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IRS Audits Focus on Captive Insurance Plans
April 2011 Edition
By Lance Wallach
The IRS started auditing § 419 plans in the 1990s, and then continued going after § 412
(i) and other plans that they considered abusive, listed, or reportable transactions, or
substantially similar to such transactions. If an IRS audit disallows the § 419 plan or the §
412(i) plan, not only does the taxpayer lose the deduction and pay interest and
penalties, but then the IRS comes back under IRC 6707A and imposes large fines for
not properly filing.
Insurance agents, financial planners and even accountants sold many of these plans.
The main motivations for buying into one were large tax deductions. The motivation for
the sellers of the plans was the very large life insurance premiums generated. These
plans, which were vetted by the insurance companies, put lots of insurance on the
books. Some of these plans continue to be sold, even after IRS disallowances and
lawsuits against insurance agents, plan promoters and insurance companies.
In a recent tax court case, Curcio v. Commissioner (TC Memo 2010-115), the tax court
ruled that an investment in an employee welfare benefit plan marketed under the name
“Benistar” was a listed transaction in that the transaction in question was substantially
similar to the transaction described in IRS Notice 95-34. A subsequent case, McGehee
Family Clinic, largely followed Curcio, though it was technically decided on other
grounds. The parties stipulated to be bound by Curcio on the issue of whether the
amounts paid by McGehee in connection with the Benistar 419 Plan and Trust were
deductible. Curcio did not appear to have been decided yet at the time McGehee was
argued. The McGehee opinion (Case No. 10-102, United States Tax Court, September
15, 2010) does contain an exhaustive analysis and discussion of virtually all of the
relevant issues.
Taxpayers and their representatives should be aware that the IRS has disallowed
deductions for contributions to these arrangements. The IRS is cracking down on small
business owners who participate in tax reduction insurance plans and the brokers who
sold them. Some of these plans include defined benefit retirement plans, IRAs, or even
401(k) plans with life insurance.
In order to fully grasp the severity of the situation, one must have an understanding of
IRS Notice 95-34, which was issued in response to trust arrangements sold to
companies that were designed to provide deductible benefits such as life insurance,
disability and severance pay benefits. The promoters of these arrangements claimed
that all employer contributions were tax-deductible when paid, by relying on the 10-or-
more-employer exemption from the IRC § 419 limits. It was claimed that permissible tax
deductions were unlimited in amount.
In general, contributions to a welfare benefit fund are not fully deductible when paid.
Sections 419 and 419A impose strict limits on the amount of tax-deductible prefunding
permitted for contributions to a welfare benefit fund. Section 419A(F)(6) provides an
exemption from § 419 and § 419A for certain “10-or-more employers” welfare benefit
funds. In general, for this exemption to apply, the fund must have more than one
contributing employer, of which no single employer can contribute more than 10 percent
of the total contributions, and the plan must not be experience-rated with respect to
individual employers.
According to the Notice, these arrangements typically involve an investment in variable
life or universal life insurance contracts on the lives of the covered employees. The
problem is that the employer contributions are large relative to the cost of the amount of
term insurance that would be required to provide the death benefits under the
arrangement, and the trust administrator may obtain cash to pay benefits other than
death benefits, by such means as cashing in or withdrawing the cash value of the
insurance policies. The plans are also often designed so that a particular employer’s
contributions or its employees’ benefits may be determined in a way that insulates the
employer to a significant extent from the experience of other subscribing employers. In
general, the contributions and claimed tax deductions tend to be disproportionate to the
economic realities of the arrangements.
Benistar advertised that enrollees should expect to obtain the same type of tax benefits
as listed in the transaction described in Notice 95-34. The benefits of enrollment listed in
its advertising packet included:
· Virtually unlimited deductions for the employer;
· Contributions could vary from year to year;
· Benefits could be provided to one or more key executives on a selective basis;
· No need to provide benefits to rank-and-file employees;
· Contributions to the plan were not limited by qualified plan rules and would not
interfere with pension, profit sharing or 401(k) plans;
· Funds inside the plan would accumulate tax-free;
· Beneficiaries could receive death proceeds free of both income tax and estate tax;
· The program could be arranged for tax-free distribution at a later date;
· Funds in the plan were secure from the hands of creditors.
