Lance Wallach Expert Witness • 419 Plan Litigation

Serious Problems with the IRS

Employers and Promoters Face Serious Problems with the IRS – 419 plan

If you’re the owner of a small business with a “419 plan” for your employees, you may be in serious trouble with the IRS, either now or in the near future. The same is true if you’ve sold one of these plans to a business. This blog post explains the details. This post is a bit technical, but so is tax law.

Here is the typical situation. A closely held business is sold, along with other employers, a welfare benefit plan-an “IRC 419 Plan”-and is told by the plan promoter that the employer’s contributions to the multiple employer welfare benefit fund are tax deductible when paid. In almost every case, this is mistaken.

An employer’s contributions to certain §§ 419 and 419A plans are deductible, but that is the exception, not the general rule. What is happening is that the promoters of most § 419 plans tell the employer’s they sell the plans to that contributions to the plan meet that exception but, again, most of the time that is mistaken.

Tax Law –

A “welfare benefit plan” is a plan that provides certain benefits, like medical or death benefits, to employees or their beneficiaries.

The general rule is that an employer’s contributions to a welfare benefit plan are deductible when paid only if (1) they qualify for an “ordinary and necessary” business expense (which must meet a certain definition set by 26 U.S.C. §162 and underlying regulations), and (2) only to the extent it’s allowed under 26 U.S.C. §§419 and 419A, which place some rather strict limits on the amount an employer may deduct.

However, a narrow exemption (found in § 419A(f)(6)) to the general rule of §§419 and 419A is carved out, permitting deductions beyond the limitations of (2), above. It is the exemption that the promoters of certain “419 plans” claim is satisfied by their plan; most of the time, however, it is not.

Generally, to qualify for the exemption, an employer must be (i) contributing to a welfare benefit fund that is part of a 10 or more employer plan, (ii) is precluded from contributing more than 10% of the total contributions to the plan, and (iii) the plan is not experience related with respect to certain employers.

Problematic 419 Plans –

The problematic 419 plans usually involve investing in variable life or universal life insurance policies (placed in a trust) that insure the owner or key employees, where the employer makes significant contributions beyond what is required for the cost of the term insurance, and the trust administrator is permitted by the contract to withdrawal the insurance policies’ cash value.

Further, the insurance proceeds are distributed to participants when the plan is terminated. Business owners are wrongly being told that their contributions to the plan that is used to pay insurance premiums are deductible as qualified costs without a corresponding inclusion in the employer’s income.

More specifically, the trustee uses the employer’s contributions to the trust to buy life insurance policies: cash value policies on the lives of the owners of the business, and term life policies on the employees’ lives. Down the line, when the plan terminates, the cash value and other property in the trust is distributed to the then-existing employees.

Due to the termination timing and trust allocations, it’s expected that a small amount of trust proceeds will go to the employees, while most of it will go to the business owners and key employees.

The IRS doesn’t like these plans. That is why these sorts of arrangements typically do not satisfy the requirements of 26 USC § 419A(f)(6), and thus are not permitted tax deductions that the plan promoters claim business owners are entitled to.

Insurance Companies Are in Trouble and Don’t Know It

Many life insurance companies are using captive insurance to alter their books and look better. This could lead to another taxpayer bailout and insurance companies being taken over.

This would put benefits in policies at risk for some policyholders.

By using captive insurance arrangements, many insurance companies allow the taxpayer to describe themselves as richer and stronger. This misleads regulators, the ratings agency and consumers who rely on rating.

The NY insurance department said the insurance based in New York had burnished their books by $48 billion by using captive insurance companies, often owned by the insurers.

I have been writing books and articles about some problems with captives for years. This is only one of the problems. The use of a captive to mislead people is not what captives are made for, but some do this anyway.

Insurance regulation is based on solvency because the transactions of using captives make companies look richer than they normally would be. So insurance companies are diverting reserves to other uses like executive compensation and stockholder dividends in order to try and raise the price of their stock. This is not a problem with mutual insurance companies where the insured’s are the stockholders.

By using a captive and trying to hide the fact, some insurance companies artificially increase their risk based capital rations. These ratios are an important measurement of solvency.

