Abusive Insurance, Welfare Benefit, and Retirement Plans
The IRS has various task forces auditing all section 419, section 412(i), and other
plans that tend to be abusive. These plans are sold by most insurance agents. The IRS
is looking to raise money and is not looking to correct plans or help taxpayers. The
fines for being in a listed, abusive, or similar transaction are up to $200,000 per year
(section 6707A), unless you report on yourself. The IRS calls accountants, attorneys,
and insurance agents "material advisors" and also fines them the same amount, again
unless the client's participation in the transaction is reported. An accountant is a material
advisor if he signs the return or gives advice and gets paid. More details can be found on
http://www.irs.gov and http://www.vebaplan.com.
Bruce Hink, who has given me written permission to use his name and circumstances,
is a perfect example of what the IRS is doing to unsuspecting business owners. What
follows is a story about how the IRS fines him $200,000 a year for being in what they
called a listed transaction. Listed transactions can be found at http://www.irs.gov. Also
involved are what the IRS calls abusive plans or what it refers to as substantially similar.
Substantially similar to is very difficult to understand, but the IRS seems to be saying, "If
it looks like some other listed transaction, the fines apply." Also, I believe that the
accountant who signed the tax return and the insurance agent who sold the retirement
plan will each be fined $200,000 as material advisors. We have received many calls
for help from accountants, attorneys, business owners, and insurance agents in similar
situations. Don't think this will happen to you? It is happening to a lot of accountants
and business owners, because most of theses so-called listed, abusive, or substantially
similar plans are being sold by insurance agents.
Recently I came across the case of Hink, a small business owner who is facing $400,000
in IRS penalties for 2004 and 2005 because of his participation in a section 412(i) plan.
(The penalties were assessed under section 6707A.)
In 2002 an insurance agent representing a 100-year-old, well established insurance
company suggested the owner start a pension plan. The owner was given a portfolio of
information from the insurance company, which was given to the company's outside CPA
to review and give an opinion on. The CPA gave the plan the green light and the plan
Contributions were made in 2003. The plan administrator came out with amendments to
the plan, based on new IRS guidelines, in October 2004.
The business owner's insurance agent disappeared in May 2005, before implementing the
new guidelines from the administrator with the insurance company. The business owner
was left with a refund check from the insurance company, a deduction claim on his 2004
tax return that had not been applied, and no agent.
It took six months of making calls to the insurance company to get a new insurance agent
assigned. By then, the IRS had started an examination of the pension plan. Asking
advice from the CPA and a local attorney (who had no previous experience in these
cases) made matters worse, with a "big name" law firm being recommended and over
$30,000 in additional legal fees being billed in three months.
To make a long story short, the audit stretched on for over 2 ½ years to examine a 2-
year-old pension with four participants and the $178,000 in contributions. During the
audit, no funds went to the insurance company, which was awaiting formal IRS approval
on restructuring the plan as a traditional defined benefit plan, which the administrator
had suggested and the IRS had indicated would be acceptable. The $90,000 in 2005
contributions was put into the company's retirement bank account along with the 2004
In March 2008 the business owner received a private e-mail apology from the IRS agent
who headed the examination, saying that her hands were tied and that she used to believe
she was correcting problems and helping taxpayers and not hurting people.
The IRS denied any appeal and ruled in October 2008 the $400,000 penalty would stand.
The IRS fine for being in a listed, abusive, or similar transaction is $200,000 per year for
corporations or $100,000 per year for unincorporated entities. The material advisor fine
is $200,000 if you are incorporated or $100,000 if you are not.
Could you or one of your clients be next?
To this point, I have focused, generally, on the horrors of running afoul of the IRS by
participating in a listed transaction, which includes various types of transactions and the
various fines that can be imposed on business owners and their advisors who participate
in, sell, or advice on these transactions. I happened to use, as an example, someone
in a section 412(i) plan, which was deemed to be a listed transaction, pointing out the
truly doleful consequences the person has suffered. Others who fall into this trap, even
unwittingly, can suffer the same fate.
Now let's go into more detail about section 412(i) plans. This is important because these
defined benefit plans are popular and because few people think of retirement plans as
tax shelters or listed transactions. People therefore may get into serious trouble in this
area unwittingly, out of ignorance of the law, and, for the same reason, many fail to take
necessary and appropriate precautions.
The IRS has warned against the section 412(i) defined benefit pension plans, named for
the former code section governing them. It warned against 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 the 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 some 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 the transactions. In
general, IRS auditors divide audited plan into those they consider noncompliant and other
they consider abusive. While the alternatives available to the sponsor of 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 than participants.
Although in some situation 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.
Another plan the IRS is auditing is the section 419 plan. 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 the arrangements purporting to allow the deductibility of
premiums paid for life insurance under a welfare benefit plan or section 419 plan. These
plans have been sold by most insurance agents and insurance companies.
Some of theses abusive employee benefit plans are represented as satisfying section
419, which sets limits on purposed and balances of "qualified asset accounts" for the
benefits, although the plans purport to offer the deductibility of contributions without
any corresponding income. Others attempt to take advantage of the exceptions to
qualified asset account limits, such as sham union plans that try to exploit the exception
for the separate welfare benefit funds under collective bargaining agreements provided
by section 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, defines benefit sections 412(i)
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 IRS steadily added these abusive plans to its designations of listed transactions.
With Revenue Ruling 90-105, it warned against deducting some plan contributions
attributable to compensation earned by plan participants after the end of the tax year.
Purported exceptions to limits of sections 419 and 419A claimed by 10-or-more-
employer benefit funds were likewise prescribed in Notice 95-24 (Doc 95-5046, 95 TNT
98-11). Both positions were designated as 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 theses are now single-employer plans. And again, the IRS has tried
to rein them in, reminding taxpayers that listed transactions include those substantially
similar to any that are specifically described and so designated.
On October 17, 2007, the IRS issues Notices 2007-83 (Doc 2007-23225, 2007 TNT 202-
6) and 2007-84 (Doc 2007-23220, 2007 TNT 202-5). In the former, the IRS identified
some trust arrangements involving cash value life insurance policies, and substantially
similar arrangements, as listed transactions. The latter similarly warned against some
postretirement medical and life insurance benefit arrangements, saying they might be
subject to "alternative tax treatment." The IRS at the same time issued related Rev.
Rul. 2007-65 (Doc 2007-23226, 2007 TNT 202-7) to address situations in which an
arrangement is considered a welfare benefit fund but the employer's deduction for its
contributions to the fund id denied in whole or in 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 sections264(a).
Notice 2007-83 targets 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 anticipate that the cash value policies will
be distributed to the owners or key employees, with 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.
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 section 419A(f)(6) promoters and, therefore,
will be scrutinizing the promoter carefully if the promoter was once active in that area, as
many current section 419(e) (welfare benefit fund or plan) promoters were. This makes
an audit of your client more likely and far riskier.
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 was to pass muster, something else may not.