Keep a
watchful eye
Tax avoidance can lurk in employee benefit plans
By Lance
Wallach, CLU, ChFC
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. 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 advisors" 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 October 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 nonqualified 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 advisors and subject to a $200,000 IRS fine.
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. He can be reached at lawallach@aol.com,
(516) 938-5007.
Disclaimer:
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.
Reprinted
with permission from the Virginia Society of CPAs.
Call Lance Wallach at (516) 938-5007