The Court said that the Benistar Plan was factually similar to the plans described in
Notice 95-34 at all relevant times.
In rendering its decision the court heavily cited Curcio, in which the court also ruled in
favor of the IRS. As noted in Curcio, the insurance policies, overwhelmingly variable or
universal life policies, required large contributions relative to the cost of the amount of
term insurance that would be required to provide the death benefits under the
arrangement. The Benistar Plan owned the insurance contracts.
Following Curcio, as the Court has stipulated, the Court held that the contributions to
Benistar were not deductible under § 162(a) because participants could receive the
value reflected in the underlying insurance policies purchased by Benistar—despite the
payment of benefits by Benistar seeming to be contingent upon an unanticipated event
(the death of the insured while employed). As long as plan participants were willing to
abide by Benistar’s distribution policies, there was no reason ever to forfeit a policy to
the plan. In fact, in estimating life insurance rates, the taxpayers’ expert in Curcio
assumed that there would be no forfeitures, even though he admitted that an insurance
company would generally assume a reasonable rate of policy lapses.
The McGehee Family Clinic had enrolled in the Benistar Plan in May 2001 and claimed
deductions for contributions to it in 2002 and 2005. The returns did not include a Form
8886, Reportable Transaction Disclosure Statement, or similar disclosure.
The IRS disallowed the latter deduction and adjusted the 2004 return of shareholder
Robert Prosser and his wife to include the $50,000 payment to the plan. The IRS also
assessed tax deficiencies and the enhanced 30 percent penalty totaling almost $21,000
against the clinic and $21,000 against the Prossers. The court ruled that the Prossers
failed to prove a reasonable cause or good faith exception.
Other important facts:
· In recent years, some § 412(i) plans have been funded with life insurance using
face amounts in excess of the maximum death benefit a qualified plan is permitted to
pay. Ideally, the plan should limit the proceeds that can be paid as a death benefit in
the event of a participant’s death. Excess amounts would revert to the plan. Effective
February 13, 2004, the purchase of excessive life insurance in any plan is considered a
listed transaction if the face amount of the insurance exceeds the amount that can be
issued by $100,000 or more and the employer has deducted the premiums for the
insurance.
· A 412(i) plan in and of itself is not a listed transaction; however, the IRS has a task
force auditing 412(i) plans.
· An employer has not engaged in a listed transaction simply because it is a 412(i)
plan.
· Just because a 412(i) plan was audited and sanctioned for certain items, does not
necessarily mean the plan engaged in a listed transaction. Some 412(i) plans have been
audited and sanctioned for issues not related to listed transactions.
Companies should carefully evaluate proposed investments in plans such as the
Benistar Plan. The claimed deductions will not be available, and penalties will be
assessed for lack of disclosure if the investment is similar to the investments described
in Notice 95-34. In addition, under IRC 6707A, IRS fines participants a large amount of
money for not properly disclosing their participation in listed, reportable or similar
transactions; an issue that was not before the tax court in either Curcio or McGehee.
The disclosure needs to be made for every year the participant is in a plan. The forms
need to be properly filed even for years that no contributions are made. I have received
numerous calls from participants who did disclose and still got fined because the forms
were not filled in properly. A plan administrator told me that he assisted hundreds of his
participants with filing forms, and they still all received very large IRS fines for not
properly filling in the forms.
IRS has targeted all 419 welfare benefit plans, many 412(i) retirement plans, captive
insurance plans with life insurance in them and Section 79 plans.
Lance Wallach, National Society of Accountants Speaker of the Year and member of the
American Institute of CPAs faculty of teaching professionals, is a frequent speaker on
retirement plans, financial and estate planning, and abusive tax shelters. He speaks at
more than ten conventions annually and writes for over fifty publications. Lance has
written numerous books including Protecting Clients from Fraud, Incompetence and
Scams published by John Wiley and Sons, Bisk Education's CPA's Guide to Life
Insurance and Federal Estate and Gift Taxation, as well as AICPA best-selling books,
including Avoiding Circular 230 Malpractice Traps and Common Abusive Small Business
Hot Spots. He does expert witness testimony and has never lost a case. Mr. Wallach may
be reached at 516/938.5007, wallachinc@gmail.com, or at www.taxaudit419.com or www.
lancewallach.com.
