| Lawyer 4 Audits .com |
| "Tipping the scales of justice in your favor." |
| The Law Firm defending & protecting businesses & financial professionals from IRS audits, Insurance co's & Brokerage firms. |
| Email : LAWallach@aol.com |
| Telephone: 516-938-5007 |
| Copyright (C) 2009 Lawyer4Audits.com All rights reserved. |
| Lawyer 4 Audits .com The Law Offices of Ira Kaplan |
Journal of Accountancy
September 2008
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
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.
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 sidebar “Defined-Benefit 412(i) Plans Under Fire”).
Promoters and Their Best-Laid Plans
Sections 419 and 419A were added to the Code in 1984 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 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.” 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 part for premiums paid
by the trust on cash-value 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 owner-employees 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 owner-employee 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.
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.
SIDEBAR
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.
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 at (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.
AICPA RESOURCES
CPE
■ Avoiding Circular 230 Malpractice Traps and Common Abusive Small Business Hot Spots, by Sid Kess, a CPE
self-study course (#733720)
■ Sid Kess’ Practical Alternatives to Commonly Misused and Abused Small Business Tax Strategies: Insuring
Your Client’s Future, a CPE self-study course (#733730)
For more information or to place an order, go to www.cpa2biz.com or call the Institute at 888-777-7077.
AICPA PFP Center and PFS Credential
The AICPA Personal Financial Planning (PFP) Center provides a range of valuable resources that CPAs need
for professional and ethical financial planning. The center also contains information about the AICPA Personal
Financial Specialist (PFS) credential and PFP section membership. For more information go to http://pfp.aicpa.
org.
OTHER RESOURCES
Law, rulings and guidance
■ Internal Revenue Code §§ 264, 419, 419A, 6111 and 6112
■ News Releases IR 2007-170 and IR 2004-21
■ Revenue Ruling 2007-65
■ Notices 2007-83 and 2007-84