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| Copyright 2011 All rights reserved |
IRS Audits Focus on Captive Insurance Plans
April 2011 Edition
By Lance Wallach
The IRS started auditing § 419 plans in the 1990s, and then continued going after §
412(i) and other plans that they considered abusive, listed, or reportable
transactions, or substantially similar to such transactions. If an IRS audit disallows the
§ 419 plan or the § 412(i) plan, not only does the taxpayer lose the deduction and
pay interest and penalties, but then the IRS comes back under IRC 6707A and
imposes large fines for not properly filing.
Insurance agents, financial planners and even accountants sold many of these
plans. The main motivations for buying into one were large tax deductions. The
motivation for the sellers of the plans was the very large life insurance premiums
generated. These plans, which were vetted by the insurance companies, put lots of
insurance on the books. Some of these plans continue to be sold, even after IRS
disallowances and lawsuits against insurance agents, plan promoters and insurance
companies.
In a recent tax court case, Curcio 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 in that the transaction in question was
substantially similar to the transaction described in IRS Notice 95-34. A subsequent
case, McGehee Family Clinic, largely followed Curcio, though it was technically
decided on other grounds. The parties stipulated to be bound by Curcio on the issue
of whether the amounts paid by McGehee in connection with the Benistar 419 Plan
and Trust were deductible. Curcio 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 IRS 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, one must have an understanding
of IRS Notice 95-34, which was issued in response to trust arrangements sold to
companies that were 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, by relying on the 10-or-
more-employer exemption from the IRC § 419 limits. It was claimed that 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 419A(F)(6)
provides an exemption from § 419 and § 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 percent of the total contributions, and 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, and the trust administrator may obtain cash to pay
benefits other than death benefits, by such means as cashing in or withdrawing the
cash value of the insurance policies. The plans are also often designed so that a
particular employer’s contributions or its employees’ benefits may be determined in 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 arrangements.
Benistar advertised that enrollees should expect to obtain the same type of tax
benefits as listed in the transaction described in Notice 95-34. The benefits of
enrollment listed in its advertising packet included:
· 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 Curcio, in which the court also ruled
in favor of the IRS. As noted in Curcio, the insurance policies, overwhelmingly
variable or universal life policies, 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 owned the insurance contracts.
Following Curcio, as the Court has stipulated, the Court held that the contributions to
Benistar were not deductible under § 162(a) because 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 (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 lapses.
The McGehee Family Clinic had enrolled in the Benistar Plan in May 2001 and
claimed deductions for contributions to it in 2002 and 2005. The returns did not
include a Form 8886, Reportable Transaction Disclosure Statement, or similar
disclosure.
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
also assessed tax deficiencies and the enhanced 30 percent 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.
Other important facts:
· In recent years, some § 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 can 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.
· A 412(i) plan in and of itself 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 transactions.
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
Curcio or McGehee. The disclosure needs to be made for every year the participant
is in a plan. The forms need to be properly filed 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 assisted hundreds of his participants with filing forms, and they still all
received very large IRS fines for not properly filling in the forms.
IRS has targeted all 419 welfare benefit plans, many 412(i) retirement plans, captive
insurance plans with life insurance in them and Section 79 plans.
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
type of advice for any specific individual or other entity. You should contact an
appropriate professional for any such advice.