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 employers.
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
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 selective basis.
· 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 date.
· 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
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
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,
firstname.lastname@example.org, 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.
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