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.
April 2011 Edition
By Lance Wallach
The IRS started auditing § 419 plans in the 1990s, and then continued going after § 412
(i) and other plans that they considered abusive, listed, or reportable transactions, or
substantially similar to such transactions. If an IRS audit disallows the § 419 plan or the §
412(i) plan, not only does the taxpayer lose the deduction and pay interest and
penalties, but then the IRS comes back under IRC 6707A and imposes large fines for
not properly filing.
Insurance agents, financial planners and even accountants sold many of these plans.
The main motivations for buying into one were large tax deductions. The motivation for
the sellers of the plans was the very large life insurance premiums generated. These
plans, which were vetted by the insurance companies, put lots of insurance on the
books. Some of these plans continue to be sold, even after IRS disallowances and
lawsuits against insurance agents, plan promoters and insurance companies.
In a recent tax court case, Curcio v. Commissioner (TC Memo 2010-115), the tax court
ruled that an investment in an employee welfare benefit plan marketed under the name
“Benistar” was a listed transaction in that the transaction in question was substantially
similar to the transaction described in IRS Notice 95-34. A subsequent case, McGehee
Family Clinic, largely followed Curcio, though it was technically decided on other
grounds. The parties stipulated to be bound by Curcio on the issue of whether the
amounts paid by McGehee in connection with the Benistar 419 Plan and Trust were
deductible. Curcio did not appear to have been decided yet at the time McGehee was
argued. The McGehee opinion (Case No. 10-102, United States Tax Court, September
15, 2010) does contain an exhaustive analysis and discussion of virtually all of the
relevant issues.
Taxpayers and their representatives should be aware that the IRS has disallowed
deductions for contributions to these arrangements. The IRS is cracking down on small
business owners who participate in tax reduction insurance plans and the brokers who
sold them. Some of these plans include defined benefit retirement plans, IRAs, or even
401(k) plans with life insurance.
In order to fully grasp the severity of the situation, one must have an understanding of
IRS Notice 95-34, which was issued in response to trust arrangements sold to
companies that were designed to provide deductible benefits such as life insurance,
disability and severance pay benefits. The promoters of these arrangements claimed
that all employer contributions were tax-deductible when paid, by relying on the 10-or-
more-employer exemption from the IRC § 419 limits. It was claimed that permissible tax
deductions were unlimited in amount.
In general, contributions to a welfare benefit fund are not fully deductible when paid.
Sections 419 and 419A impose strict limits on the amount of tax-deductible prefunding
permitted for contributions to a welfare benefit fund. Section 419A(F)(6) provides an
exemption from § 419 and § 419A for certain “10-or-more employers” welfare benefit
funds. In general, for this exemption to apply, the fund must have more than one
contributing employer, of which no single employer can contribute more than 10 percent
of the total contributions, and the plan must not be experience-rated with respect to
individual employers.
According to the Notice, these arrangements typically involve an investment in variable
life or universal life insurance contracts on the lives of the covered employees. The
problem is that the employer contributions are large relative to the cost of the amount of
term insurance that would be required to provide the death benefits under the
arrangement, and the trust administrator may obtain cash to pay benefits other than
death benefits, by such means as cashing in or withdrawing the cash value of the
insurance policies. The plans are also often designed so that a particular employer’s
contributions or its employees’ benefits may be determined in a way that insulates the
employer to a significant extent from the experience of other subscribing employers. In
general, the contributions and claimed tax deductions tend to be disproportionate to the
economic realities of the arrangements.
Benistar advertised that enrollees should expect to obtain the same type of tax benefits
as listed in the transaction described in Notice 95-34. The benefits of enrollment listed in
its advertising packet included:
· Virtually unlimited deductions for the employer;
· Contributions could vary from year to year;
· Benefits could be provided to one or more key executives on a selective basis;
· No need to provide benefits to rank-and-file employees;
· Contributions to the plan were not limited by qualified plan rules and would not
interfere with pension, profit sharing or 401(k) plans;
· Funds inside the plan would accumulate tax-free;
· Beneficiaries could receive death proceeds free of both income tax and estate tax;
· The program could be arranged for tax-free distribution at a later date;
· Funds in the plan were secure from the hands of creditors.
