Abusive Plans: abusive plans

By Lance Wallach, CLU, CHFC Abusive Tax Shelter, Listed Transaction, Reportable Transaction Expert Witness

Call Lance Wallach at (516) 938-5007

During the savings & loan crisis of the late 1980s and early 1990s, the courts used a particular acronym to describe cases where a physician had made an obviously bad investment in an oil & gas deal, and then sued to try to recoup their losses. Such a case was known as a "DDC", which was short for "Dumb Doctor Case".

Some doctors have a habit of getting into deals that don't make any sense. There's a saying that doctors will crawl on their bellies over broken glass for a mile to get to a bad deal, but they won't walk across the street to get to a good one.

Life insurance companies started pushing 412i plans and 419 welfare benefit plans in the 90s to business owners. When I spoke at the annual national convention of the National Society of Actuary’s about the problems with 419 and 412i plans in 2002 the IRS invited me to address their high level people that were writing regulations on point. We discussed the problems with these plans. The IRS then came up with additional regulations and set up task forces to audit these plans. The results for the business owners and Doctors were audits and very large taxes. I warned in financial publications and at conventions that I spoke at about the upcoming problems. I told people to file under IRS 6707A properly to at least reduce IRS fines on audit. In 2002 I also wrote to life insurance companies like Hartford Life etc. What was the result? The insurance companies continued to push these abusive plans and the IRS audited them. As an expert witness against these insurance companies and plans my side has never lost a case.

By Lance Wallach

Accountants who are unaware of recent developments are likely to encounter a nightmarish

scenario that may play out something like this: you sign a client’s tax return that claims a tax

deduction for participation in a “welfare benefit plan”. A few years pass, and nothing happens.

Then, on audit, the deductions are disallowed and your client is hit with back taxes, penalties, and

interest. He discovers that he may be looking at a large penalty for not disclosing his participation

in the plan to the IRS.

Naturally, at this point, your client wants out of the plan. But he discovers that he cannot get the

money that he has contributed out of the plan. He finds that the money is being used by the plan

sponsor to fight the IRS; his money is being used to defend a plan that he no longer wants to be

in. This is claimed to be legal. Or he may even find that the money is simply gone, that it has

been stolen or otherwise misappropriated.

And now you find that you are a “material advisor” with respect to your client’s participation in

the plan. Like your client, you were supposed to disclose your role here; in your case, as a

“material advisor”. You also may be looking at a large penalty for failing to disclose.

If you think this could never happen to you, think again.

Welfare benefit plans are a creation of and are sanctioned by Section 419 of the Internal Revenue

Code. There are single employer plans and multiple employer plans; the latter rely mostly on IRC

Section 419A (f) (6) (in the most common cases where there are ten or more employers as part

of the same plan). The 419A(f)(6) plans are, and perhaps always were, generally regarded as

abusive, and were substantially curtailed in recent years by harsh IRS regulation. Amazingly,

however, they refuse to totally die, and are still being marketed. These plans are called listed

transactions (more on that later).

While the principle purpose of this article is to discuss the current state of the welfare benefit

plan, and everything outside of this paragraph will do just that, it is perhaps worth noting that

welfare benefit plans are not the only subject of current IRS scrutiny and/or regulation. The

Section 412(i) defined benefit plan, for example, is such a target that a task force has been

formed internally solely to audit 412(i) plans. Many of them are being deemed listed transactions,

many of the plans are being involuntarily terminated, and back taxes, penalties, and interest are

being assessed. Not surprisingly, all of this has resulted in considerable litigation.

Single employer welfare benefit plans are now more popular than multiple employer plans. All

welfare benefit plans tend to share certain characteristics, however. They tend to be marketed

most frequently by insurance agents and financial planners, and sometimes by accountants and

attorneys. Prospects tend to be professionals and profitable small businesses. The most attractive

selling point is the ability to claim large tax deductions and remove money tax free. Life insurance

tends to be the funding vehicle. Often cheap term insurance is purchased for rank and file

workers and some form of permanent coverage (universal life, variable life, etc., for the owners

and key employees. But many times workers are completely left out of the plan. For businesses

looking to do as little as possible for workers, a selling point is that the great majority of benefits,

in most cases, eventually go to the owners. This type of discrimination was recently addressed

by IRS Notice 2007-84, which disallowed tax deductions and penalties with respect to welfare

benefit plans that discriminate. If done correctly, the plans can accomplish things like facilitating

estate planning, business succession, and asset protection. But the promised tax deduction is

usually the sizzle that sells the steak.

