Lance Wallach
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Abusive Insurance and Retirement Plans
Single–employer section 419 welfare benefit plans are the
latest incarnation in insurance deductions the IRS deems
abusive
BY LANCE WALLACH
SEPTEMBER 2008
EXECUTIVE SUMMARY
Some of the listed transactions CPA tax practitioners
are most likely to encounter are employee benefit
insurance plans that the IRS has deemed abusive. Many of
these plans have been sold by promoters in conjunction
with life insurance companies.
As long ago as 1984, with the addition of IRC §§ 419 and
419A, Congress and the IRS took aim at unduly accelerated
deductions and other perceived abuses. More recently,
with guidance and a ruling issued in fall 2007, the
Service declared as abusive certain trust arrangements
involving cash-value life insurance and providing post-
retirement medical and life insurance benefits.
The new "more likely than not" penalty standard for tax
preparers under IRC § 6694 raises the stakes for CPAs
whose clients may have maintained or participated in such
a plan. Failure to disclose a listed transaction carries
particularly severe potential penalties.
Lance Wallach, CLU, ChFC, CIMC, is the author of the
AICPA’s The Team Approach to Tax, Financial and Estate
Planning. He can be reached at lawallach@aol.com or on
the Web at, www.vebaplan.com or 516-938-5007. The
information in this article is not intended as
accounting, legal, financial or any other type of advice
for any specific individual or other entity. You should
consult an appropriate professional for such advice.
Many of the listed transactions that can get your clients
into trouble with the IRS are exotic shelters that
relatively few practitioners ever encounter. When was the
last time you saw someone file a return as a Guamanian
trust (Notice 2000-61)? On the other hand, a few listed
transactions concern relatively common employee benefit
plans the IRS has deemed tax-avoidance schemes or
otherwise abusive. Perhaps some of the most likely to
crop up, especially in small business returns, are
arrangements purporting to allow deductibility of
premiums paid for life insurance under a welfare benefit
plan.
Some of these abusive employee benefit plans are
represented as satisfying section 419 of the Code, which
sets limits on purposes and balances of “qualified asset
accounts” for such benefits, but purport to offer
deductibility of contributions without any corresponding
income. Others 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) (still
so-called, even though the subsection has since been
redesignated section 412(e)(3)). See section below, “
Defined-Benefit 412(i) Plans Under Fire.”
Parts of this article are from the AICPA CPE self-study
course Avoiding Circular 230 Malpractice Traps and Common
Abusive Small Business Hot Spots, by Sid Kess, authored
by Lance Wallach.
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 who 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 law
to the contrary were either glossed over or explained
away.
The IRS steadily added these abusive plans to its
designations of listed transactions. With Revenue Ruling
90-105, it warned against deducting certain plan
contributions attributable to compensation earned by plan
participants after the en 419A claimed by 10-or-more-
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.” The IRS at the same time
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 in part
for premiums paid by the trust on cashvalue life
insurance policies. It 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 employee/owners or key employees
may be disqualified benefits for purposes of the 100%
excise tax under section 4976.
Whenever the property distributed from a trust has not
been properly valued by the taxpayer, the IRS said in
Notice 2007-84 that it intends to challenge the value of
the distributed property, 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 employee/owner may be
characterized as dividends or as nonqualified deferred
compensation subject to section 404(a)(5), section 409A
or both, depending on the facts and circumstances.
THE HIGHER RISKS FOR PRACTITIONERS UNDER NEW PENALTIES
The updated Circular 230 regulations and the new law (IRC
§ 6694, preparer penalties) make it more important for
CPAs to understand what their clients are deducting on
tax returns. A CPA may not prepare a tax return unless he
or she has a reasonable belief that the tax treatment of
every position on the return would more likely than not
be sustained on its merits. Proposed regulations issued
in June 2008 spell out many new implications of these
changes introduced by the Small Business and Work
Opportunity Act of 2007.
The CPA should study all the facts and, based on that
study, conclude that there is more than a 50% likelihood
(“more likely than not”) that, if the IRS challenges the
tax treatment, it will be upheld. As an alternative,
there must be a reasonable basis for each position on the
tax return, and each position needs to be adequately
disclosed to the IRS. The reasonable-basis standard is
not satisfied by an arguable claim. A CPA may not take
into account the possibility that a return will not be
audited by the IRS, or that an issue will not be raised
if there is an audit.
It is worth noting that listed transactions are subject
to a regulatory scheme applicable only to them, entirely
separate from Circular 230 requirements, regulations and
sanctions. Participation in such a transaction must be
disclosed on a tax return, and the penalties for failure
to disclose are severe—up to $100,000 for individuals and
$200,000 for corporations. The penalties apply to both
taxpayers and practitioners. And the problem with
disclosure, of course, is that it is apt to trigger an
audit, in which case even if the listed transaction were
to pass muster, something else may not.
NEED FOR CAUTION
Should a client approach you with one of these plans, be
especially cautious, for both of you. Advise your client
to check out the promoter very carefully. Make it clear
that the government has the names of all former 419A(f)
(6) promoters and, therefore, will be scrutinizing the
promoter carefully if the promoter was once active in
that area, as many current 419(e) (welfare benefit fund
or plan) promoters were. This makes an audit of your
client far riskier and more likely.
DEFINED-BENEFIT 412(i) PLANS UNDER FIRE
The IRS has warned against so-called section 412(i)
defined-benefit pension plans, named for the former IRC
section governing them. It warned against certain trust
arrangements it deems abusive, some of which may be
regarded as listed transactions. Falling into that
category can result in taxpayers having to disclose such
participation under pain of penalties, potentially
reaching $100,000 for individuals and $200,000 for other
taxpayers. Targets also include some retirement plans.
One reason for the harsh treatment of 412(i) plans is
their discrimination in favor of owners and key, highly
compensated employees. Also, the IRS does not consider
the promised tax relief proportionate to the economic
realities of these transactions. In general, IRS auditors
divide audited plans into those they consider
noncompliant and others they consider abusive. While the
alternatives available to the sponsor of a noncompliant
plan are problematic, it is frequently an option to keep
the plan alive in some form while simultaneously hoping
to minimize the financial fallout from penalties.
The sponsor of an abusive plan can expect to be treated
more harshly. Although in some situations something can
be salvaged, the possibility is definitely on the table
of having to treat the plan as if it never existed, which
of course triggers the full extent of back taxes,
penalties and interest on all contributions that were
made, not to mention leaving behind no retirement plan
whatsoever.
Lance Wallach, the National Society of Accountants
Speaker of the Year, speaks and writes extensively about
retirement plans, Circular 230 problems and tax reduction
strategies. He speaks at more than 40 conventions
annually, writes for over 50 publications and has written
numerous best-selling AICPA books, including Avoiding
Circular 230 Malpractice Traps and Common Abusive
Business Hot Spots. Contact him at 516.938.5007 or visit
www.vebaplan.com.
The information provided herein is not intended as legal,
accounting, financial or any other type of advice for any
specific individual or other entity. You should contact
an appropriate professional for any such advice.
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