prior to retirement, such death benefit being equal to the premiums paid by the employer for the annuity benefit, but not exceeding 56 times the monthly retirement annuity which would have commenced at normal retirement age if the employee had not died. This portion of the plan has been held to meet the requirements of section 165(a)(3), (4), (5), and (6) of the Internal Revenue Code of 1939.

The insurance portion of the contract provides benefits payable upon death of an eligible employee prior to retirement which consist of (a) one year term group insurance for employees not yet eligible for retirement annuity coverage; and, for employees covered by the annuity portion of the contract: (b) a lump-sum insurance benefit which, when added to the death benefit payable under the annuity portion of the contract, will be equal to 56 times the amount of the monthly retirement benefit expected at normal retirement age, and (c) a monthly income death benefit of one-half the monthly retirement benefit expected at normal retirement age, but not exceeding $100 per month. The benefit provided in (c) is available only for married male employees and runs from the date of death of such employee to what would have been his normal retirement date had he lived. The employee has the right to designate the beneficiary of any death benefits.

Under the contract for those employees eligible for retirement annuity coverage, separate level annual premiums are specified for each benefit, i.e. , the retirement annuity benefit and the insurance benefits indicated in (b) and (c) above. In this respect this contract differs from the group permanent forms of insurance and annuity contracts where the specified premium covers both annuity and insurance benefits. Moreover, the reserve maintained by the insurer for the annuity portion of the contract is the full actuarial reserve for such benefits, without adjustment on account of any deficiency in the reserve for the insurance benefits outlined in (b) and (c) above. (In connection with the insurance benefits in (b) and (c) above, `negative' reserves arise because a level premium is charged for a benefit which decreases in such a way that the annual cost of insurance protection decreases. The level premiums are insufficient to pay the insurance costs in earlier years, which results in a deficiency which is not made up until the end of the premium-paying period.) For state insurance department valuation purposes, a separate minimum reserve is maintained for the insurance benefits, part of such reserve being borrowed from the insurer's general surplus. It thus appears it would be possible to issue separate contracts for the insurance and annuity benefits without necessarily requiring any change in the premiums charged, in the reserve maintained, or in the benefits provided. In this respect also, the contract differs from the group permanent forms in which a single combined reserve is maintained for the insurance and annuity features with respect to active lives.

As noted above, after an employee becomes eligible for retirement annuity coverage, level annual premiums are charged for the insurance benefits in (b) and (c) above. Although in this respect the insurance benefits are more like group permanent insurance than the typical group (one-year term) insurance, the use of the level premium method in connection with the decreasing amounts of insurance produces negative reserves, so that there is no advance funding for these insurance benefits. Therefore, the only benefit which can be derived from the premiums paid for these insurance benefits consists of current insurance protection; thus, it is this feature that distinguishes typical group term insurance from group permanent insurance in which reserves are built up which may be used for continued insurance protection or some other benefit. In the present contract, benefits payable upon termination of employment prior to death or retirement, or upon termination of the plan, are derived solely from the reserve accumulated under the retirement annuity portion of the contract, and no portion of the reserve can be applied to continued insurance protection.

Upon termination of employment prior to retirement, a participant has the right to convert his term insurance coverage to individual permanent insurance, without evidence of insurability, the premium for this permanent insurance being that applicable to the class of risk to which the participant belongs and to the form and amount of the policy at his then current age. However, in accordance with Revenue Ruling 54-165, C.B. 1954-1, 17, the mere fact that an insurance contract permits conversion of term insurance to permanent types of insurance for which the employee pays the entire cost would not make the employer's premium payments for the term insurance includible in the employee's gross income if, in the absence of such a provision for conversion, such premiums would not be so includible.

On the basis of the foregoing considerations, it is held that the contract shall be considered as the equivalent of a combination of group term life insurance and group annuity contracts and not as a group permanent form. Accordingly, the tax consequences set forth in Mimeograph 6477, C.B. 1950-1, 16, with respect to group permanent life insurance, are not here applicable.

A deduction from gross income is provided in section 23(a)(1)(A) of the Code for all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including a reasonable allowance for salaries or other compensation for personal services actually rendered.

The last sentence of section 39.22(a)-3 of Regulations 118 prescribes that premiums paid by an employer on policies of group life insurance covering the lives of his employees, the beneficiaries of which are designated by the employees, are not income to the employees.

Section 22(b)(1)(A) of the Code provides that there shall be excluded from gross income and exempt from income tax, amounts received under a life insurance contract paid by reason of the death of the insured.

A $5,000 exclusion from gross income is provided in section 22(b)(1)(B) of the Code for amounts paid by or on behalf of an employer by reason of the death of an employee. Paragraph (d)(1) of section 39.22(b)(1)-2 of Regulations 118 states in effect that such esclusion is limited to amounts which are specifically designated as a death payment with respect to which the deceased employee did not have a nonforfeitable right while living. See also Rev. Rul. 55-74, page 230, this Bulletin.

Under paragraph (c), section 39.22(b)(2)-5 of Regulations 118, if upon the death of a retired employee, the beneficiary of such employee is paid, in accordance with the terms of the annuity contract relating to the deceased employee, an annuity or other death benefit, the amounts received shall be included in the beneficiary's income to the extent they would have been included in the income of the deceased employee had he lived and received such payment, except to the extent the exclusion provided by section 22(b)(1)(B) is applicable. Similar tax treatment would apply to the death benefit under an annuity where the employee dies before retirement.

Accordingly, it is held that where an employer establishes a nontrusteed pension and insurance plan for the benefit of his employees, funded by means of a contract which is the equivalent of a combination group term life insurance and group annuity contract, the premiums paid for the insurance benefits under the contract by the employer are deductible by the employer under section 23(a)(1)(A) of the Code as ordinary and necessary business expenses in the year paid and, as prescribed in the last sentence of section 39.22(a)-3 of Regulations 118, are not taxable to the employees. Insurance benefits under the contract paid beneficiaries by reason of the death of an employee are not taxable to the beneficiary in accordance with section 22(b)(1)(A) of the Code. Benefits derived from the annuity portion of the contract paid by reason of the death of an employee prior to retirement, are taxable to the beneficiary in accordance with section 39.22(b)(2)-5 or Regulations 118 to the same extent they would have been taxable to the employee had he lived and received such benefits, except that any portion of such amounts paid as a death benefit in excess of that in which the employee had a nonforfeitable interest at the time of death will be excluded from gross income of the beneficiary in an amount not in excess of $5,000 as provided under section 22(b)(1)(B) of the Code