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Potential Abusive Tax Avoidance Transactions


     By Lance Wallach, CLU, CHFC Abusive Tax Shelter, Listed Transaction, Reportable Transaction Expert Witness

PhoneCall Lance Wallach at (516) 938-5007


412(i) plans and employers under audit for "potential abusive tax avoidance transactions" have asserted claims against insurance companies and their agents to recover money paid for insurance policies and for IRS assessed interest and penalties. Most are or will be audited by IRS for not properly filing under IRS code 6707a and will also lose the lawsuits for failing to mitigate the damages etc.
Section 412(i) tax-qualified retirement plans (the "Plans") and employers who have funded those Plans, who may now or in the future be under IRS audit for "potential abusive tax avoidance transactions", have asserted claims under California law against insurance companies and their agents to recover (i) money paid for specially designed life insurance policies, commonly known as "springing cash value policies", used to fund the Plans ("Insurance Policies"); and (ii) IRS assessed penalties and interest. Generally, the claims assert that the insurance companies and their agents did not disclose to the Plans and funding employers that the IRS, since at least 1992, had taken the position that 412(i) plans which purchased these Insurance Policies could be engaged in a "potential abusive tax avoidance transaction" and that on account of that designation, the employer who took a deduction for the cost of the Insurance Policy premium and the Plan could face material tax risks associated with reporting those tax deductions. Plaintiffs allege that those risks include, without limitation, complete disallowance of such deductions, constructive dividend treatment of excess premiums to the insured-Plan participants, interest and substantial penalties.

Section 412(i) plans are pension plans funded exclusively by the purchase of life insurance and annuity contracts and are not subject to the funding rules that apply to other defined benefit plans if they meet all of the requirements of Section 412(i). Generally, the Insurance Policies are made available only to highly compensated employees.

The IRS has announced that it is "well along in the process of auditing potential abusive tax avoidance transactions involving defined benefit pension plans claiming to be 412(i) plans." Further, according to the IRS, “[s]ome taxpayers have attempted to use the special 412(i) funding rules to take excessive deductions and to avoid taxes they properly owe. Other purported 412(i) plans merely fail to follow the specific rules that apply to 412(i) plans, though the deductions taken generally are not greater than the deductions that would have been allowable had the plan not claimed to be a 412(i) plan. In all cases the defects must be corrected.”

The IRS commenced its campaign against springing cash value polices as early as 1989. Notice 89-25 pointed out that where springing cash value policies are used, the consequences could extend to treating the purchase of such a policy by a plan as a prohibited transaction, which, among other things, could cause a plan to lose its qualified status. Notice 89-25 was followed up by revisions to the IRS audit manual for employee plans, directing auditors to examine distributions of life insurance policies that might be springing cash value policies. These audit guidelines, IRS Announcement 92-182, made clear that if the surrender value at the time a policy is distributed by a plan is “much lower” than the premiums paid by the plan, the policy may be treated as a springing cash value policy, subject to valuation adjustment which could result in the disqualification of the plan. Finally, in February 2004, the Treasury Department and the IRS issued four items of guidance to shut down abuses involving the use of certain specially designed life insurance policies known as "springing cash value" insurance polices used in 412(i) Plans. In particular, the guidance designates certain arrangements, which would appear to include the 412(i) Plan, as an "abusive transaction" for tax-shelter reporting purposes.

It has been alleged by plaintiffs in complaints filed in California and in other states that the 412(i) Plan or funding employer would not have caused a Plan to purchase the Insurance Policies if they had been informed that (i) the IRS had identified 412(i) Plans funded with the Insurance Policies as a "potential abusive tax avoidance transaction" and (ii) the consequences flowing from that IRS classification. See, e.g., Sri Kantha, M.D. v. Pacific Life Insurance Company, 2006 U.S. Dist. LEXIS 63285 (D.N.J. 2006), Charles D. Kennard, M.D. v. Indianapolis Life Insurance Company, 420 F. Supp. 2d 601 (N.D. Tex. 2006) and Atiya Enterprises et al. v. Hartford Life, et al, (S.D. Cal. Case No. 3:06-cv-01681); Omni Home Financing et al. v. Hartford Financial, et al, (S.D. Cal. Case no. 3:06-cv-00921). Among other claims, plaintiffs seek rescission of the insurance contract where it is alleged that material information has been concealed by the insurer and return of the amount of the premium paid for a policy when "the contract is voidable, on account of the [alleged] fraud or misrepresentation of the insurer" or "the contract is voidable on account of facts, of the existence of which the insured was ignorant without his fault."

In support of their claims, plaintiffs allege that they would not have purchased the Insurance Policies if they had been told about the substantial economic risks involved, including the possible complete disallowance of claimed tax deductions, constructive dividend treatment of excess premiums to the insured-Plan participants, interest and substantial penalties. The plaintiffs in these complaints further allege that the insurance companies never disclosed to their insured, to the Plans purchasing the Insurance Policies or to the employers which funded those purchases, the above-referenced material information about the IRS's campaign against the use of the Insurance Policies in connection with 412(i) Plans.
As an expert witness my side has never lost a case. The participants in these abusive plans were forced by insurance companies, agents and promoters to sign fraudulent disclaimers that they would get their own tax advice. In 2002 I spoke at the annual national convention of the American Society of Pension Actuary's on abusive's. Jim Holland, IRS chief actuary also spoke about IRS looking at abusive plans. The sellers of these plans, and the insurance that went inside knew of the potential IRS problems with these plans. They had a duty to inform buyers but they did not. Instead they had the buyer’s sign disclaimers that they would get their own tax advise. Most attorneys are losing lawsuits based on the disclaimers. They do not know how to explain that the disclaimers were fraudulent and many cases are dismissed.

Participants in abusive 412i and other plans must file under IRS code 6707a and tell IRS that they were or are in an abusive tax shelter, yet most don't. When they try to do the forms after the fact the forms are done wrong. I only know of two people who know how to do the forms correctly. Wrong forms, or no forms allow the IRS statue of limit ions to run. Wrong or unfilled forms also subject participants in abusive 412i and other plans like abusive 419, captive insurance or section 79 plans to large IRS fines.





The information provided herein is not intended as legal, accounting, financial or any type of advice for any specific individual or other entity. You should contact an appropriate professional for any such advice.

ABOUT THE AUTHOR: Lance Wallach
Lance Wallach, CLU, ChFC, CIMC, speaks and writes extensively about financial planning, retirement plans, and tax reduction strategies. He is an American Institute of CPA’s course developer and instructor and has authored numerous best selling books about abusive tax shelters, IRS crackdowns and attacks and other tax matters. He speaks at more than 20 national conventions annually and writes for more than 50 national publications.

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While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer. For specific technical or legal advice on the information provided and related topics, please contact the author.

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