IRS Attacks Accountants and Business Owners

by Lance Wallach

Senate Response: Senator Ben Nelson (D-Nebraska) has sponsored legislation (S.765) to curtail the IRS and its nearly unlimited authority and power under Code section 6707A. Senator Nelson is actively seeking co-sponsors of the bill. The bill seeks to scale back the scope of the section 6707A reportable and/or listed transaction nondisclosure penalty to a more reasonable level.

The current law provides for penalties that are draconian by nature and offer no flexibility to the IRS to reduce or abate the imposition of the 6707A penalty. This has served as a weapon of mass destruction for the IRS and has hit many small businesses and their owners with unconscionable results.

Internal Revenue Code 6707A was enacted as part of the American Jobs Creation Act on October 22, 2004. It imposes a strict liability penalty for any person that failed to disclose either a listed transaction or reportable transaction per each occurrence.

Reportable transactions usually fall within certain general types. For example; confidential transactions, transactions with tax protection, certain loss generating transactions and transactions of interest arbitrarily so designated by the IRS that have the potential for tax avoidance.

Listed transactions are specified transactions that have been publicly designated by the IRS, including anything that is substantially similar to such a transaction (a phrase which is given very liberal construction by the IRS).

There are currently 34 listed transactions, including certain retirement plans under Code section 412(i) and certain employee welfare benefit plans funded in part with life insurance under Code sections 419A(f)(5), 419(f)(6) and 419(e). Many of these plans were implemented by a small business seeking to provide retirement income or health benefits to their employees.

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Accountants Fined $100,000 for Selling 419 Plans

Accountants fined $100,000 for signing tax returns and selling 419 plans, 412i plans and other abusive life insurance plans.

Accounting Today – Don’t Become A Material Advisor – Accountants, insurance professionals and others need to be careful that they don’t become what the IRS calls material advisers by selling faulty 419 plans.

If they sell or give advice, or sign tax returns for abusive transactions, listed transactions or any similar plan, they risk a minimum of $100,000 fine. Their client will then probably sue them after having dealt with the IRS.

In 2010, the IRS raided the offices of Benistar in Simsbury, Connecticut and seized the retirement benefit plan administration firm’s files and records. In the McGehee Family Clinic, the Tax Court ruled that a clinic and shareholder’s investment in an employee benefit plan marketed under the name “Benistar” was a listed transaction. It was substantially similar to the transaction described in Notice 95-34 (1995-1 C.B. 309).

This is at least the second case in which the court has ruled against the Benistar welfare benefit plan, by denominating it a listed transaction.

The McGehee Family Clinic

The McGehee Family Clinic enrolled in the Benistar Plan in May 2001 and claimed deductions for contributions to it during 2002 and 2005. The returns did not include a Form 8886 or a Reportable Transaction Disclosure Statement. The IRS disallowed the latter deduction and adjusted the 2004 return of shareholder Robert Prosser and his wife to include the $50,000 payment to the plan.

The IRS assessed tax deficiencies and the enhanced 30 percent penalty under Section 6662A. 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.

In rendering its decision, the court cited Curcio v. Commissioner and in which the court also ruled in favor of the IRS.

As noted in Curcio, the insurance policies which were overwhelmingly variable or universal life policies. They required large contributions relative to the cost of the amount of term insurance that would be required to provide the death benefits under the arrangement.

The Benistar Plan

The Benistar Plan owned the insurance contracts. The excessive cost of providing death benefits was a reason for the court’s finding in Curcio that tax deductions had been properly disallowed.

The McGehee court held that the contributions to Benistar were not deductible under Section 162(a). Reason being that the participants could receive the value reflected in the underlying insurance policies purchased by Benistar. Despite the payment of benefits by Benistar seeming to be contingent upon an unanticipated event. For example; the death of the insured while employed.

As long as plan participants were willing to abide by Benistar’s distribution policies, there was no reason ever to forfeit a policy to the plan. In fact, in estimating life insurance rates, the taxpayers’ expert in Curcio assumed that there would be no forfeitures, even though he admitted that an insurance company would generally assume a reasonable rate of policy lapse.

419 Life Insurance Plans and Other Scams – Large IRS Fines

– The IRS Raids Plan Promoters, What Does All This Mean To You?