In October of 2007, welfare benefit plans were affected by IRS rulings. The two most important

developments were Revenue Ruling 2007-65, which declared, in essence, that premiums paid

inside of a welfare benefit plan for cash value life insurance were not tax deductible, and Notice

2007-83, which identified the trust within welfare benefit plans involving cash value life insurance

policies, AND substantially similar arrangements, as listed transactions. In other words, in

essence, not only are premiums paid for cash value life insurance policies in welfare benefit plans

not tax deductible, but, and far more importantly, the plans themselves are now listed

transactions. This, in turn, means that most welfare benefit plans are now listed transactions,

because most feature cash value life insurance. This designation creates disclosure obligations

with absurdly harsh penalties both for failure to disclose or incorrectly or incompletely disclosing,

as we shall soon see.

A listed transaction, basically, is any transaction identified as such by specific IRS guidance OR

any transaction substantially similar to the specifically identified transaction. Participants in listed

transaction must file Form 8886 with both the Service and the Office of Tax Shelter Analysis.

Failure to timely and completely file leads to penalties of $100,000 for individuals and $200,000

for corporate taxpayers.

The practitioner has filing requirements, also, which can lead to equally severe penalties, if the

practitioner qualifies as a “material advisor” with respect to one of these transactions. What is a

material advisor? Basically, someone who gives advice, sells, or otherwise plays a significant part

in the promotion, sale, or paperwork with respect to a taxpayer’s participation in a listed

transaction. Put simply, from an accountant’s standpoint, you must give advice, the client must

do it, and you must satisfy a certain income threshold with respect to the transaction, usually

$10,000. The accountant who signs a return taking a tax deduction with respect to the

transaction is surely a material advisor, if the income threshold is met.

A problem is that many accountants are not even aware of these plans. Often it is discovered

when preparing the client’s tax return, at which point the client expects you to allow the

deduction and sign the return, since the client was sold a tax deduction. Or worse yet, the

deduction may already have been disallowed on audit. The point is that, far too frequently, the

practitioner does not even discover a client’s involvement in a listed transaction until too much

damage has already been done. This is often the case if the contribution has already been made,

as it usually has, and irretrievably so if the deductions have already been disallowed on audit. And

added to all of this is the distaste that most professionals must have for all of these policing types

of duties, to say nothing of the difficulties that are created with clients and, probably, the loss of

some clients.

The material advisor must file Form 8918 describing her exact role in the client’s participation in

the transaction. Failure to file can lead to penalties imposed on the advisor that are as severe as

those imposed on taxpayers ($100,000 for individuals and $200,000 for corporations) who fail to

file Form 8886. The accountant may escape material advisor status by not meeting the $10,000

income threshold. A problem, however, is the accountant who is paid $10,000 in the aggregate

by the client, but not that much specifically with respect to the listed transaction. Does such a

person satisfy the income threshold? The author and his associates have discussed this point,

among others, directly with IRS personnel who actually wrote published guidance in this area.

The best we have been able to get is a declaration that any test that would be applied to the

determination of any of these issues would have to consider all surrounding facts and

circumstances. This would be unlikely to yield any general rules, for each situation has its own

facts and circumstances.

Another section that the practitioner, or at least the prudent one, should be aware of, largely apart

from what has been discussed so far in this article, is Section 6701, entitled “penalties for aiding

and abetting understatement of tax liability.” This penalty is imposed upon those who assist in,

procure, or advise while knowing or having reason to believe that the subject matter will be used

in connection with any material matter arising under the tax laws and who know that the use

thereof would result in the understatement of another person’s tax liability. The penalty may be

applied separately to each occurrence, and it is $1,000 if an individual is the taxpayer and $10,000

for a corporate taxpayer.

Three (3) definitions are now in order, which will hopefully help to clarify any confusion that

may exist in the reader’s mind. A “material advisor” is any person who provides any material aid,

assistance, or advice with respect to organizing, managing, promoting, selling, implementing,

insuring, or carrying out any reportable transaction, and who directly or indirectly derives gross

income in excess of a certain threshold amount. More on threshold soon, but the most common

one is $10,000 for listed transactions. A “reportable transaction”, basically, is any transaction

which has been deemed to have a potential for tax avoidance or evasion. That is pretty broad, and

the reader should consult the regulations under section 6011 for more on this. Finally, a “listed

transaction” is a reportable transaction which is identical or substantially similar to a transaction

specifically identified as a tax avoidance transaction.

As for threshold amounts, in the case of reportable transactions, it is $50,000, if substantially all

tax benefits are provided to natural persons, and $250,000 in other cases. Natural person is

construed most broadly, generally ignoring trusts, corporations, and other such entities. For listed

transactions, the numbers are $10,000 (previously discussed) and $25,000.

Lance Wallach speaks and writes about benefit plans, and has authored numerous books for the

AICPA, Bisk Total tape, and others. He can be reached at (516) 938-5007 or

wallachinc@gmail.com. For more articles on this or other subjects, feel free to visit his website

at www.taxlibrary.us.

The information contained in this article is not intended as legal, accounting, financial or any

other type of advice for any specific individual or entity. You should seek such advice from an

appropriate professional.

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