By Lance Wallach, CLU, ChFC, CIMC
While many taxpayers adopt legitimate Voluntary Employee Beneficiary Association (“VEBA”) Plans, Welfare Benefit Plans (“419(e) Plans”) and Fully-Insured Defined Benefit Pensions (“412(i) Plans”), all of the foregoing plans are also sold as a way for owners to obtain huge tax deductions, with the ability to take money out of a corporation tax-free, protect assets from creditors, tax-deduct life, health, disability and long-term care insurance premiums and pass wealth tax free to the next generation. This article will explore those claims.
We have worked with each of these benefit plans for years without problems for ourselves or for our clients. Yet a review of recent Internal Revenue Service (“IRS”) rulings and court cases instituted both by the IRS as well as the Department of Labor (“DOL”) shows that some taxpayers adopting 419 Plans or 412(i) Plans have had tax deductions disallowed, been the subject of lawsuits, or even worse. Many plans have been determined by IRS to be “listed transactions” (or potentially abusive tax shelters) requiring notification of the Services and potentially triggering heavy penalties.
When the various plans are sold and operated properly, they can provide excellent advantages. However, rather than brave the regulatory minefield, many accountants and advisors would rather simply just say “no”. How can a non-specialist differentiate between a legitimate plan and one that IRS or DOL may attack?
In addition to the additional caution begin exercised by accountants and advisors, some insurance companies have stopped allowing their products to be sold in connection some or all of the above-named benefit plans, while others require that their legal department do an extensive review of the plan and that the client sign a disclosure acknowledgement form that exonerates the insurance company. This is as a direct result of a number of lawsuits against insurance companies in connection with such benefit plans, usually after IRS has closed down a plan or disallowed tax deductions. In such situations, the insurance company is portrayed as the “deep pockets” which should have done a better job of investigating the integrity and history of the plan administrator. [Interestingly, other insurance companies see their role as issuing and underwriting insurance and annuity contracts and don’t opine on the purported tax benefits.]
VEBAs and 419(e) Plans
VEBAs potentially provide a triple-tax benefit: (i) Contributions to a legitimate VEBA or other welfare benefit plan may be tax-deductible within the limitations of Sections 419 and 419A of the Internal Revenue Code (“IRC”), as actuarially-determined. (ii) Investment income may accumulate tax-deferred inside a VEBA. And (iii) benefits paid from the VEBA can be distributed income tax free, either as death proceeds of life insurance (IRC Section 101(a) or for health reimbursement arrangement benefits under IRC Section 105(h). Welfare benefit plans are similar except that they do not provide tax-free investment income inside the plan.
If properly designed and established, the benefits inside a VEBA/419 plan are protected from creditors and the death benefits may be excluded from the participant’s estate for estate tax purposes.
A few months ago when the author addressed the annual convention of the National Network of Estate Planning Attorneys, the attorneys were surprised to learn about using VEBAs and welfare benefit plans to tax-deduct life insurance premiums while still excluding the death proceeds from the insured’s estate. This makes for an ideal package: Instead of buying life insurance with after-tax dollars inside an irrevocable life insurance trust (“ILIT”) to pay estate taxes, it may be possible to make a tax-deductible contribution to the VEBA, let the VEBA buy the life insurance with pretax dollars and name the ILIT as the irrevocable beneficiary.
Similarly, at the National Convention of the American Association of Attorney–Certified Public Accountants which I also addressed, the attendees were interested to learn about using VEBAs as a way to attract high net worth clients. These are under-utilized, under-marketed and misunderstood plans.
419A(f)(5) and (6) Plans
Over the past few years, the Treasury and the IRS have acted forcefully to eliminate so-called “Section 419 plans”. In Notice 2000-15 and Notice 2001-51, the IRS included such plans as potentially abusive tax shelters or “listed transactions.” Treasury Decision 9000 extended the scope of those notices. The Section 419 Plans that are in disfavor with the IRS are those plans that claim to be exempt from the tax-deduction limitations imposed by Sections 419 and 419A of the IRC by virtue of supposed compliance with IRC Sections 419A(f)(5) or 419A(f)(6).
So-called Section 419A(f)(5) plans are marketed as “union” plans (sometimes called “VEBAs”). Some of these use convincing language to persuade employers that they are able to include only key employees and owner-employees in their “union,” and to provide such “union members” with an inviting array of benefits. There are variations on this scam, but no plan that offers benefits to doctors, executives or highly-compensated employees through such an arrangement is legitimate. Moreover, the IRS considers such arrangements to be listed transactions.
Section 419A(f)(6) plans, also called “10-or-more employer plans” are marketed as exempt from tax deduction limitations altogether. Some plans have even claim to be exempt from non-discrimination requirements. It now appears that IRS succeeded in eliminating most such plans by issuing Regulations under this Section of the IRC and classifying such arrangements as listed transactions.
The ramifications for clients who are involved in abusive tax shelters is substantial. Code section 6707A provides for a $100,000 penalty for an individual and a $200,000 penalty for all other taxpayers when the client does not disclose involvement with a “listed” tax transaction. The penalty cannot be waived by the IRS and cannot be reviewed or overturned by a court of law.
