California Broker, June 2011
Employee Retirement Plans
By Lance Wallach
412i, 419, Captive Insurance and Section 79
Plans; Buyer Beware
The IRS has been attacking all 419 welfare benefit plans, many 412i
retirement plans, captive insurance plans with life insurance in them,
and Section 79 plans. IRS is aggressively auditing various plans and
calling them “listed transactions,” “abusive tax shelters,” or “reportable
transactions,” participation in any of which must be disclosed to the
Service. The result has been IRS audits, disallowances, and huge
fines for not properly reporting under IRC 6707A.
In a recent tax court case, Curico 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. It was substantially similar to the transaction described in
IRS Notice 95-34. A subsequent case, McGehee Family Clinic, largely
followed Curico, though it was technically decided on other grounds.
The parties stipulated to be bound by Curico regarding whether the
amounts paid by McGehee in connection with the Benistar 419 Plan
and Trust were deductible. Curico 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 Service
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, you have to
understand Notice 95-34. It was issued in response to trust
arrangements that were sold to companies 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. They relied on
the 10-or-more-employer exemption from the IRC § 419 limits. They
claimed that the 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 419(A)(F)(6) provides an exemption from
Section 419 and Section 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% of the total contributions.
Also, the plan must not be experience-rated with respect to individual
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. Also, the trust administrator can cash in or withdraw
the cash value of the insurance policies to get cash to pay benefits
other than death benefits. The plans are often designed to determine
an employer’s contributions or its employees’ benefits based on 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 the same type of tax
benefits as listed in the transaction described in Notice 95-34. The
advertising packet listed the following benefits of enrollment:
· 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
· 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
· 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 Curico, in which the court also ruled in
favor of the IRS. As noted in Curico, the insurance policies, which were
overwhelmingly variable or universal life policies, required large
contributions compared 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 Curico, the Court held that the contributions to Benistar were
not deductible under section 162(a) because participants could receive
the value reflected in the underlying insurance policies purchased by
Benistar. This is despite the fact that payment of benefits by Benistar
seemed 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 never a reason to
forfeit a policy to the plan. In fact, in estimating life insurance rates, the
taxpayers’ expert in Curico 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 andclaimed 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 2005 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% 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.
More You Should Know
· In recent years, some section 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 could 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.
· By itself, a 412(i) plan 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
Curico or McGehee. The disclosure needs to be made for every year
the participant is in a plan. The forms need to be filed properly 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
helps hundreds of his participants file forms, and they all still received
very large IRS fines for not filling in the forms properly.
Lance Wallach is National society of Accountants Speaker of the Year
and member of the AICPA faculty of teaching professionals. He does
expert witness testimony and has never lost a case. Contact him at
516-938-5007, email@example.com, or visit www.taxaudit419.com or
www.lancewallach.com. 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.