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


    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.

    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.


    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 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.


    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.  


    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, 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.

    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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Abusive Insurance and Retirement Plans