Recently IRS raided Benistar, which is also known as the Grist Mill Trust, the promoter and operator of one of the better known and more heavily scrutinized of the Section 419 life insurance plans. IRS attacked the Benistar 419 plan, and one of its tactics was to demand the names of all the clients Benistar worked with — so they could be audited by the IRS, Benistar refused to give the names and actually appealed the decision to turn over the names.

The appeal was unsuccessful, but Benistar officials still refused to give up the names. Recently, the IRS raided the Benistar office and took hundreds of boxes of information, which included information on clients who were in their 419 plan. In documents filed by Benistar itself, they stated that 35 to 50 armed IRS agents descended upon their office to seize documents.

IRS has visited, and is still visiting most of the other plans and obtaining names of participants, selling insurance agents, accountants, etc. They have a whole task force devoted to auditing 419, 412i and other abusive plans.

It’s important to understand what could happen to unsuspecting business owners if they get involved in plans that are not above board. Their names could be turned over to the IRS, where audits could ensue, and where the outcome could be the payment of back taxes and significant penalties. Then they would be fined another time under Section 6707A for not properly reporting on themselves.

Most 419 life insurance and 412i defined benefit pension plans were sold to successful business owners as plans with large tax deductions where money would grow tax free until needed in retirement. I would speak at national accounting and other conventions talking about the problems with most of these plans. I would be attacked by some attendees who where making large insurance commissions selling the plans. I would try to warn insurance company home office executives, but they too had their heads in the sand because of all the money these plans brought in.

Then the IRS got tough and started fining the unsuspecting business owners hundreds of thousands a year for not reporting on themselves for being in the plan. The agents and insurance companies advise against filing. “This is a good plan. We have approval.” Not only were the business owners fined under IRS Code 6707A, but the insurance agents were also fined $100,000 for not reporting on themselves.

Accountants who signed tax returns are even being fined 100,000 by IRS. Then the business owners sue the accountants, insurance agents, etc. I have been following these scenarios for a long time. In fact, I have been an expert witness in many of these cases, and my side has never lost.

Most promoters of 419 plans told clients that their plans complied with the laws and, therefore, were not listed tax transactions. Unfortunately, the IRS doesn’t care what a promoter of a tax-avoidance plan says; it makes its own determination and punishes those who don’t comply.

The McGehee Family Clinic, P.A. was recently hit with back taxes and a penalty under Code Sec. 666A in conjunction with a deduction to the Benistar 419 plan

Dr. McGehee’s clinic took a deduction for a 419 plan (the Benistar plan) back in 2005. Eventually, the McGhee Family Clinic was audited. After the audit, the doctor was told that the deduction would be disallowed and that back taxes were due. Additionally, Dr. McGehee was hit with a 20 percent accuracy-related penalty under Code Sec. 6662A. Finally, the tax court sustained the IRS’s determination that McGehee was subject to the increased 30 percent penalty, because its return did not include a disclosure statement indicating its participation in the Benistar Trust.

I think that in addition to the aforementioned fines, IRS will now fine him, both on a corporate and personal level, another $200,000 or more, under IRC 6707A, for not properly disclosing his participation in a listed transaction. There was a moratorium on those fines until June 2010, pending new legislation to reduce them. The fines had been 200,000 per year on the corporate level and $100,000 per year on the personal level. You got the fine even if you made no contributions for the year. All you had to do was to be in the plan. So Dr. McGehee’s fine would be a total of $300,000 per year for every year that he and his corporation were in the plan.

IRS also says the fine is not appealable. His fine would be in the million-dollar range and it would be in addition to the back taxes, interest, and penalties already discussed earlier in this paragraph.

Legislation just passed slightly reducing those fines, but you still have to properly file to start the Statute of Limitations running to avoid the fines. IRS is fining people who report on themselves, but make a mistake on the forms. Now that the moratorium on the fines has passed, and so has the new legislation, IRS has aggressively moved to fine unsuspecting business owners hundreds of thousands. This is usually after they get audited, and sometimes reach agreement with IRS. Then another division or department of the IRS imposes a fine under 6707A.

I am receiving a lot of phone calls from business owners who this is happening to. Unfortunately, some of these people already had called me. I warned them to properly file under 6707A. Either they did not believe me – it is unbelievable – or their accountant or tax attorney filed incorrectly. Then they called again after being fined.