This is not a game, and the IRS has made that clear. Advisors (financial planners, CPAs, accountants, attorneys, EAs and others) are not outside of the reach of the IRS. See the following:
Act section 822(a)(1)(B) provides in part that:
“The Secretary may impose a monetary penalty on any representative …(which) shall not exceed the gross income derived from … the conduct giving rise to the penalty …”
An IRS press release (IR 2004-138) states that:
"The new 2004 Jobs Act strengthens our hand in the fight against abusive shelters," said IRS Commissioner Mark W. Everson. "Under the new law, attorneys, accountants and other tax advisers who fail to comply with these disclosure requirements will face significant monetary penalties.”
Many advisors are unaware of the fact that the IRS has a task force that does nothing but hunt down clients that are in abusive 419 Plans. If the IRS believes an advisor is invovled in any way in promoting abusive 419 Plans, a request for production of documents and for a client list will come in the mail to the advisor giving the advice. These inquiries are not fun and can cause significant grief for both the advisor and his/her unsuspecting clients.
The best course of action when dealing with advanced tax planning is to work with someone who has a track record of being reputable so as to prevent advisors and their clients from becoming “infamous.”
412(i) Fully Insured Defined Benefit Plans
412(i) plans continue to generate both interest and caution following recent Internal Revenue Service and Treasury Department actions to crack down on a number of abusive schemes that had cropped up in this marketplace.
Unlike 401(k) and other defined-contribution plans, defined benefit plans, including 412(i) Plans, are not subject to the $42,000 contribution limit ($46,000 with catch-up salary deferrals). Benefits are limited to 100% of pay, but employers may deduct the projected cost of funding the maximum benefit at the participant’s normal retirement date. Generally these contribution limitations are determined by the taxpayer’s actuary.
Section 412(i) Plans provide an alternative to using an independent actuary. If all plan contributions are invested in life insurance and annuity contracts of an insurance company, the contractually-guaranteed rates under those contracts may be used to determine the maximum tax-deductible contribution to the plan. This has the potential of increasing the taxpayer’s maximum tax deduction by 20%-40%.
Many accountants like S corporations for their clients. This allows the client to have large amounts of income without worrying about excess profits, accumulating retained earnings, dividends or double taxation of profits. However, since W-2 wages are subject to payroll taxes and passive dividend income is not, many S corporation owners limit their W-2 wages to a modest amounts and pass through the majority of the client’s income free of payroll tax. While this may make tax-planning sense, it may dramatically curtail the amount of retirement plan or welfare benefit plan contributions, which may only take W-2 wages into account.
A defined benefit plan, especially a 412(i) Plan, may provide relief for such shareholder-employees. Maximum contributions to a defined benefit plan may be achieved with as little as 3 years of W-2 wages of $70,000 per year. And the plan contribution may far exceed 100% of compensation. (We have seen cases where tax-deductible contributions in excess of $200,000 per year for a single lone participant were available.) For example, a W-2 wage of $50,000 would permit a maximum SEP-IRA contribution of $12,000 for a 50-year-old, but will allow a 412(i) contribution of over $75,000!
Defined benefit plans (including 412(i) Plans) have tremendous appeal for small, closely held businesses that are successful and have few, if any, employees. The initial tax-deductible contributions and projected benefits are unparalleled for participants age 40 and older. But care must be exercised to assure that a 412(i) or defined-benefit plan is properly designed and funded.
I recently addressed the National Convention of the American Society of Pensions Actuaries. At that meeting, Jim Holland, the IRS’ chief actuary, spoke about their concerns about abusive 412(i) Plans. Since then, officials from the IRS have publicly and privately expressed concerns about abuses in the 412(i) arena. As early as the 2003 Los Angles Benefits Conference, concerns were expressed primarily about some perceived abuses:
(i) Utilization of life insurance contracts rather than annuities as the primary or exclusive funding vehicle for 412(i) plans;
(ii) Use of life insurance products designed to minimize cash values upon early plan termination, and
(iii) Funding for benefits that that exceed Code Section 415(b) limitations.
I recently heard of a 412(i) Plan described as “two retirement plans in one: one for the participant and one for the insurance agent.” However, such criticism does not apply to all 412(i) Plans; only to abusive plans with some or all of the features described above.
Properly structured 412(i) plans are viable when avoiding the pitfalls described above and can provide the maximum tax deduction and retirement benefit.
Maximum Tax Deductions
We recommend consulting with knowledgeable tax counsel and benefit providers to develop an individualized approach for each client.
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Lance Wallach, National Society of Accountants Speaker of the Year and member of the American Institute of CPAs faculty of teaching professionals, is a frequent speaker on retirement plans, financial and estate planning, and abusive tax shelters. He speaks at more than ten conventions annually and writes for over fifty publications. Lance has written numerous books including Protecting Clients from Fraud, Incompetence and Scams published by John Wiley and Sons, Bisk Education's CPA's Guide to Life Insurance and Federal Estate and Gift Taxation, as well as AICPA best-selling books, including Avoiding Circular 230 Malpractice Traps and Common Abusive Small Business Hot Spots.
He does expert witness testimony and has never lost a case. Mr. Wallach may be reached at 516/938.5007, wallachinc@gmail.com, or at 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.
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