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 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.

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.