If you were involved with one of these abusive plans, there are steps that you can take to minimize IRS problems. With respect to filing under Section 6707A, I know the two best people in the country at filing after the fact, which is what you would be doing at this point, and still somehow avoiding the fine. It is an art that both learned through countless hours of research and numerous conversations with IRS personnel. Both have filed dozens of times for clients, after the fact, without the clients being fined. Either may well still be able to help you.

And the right accountant, one with the proper knowledge, experience, and Service contacts, can help with the other IRS problems as well. I recall a case where a CPA I knew and recommended was able to get $300,000 or so in liabilities reduced to three thousand dollars and change. Do not count on a result like this, but help is available.

It’s not worth it!

Stay away from 419 and similar plans like Section 79 plans. Be very careful with 412i plans. Avoid most captive insurance plans.

It’s getting closer to the end of the year. This is when every scammer known to man/woman comes out of the woodwork to sell some fly-by-night tax-deductible plan to clients. Sometimes they come in the form of an accountant, insurance agent-financial planner, or even an attorney. I see this in all of my expert witness cases and when I speak at conventions. I have seen this since the 1990s. I wanted to remind readers that, if it sounds too good to be true, it probably is.

419 Insurance Welfare Benefit Plans Continue To Get Accountants Into Trouble

by Lance Wallach

Popular so-called “419 Insurance Welfare Benefit Plans”, sold by most insurance professionals, are getting accountants and their clients into more and more trouble. A CPA who is approached by a client about one of the abusive arrangements and/or situations to be described and discussed in this article must exercise the utmost degree of caution, not only on behalf of the client, but for his/her own good as well. The penalties noted in this article can also be applied to practitioners who prepare and/or sign returns that fail to properly disclose listed transactions, including those discussed herein.

On October 17, 2007, the IRS issued Notice 2007-83, Notice 2007-84, and Revenue Ruling 2007-65. Notice 2007-83 essentially lists the characteristics of welfare benefit plans that the Service regards as listed transactions. Put simply, to be a listed transaction, a plan cannot rely on the union exception set forth in IRC Section 419A(f)(5),there must be cash value life insurance within the plan and excessive tax deductions for life insurance, in excess of what may be permitted by Sections 419 and 419A, must have been claimed.

In Notice 2007-84, the Service expressed concern with plans that provide all or a substantial portion of benefits to owners and/or key and highly compensated employees. The notice identified numerous specific concerns, among them:

1. The granting of loans to participants
2. Providing deferred compensation
3. Plan terminations that result in the distribution of assets rather than being used post-retirement, as originally established.
4. Permitting the transfer of life insurance policies to participants.

Alternative tax treatment may well be in the offing for such arrangements, as the IRS intends to re-characterize such arrangements as dividends, non-qualified deferred compensation (under IRC Section 404(a)(5) or Section 409A), split-dollar life insurance arrangements, or disqualified benefits pursuant to Section 4976. Taxpayers participating in these listed transactions should have, in most cases, already disclosed such participation to the Service. Those who have not should do so at the earliest possible moment. Failure to disclose can result in severe penalties – up to $100,000 for individuals and $200,000 for corporations.

Finally, Revenue Ruling 2007-65 focused on situations where cash value life insurance is purchased on owner employees and other key employees, while only term insurance is offered to the rank and file. These are sold as 419(e), 419A (f)(6), and 419 plans. Life insurance premiums are not inherently tax deductible and authority must be found in Section 79 to justify such a deduction. Section 264(a), in fact, specifically disallows tax deductions for life insurance, at least in some cases. And moreover, the Service declared, interposition of a trust does not change the nature of the transaction.

The 419 Plan Is a Good Option – If Handled Well

If your clients who are business owners are thinking about setting up a 419 plan, beware! It must be airtight to escape the tentacles of the Internal Revenue Service.

A 419 plan is a funded, welfare benefit that allows for employer-provided benefits covering sickness, accidents, disability, death or unemployment. Some plans offer benefits both before and after retirement.

If structured properly, these arrangements may allow for tax-deductible employer contributions.