The Court said that the Benistar Plan was factually similar to the plans described in
Notice 95-34 at all relevant times.
In rendering its decision the court heavily cited Curcio, in which the court also ruled in
favor of the IRS. As noted in Curcio, the insurance policies, overwhelmingly variable or
universal life policies, required large contributions relative to the cost of the amount of
term insurance that would be required to provide the death benefits under the
arrangement. The Benistar Plan owned the insurance contracts.
Following Curcio, as the Court has stipulated, the Court held that the contributions to
Benistar were not deductible under § 162(a) because participants could receive the
value reflected in the underlying insurance policies purchased by Benistar—despite the
payment of benefits by Benistar seeming to be contingent upon an unanticipated event
(the death of the insured while employed). As long as plan participants were willing to
abide by Benistar’s distribution policies, there was no reason ever to forfeit a policy to
the plan. In fact, in estimating life insurance rates, the taxpayers’ expert in Curcio
assumed that there would be no forfeitures, even though he admitted that an insurance
company would generally assume a reasonable rate of policy lapses.
The McGehee Family Clinic had enrolled in the Benistar Plan in May 2001 and claimed
deductions for contributions to it in 2002 and 2005. The returns did not include a Form
8886, Reportable Transaction Disclosure Statement, or similar disclosure.
The IRS disallowed the latter deduction and adjusted the 2004 return of shareholder
Robert Prosser and his wife to include the $50,000 payment to the plan. The IRS also
assessed tax deficiencies and the enhanced 30 percent penalty totaling almost $21,000
against the clinic and $21,000 against the Prossers. The court ruled that the Prossers
failed to prove a reasonable cause or good faith exception.
Other important facts:
· In recent years, some § 412(i) plans have been funded with life insurance using
face amounts in excess of the maximum death benefit a qualified plan is permitted to
pay. Ideally, the plan should limit the proceeds that can be paid as a death benefit in
the event of a participant’s death. Excess amounts would revert to the plan. Effective
February 13, 2004, the purchase of excessive life insurance in any plan is considered a
listed transaction if the face amount of the insurance exceeds the amount that can be
issued by $100,000 or more and the employer has deducted the premiums for the
insurance.
· A 412(i) plan in and of itself is not a listed transaction; however, the IRS has a task
force auditing 412(i) plans.
· An employer has not engaged in a listed transaction simply because it is a 412(i)
plan.
· Just because a 412(i) plan was audited and sanctioned for certain items, does not
necessarily mean the plan engaged in a listed transaction. Some 412(i) plans have been
audited and sanctioned for issues not related to listed transactions.
Companies should carefully evaluate proposed investments in plans such as the
Benistar Plan. The claimed deductions will not be available, and penalties will be
assessed for lack of disclosure if the investment is similar to the investments described
in Notice 95-34. In addition, under IRC 6707A, IRS fines participants a large amount of
money for not properly disclosing their participation in listed, reportable or similar
transactions; an issue that was not before the tax court in either Curcio or McGehee.
The disclosure needs to be made for every year the participant is in a plan. The forms
need to be properly filed even for years that no contributions are made. I have received
numerous calls from participants who did disclose and still got fined because the forms
were not filled in properly. A plan administrator told me that he assisted hundreds of his
participants with filing forms, and they still all received very large IRS fines for not
properly filling in the forms.
IRS has targeted all 419 welfare benefit plans, many 412(i) retirement plans, captive
insurance plans with life insurance in them and Section 79 plans.
Lance Wallach, National Society of Accountants Speaker of the Year and member of the
American Institute of CPAs faculty of teaching professionals, is a frequent speaker on
retirement plans, financial and estate planning, and abusive tax shelters. He speaks at
more than ten conventions annually and writes for over fifty publications. Lance has
written numerous books including Protecting Clients from Fraud, Incompetence and
Scams published by John Wiley and Sons, Bisk Education's CPA's Guide to Life
Insurance and Federal Estate and Gift Taxation, as well as AICPA best-selling books,
including Avoiding Circular 230 Malpractice Traps and Common Abusive Small Business
Hot Spots. He does expert witness testimony and has never lost a case. Mr. Wallach may
be reached at 516/938.5007, wallachinc@gmail.com, or at www.taxaudit419.com or www.
lancewallach.com.
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.