Tax Avoidance can Lurk in Employee Benefit Plans
As the Internal Revenue Service (IRS) continues to crack down on abusive retirement and employee benefit plans, many accountants will almost certainly, though inadvertently, land their clients and themselves in trouble. Two particular types of arrangements top the IRS list of abusive plans: the so-called 419 insurance welfare benefit plan and the 412(i) defined benefit retirement plan.
Virginia Society of CPAs - By Lance Wallach
These popular plans, while ostensibly for the benefit of employees, are popular with employers mainly because they can offer large tax deductions. The IRS believes those deductions are often disproportionate to the economic realities of these transactions. Both plans are usually sold by insurance agents who are motivated principally by the large commissions that flow from the sale of the insurance policies within these plans.
Some of these plans have been designated as listed transactions by the IRS. Of particular interest is a spurt of IRS regulation in late 2007 that severely affected welfare benefit plans. Any participant in a listed transaction must file Form 8886 with the IRS to disclose participation in such a transaction. Failure to file can result in penalties of up to $100,000 for individuals and $200,000 for corporations. "Material advisers" to participants in such transactions, whom many CPAs are, must file Form 8918 to disclose their role. Failure to file leads to the same penalties that apply to taxpayer participants.
Other plans attempt to take advantage of exceptions to qualified asset account limits, such as sham union plans that try to exploit the exception for separate welfare benefit funds under collective-bargaining agreements provided by IRC § 419A(f)(5). Others try to take advantage of exceptions for plans serving 10 or more employers, once popular under section 419A(f)(6). More recently, one may encounter plans relying on section 419(e) and, perhaps, defined benefit pension plans established pursuant to the former section 412(i).
Promoters and Their Best Laid Plans
Sections 419 and 419A were added to the Code by the Deficit Reduction Act of 1984 in an attempt to end employers’ acceleration of deductions for plan contributions. But it wasn’t long before plan promoters found an end run around the new Code sections. An industry developed in what came to be known as “10 or more employer plans.” The promoters of these plans, in conjunction with life insurance companies that just wanted premiums on the books, would sell people on the idea of tax-deductible life insurance and other benefits, and especially large tax deductions.
It was almost, “How much can I deduct?” with the reply, “How much do you want to?” Adverse court decisions (there were a few) and other laws to the contrary were either glossed over or explained away.
The IRS steadily added these abusive plans to its designations of listed transactions. Revenue Ruling 90-105 warned against deducting certain plan contributions attributable to compensation earned by plan participants after the end of the taxable year. Purported exceptions to limits of sections 419 and 419A claimed by 10 or more multiple-employer benefit funds were likewise proscribed in Notice 95-34. Both positions were designated listed transactions in 2000.
At that point, where did all those promoters go? Evidence indicates many are now promoting plans purporting to comply with section 419(e). They are calling a life insurance plan a welfare benefit plan (or fund), somewhat as they once did, and promoting the plan as a vehicle to obtain large tax deductions. The only substantial difference is that these are now single-employer plans. And again, the IRS has tried to rein them in, reminding that listed transactions include those substantially similar to any that are specifically described and so designated.
On Oct. 17, 2007, the IRS issued notices 2007-83 and 2007-84. In the former, the IRS identified certain trust arrangements involving cash-value life insurance policies, and substantially similar arrangements, as listed transactions. The latter similarly warned against certain post-retirement medical and life insurance benefit arrangements, saying they might be subject to "alternative tax treatment."
At the same time, the IRS issued related Revenue Ruling 2007-65 to address situations where an arrangement is considered a welfare benefit fund but the employer’s deduction for its contributions to the fund is denied in whole or part for premiums paid by the trust on cash-value life insurance policies. The Ruling states that a welfare benefit fund’s qualified direct cost under section 419 does not include premium amounts paid by the fund for cash-value life insurance policies if the fund is directly or indirectly a beneficiary under the policy, as determined under section 264(a).
Notice 2007-83 is aimed at promoted arrangements under which the fund trustee purchases cash-value insurance policies on the lives of a business’s employee/owners, and sometimes key employees, while purchasing term insurance policies on the lives of other employees covered under the plan. These plans anticipate being terminated and that the cash-value policies will be distributed to the owners or key employees, with very little distributed to other employees. The promoters claim that the insurance premiums are currently deductible by the business, and that the distributed insurance policies are virtually tax-free to the owners.
The Ruling makes it clear that going forward a business, under most circumstances, cannot deduct the cost of premiums paid through a welfare benefit plan for cash-value life insurance on the lives of its employees. The IRS may challenge the claimed tax benefits of these arrangements for various reasons:
• Some or all of the benefits or distributions provided to or for the benefit of owner-employees or key employees may be disqualified benefits for purposes of the 100 percent excise tax under section 4976.
• The IRS stated in Notice 2007-84 that whenever the property distributed from a trust has not been properly valued by the taxpayer, the IRS will challenge its value, including life insurance policies.
• Under the tax benefit rule, some or all of an employer’s deductions in an earlier year may have to be included in income in a later year if an event occurs that is fundamentally inconsistent with the premise on which the deduction was based.
• An employer’s deductions for contributions to an arrangement that is properly characterized as a welfare benefit fund are subject to the limitations and requirements of the rules in sections 419 and 419A, including reasonable actuarial assumptions and nondiscrimination. Further, a taxpayer cannot obtain a deduction for reserves for post-retirement medical or life benefits unless the employer intends to use the contributions for that purpose.
• The arrangement may be subject to the rules for split-dollar arrangements, depending on the facts and circumstances.
• Contributions on behalf of an owner-employee may be characterized as dividends or as non qualified deferred compensation subject to Section 404(a)(5), Section 409A or both, depending on the facts and circumstances.
My firm has received many calls for help from CPAs whose clients are being audited for deducting 419 or 412(i) plans. The CPAs were not aware that anything was wrong, and they are being accused of being material advisers and subject to a $200,000 IRS fine.
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. Lance Wallach adapted parts of this article from the American Institute of CPAs (AICPA) CPE self-study course he wrote, “Avoiding Circular 230 Malpractice Traps and Common Abusive Small Business Hot Spots,” by Sid Kess, as well as his September 2008 Journal of Accountancy article.
By Lance Wallach, CLU, CHFCABOUT THE AUTHOR: Lance Wallach
Abusive Tax Shelter, Listed Transaction, Reportable Transaction Expert Witness
Abusive Tax Shelter, Listed Transaction, Reportable Transaction Expert Witness
Lance Wallach, CLU, ChFC, is the author of the American Institute of CPAs (AICPA) “The Team Approach to Tax, Financial and Estate Planning” and other AICPA books. He speaks at numerous AICPA conferences and other national conventions and writes for financial publications.
Copyright Lance Wallach, CLU, CHFC
Disclaimer: 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.