Be careful: Welfare benefits are not pension or retirement benefits. Internal Revenue Code Section 419 allows employers to take deductions within certain limits. It’s allowed for contributions generally made to a trust to fund welfare benefits for employees. Such as benefits paid in the event of sickness, accident, disability, death or in some cases, unemployment. The trust can own life insurance. Yet under no circumstances can plan assets revert to the employer.

To be considered a 419(e) plan, it must be funded and offer benefits to all employees. This means that the employer must set aside assets specifically dedicated to paying benefits, often in a trust, for employees or their beneficiaries.

The typical company that uses a 419(e) plan has one or more owners in their 50s, with long-time, key employees. The typical company also has 10 employees or less.

Kurt Fasen, senior vice president of ING, in Minneapolis, says professional groups and small business operations with strong cash flows are attractive candidates for this type of program. For a medical office with two doctors and four employees, for example, contributions to this type of plan may range from $50,000 to about $250,000 annually.

Fasen notes that 419 plans use lower-cost term insurance to fund death-benefit-only benefits. Universal life insurance, which offers flexible premium rates and payments is frequently used for post-retirement medical, disability and unemployment benefits. Loans against the cash value or cash withdrawals are also used to pay for welfare benefits.

For 419 plans, ING provides only the insurance products, says Fasen. Often the company will review a plan provided by a vendor or third-party administrator to double check to see if the plan complies with the law. Fasen stresses that it’s important for business owners to hire a third party to design a plan that strictly adheres to IRS regulations.

At first blush 419 plans look like a good way for a small business to attract and keep key employees, while getting a tax deduction for the company’s 419 contributions into the insurance policy. In addition, assets in the life insurance trust are sheltered from creditors.

Experts warn that 419 plans have complex rules that dictate the need for a third-party administrator. The amount of the deductions must be actuarially certified. If the company offers post-retirement benefits, they must offer them to all the company’s employees.

Previous tax abuses involving 419 plans designed for companies with 10 or more employees may have tainted the perception and increased IRS scrutiny of 419 plans, notes Lance Wallach, financial planner. What Ever Happened to all those 419 Providers?

A study published in the March/April 2006 issue of the National Association of Enrolled Agents’ EA Journal. During the past few years, says Wallach, a number of IRS rulings and court cases, as well as Department of Labor cases, have disallowed tax deductions for 419 plans.

The IRS has come to consider 419A(f)(6) plans as a potentially abusive tax shelter and has identified them as listed transactions. Yet the IRS has issued no notice on 419(e) plans, according to John Lipold, an IRS spokesperson based in Washington.

As a result, today, 419 plans often take the place of 419A plans. Even still, 419(3) can be problematic.

Wallach’s study, done in conjunction with Ronald H. Snyder, an ERISA attorney and pension actuary with the Benefit Strategies Group, Inc., Salt Lake City, analyzed several 419 plans for potential tax problems.

Bottom line is if you are going to recommend a 419 plan, it had better be well-defined in the IRC and rely on minimal interpretation. Otherwise, expect the IRS to disallow the tax deductions.

To keep in line, be sure to follow these guidelines:

The plan must cover all employees. You may not discriminate in favor of key employees.
Severance benefits can’t be offered through a 419(e) plan.
You can’t offer 419 welfare benefits to self-employed individuals or partnerships that are subcontracted by the company for work.
Universal or whole life insurance can’t be used to fund benefits for key employees, while rank-and-file welfare benefits are covered by term insurance.
A universal or whole life insurance policy can’t be used if the company is only offering life insurance as a welfare benefit. Term insurance must be used. Cash value insurance is more costly than term life and may be considered an excessive tax deduction by the IRS. As a result, the IRS may treat the employer deduction as a taxable dividend
Aggressive actuarial assumptions can’t be used to determine the proper death benefit and employer’s premium. Aggressive assumptions can lead to excessive tax deductions. The actuary should use the conservative level annual cost method, which looks at the cost per individual in determining the total cost of the insurance that is used in the plan.

There are additional drawbacks to 419 plans

For example, a company’s business could decline, and the employer may fail to make the required contributions. As a result, the insurance policy could lapse and the employees will lose their benefits.
This article does not stress that the IRS will audit all 419 or similar plans so just be careful. File form 8886 if you are or were in a 4.

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