A Rose By Any Other Name, or...Whatever Happened to All Those 419A(f)(6) Providers?

Enrolled Agents Journal March*April 2006

A Rose By Any Other Name, or
Whatever Happened to All Those 419A(f)(6) Providers?

By Ronald H. Snyder, JD, MAAA, EA & Lance Wallach, CLU, ChFC, CIMC



For years promoters of life insurance companies and agents have tried to find ways of claiming that the premiums paid by business owners were tax deductible. This allowed them to sell policies at a “discount”.

The problem became especially bad a few years ago with all of the outlandish claims about how §§419A(f)(5) and 419A(f)(6) exempted employers from any tax deduction limits. Many other inaccurate statements were made as well, until the IRS finally put a stop to such assertions by issuing regulations and naming such plans as “potentially abusive tax shelters” (or “listed transactions”) that needed to be disclosed and registered. This appeared to put an end to the scourge of such scurrilous promoters, as such plans began to disappear from the landscape.

And what happened to all the providers that were peddling 419A(f)(5) and (6) life insurance plans a couple of years ago? We recently found the answer: most of them found a new life as promoters of so-called “419(e)” welfare benefit plans.

We recently reviewed several §419(e) plans, and it appears that many of them are nothing more than recycled §419A(f)(5) and §419A(f)(6) plans.

The “Tax Guide” written by one vendor’s attorney is illustrative: he confuses the difference between a “multi-employer trust” (a Taft-Hartley, collectively-bargained plan), a “multiple-employer trust” (a plan with more than one unrelated employer) and a “10-or-more employer trust” (a plan seeking to comply with IRC §419A(f)(6)).

Background: Section 419 of the Internal Revenue Code

Section 419 was added to the Internal Revenue Code (“IRC”) in 1984 to curb abuses in welfare benefit plan tax deductions. §419(a) does not authorize tax deductions, but provides as follows: “Contributions paid or accrued by an employer to a welfare benefit fund * * * shall not be deductible under this chapter * * *.”. It simply limits the amount that would be deductible under another IRC section to the “qualified cost for the taxable year”. (§419(b))

Section 419(e) of the IRC defines a “welfare benefit fund” as “any fund-- (A) which is part of a plan of an employer, and (B) through which the employer provides welfare benefits to employees or their beneficiaries.” It also defines the term "fund", but excludes from that definition “amounts held by an insurance company pursuant to an insurance contract” under conditions described.

None of the vendors provides an analysis under §419(e) as to whether or not the life insurance policies they promote are to be included or excluded from the definition of a “fund”. In fact, such policies will be included and therefore subject to the limitations of §§419 and 419A.

Errors Commonly Made

Materials from the various plans commonly make several mistakes in their analyses:

1. They claim not to be required to comply with IRC §505 non-discrimination requirements. While it is true that §505 specifically lists “organizations described in paragraph (9) or (20) of section 501(c)”, IRC §4976 imposes a 100% excise tax on any “post-retirement medical benefit or life insurance benefit provided with respect to a key employee” * * * “unless the plan meets the requirements of section 505(b) with respect to such benefit (whether or not such requirements apply to such plan).” (Italics added) Failure to comply with §505(b) means that the plan will never be able to distribute an insurance policy to a key employee without the 100% penalty!

2. Vendors commonly assert that contributions to their plan are tax deductible because they fall within the limitations imposed under IRC §419; however, §419 is simply a limitation on tax deductions. Providers must cite the section of the IRC under which contributions to their plan would be tax-deductible. Many fail to do so. Others claim that the deductions are ordinary and necessary business expense under §162, citing Regs. §1.162-10 in error: there is no mention in that section of life insurance or a death benefit as a welfare benefit.

3. The reason that promoters fail to cite a section of the IRC to support a tax deduction is because, once such section is cited, it becomes apparent that their method of covering only selected key and highly-compensated employees for participation in the plan fails to comply with IRC §414(t) requirements relative to coverage of controlled groups and affiliated service groups.

4. Life insurance premiums could be treated as W-2 wages and deducted under §162 to the extent they were reasonable. Other than that, however, no section of the Internal Revenue Code authorizes tax deductions for a discriminatory life insurance arrangement. IRC §264(a) provides that “[n]o deduction shall be allowed for * * * [p]remiums on any life insurance policy * * * if the taxpayer is directly or indirectly a beneficiary under the policy.” As was made clear in the Neonatology case (Neonatology Associates v. Commissioner, 115 TC 5, 2000), the appropriate treatment of employer-paid life insurance premiums under a putative welfare benefit plan is under §79, which comes with its own nondiscrimination requirements.

5. Some plans claim to impute income for current protection under the PS 58 rules. However, PS58 treatment is available only to qualified retirement plans and split-dollar plans. (Note: none of the 419(e) plans claim to comply with the split-dollar regulations.) Income is imputed under Table I to participants under Group-Term Life Insurance plans that comply with §79. This issue is addressed in footnotes 17 and 18 of the Neonatology case.

6. Several of the plans claim to be exempt from ERISA. They appear to rely upon the ERISA Top-Hat exemption (applicable to deferred compensation plans). However, that only exempts a plan from certain ERISA requirements, not ERISA itself. It is instructive that none of the plans claiming exemption from ERISA has filed the Top-Hat notification with the Dept. of Labor.

7. Some of the plans offer severance benefits as a “welfare benefit”, which approach has never been approved by the IRS. Other plans offer strategies for obtaining a cash benefit by terminating a single-employer trust. The distribution of a cash benefit is a form of deferred compensation, yet none of the plans offering such benefit complies with the IRC §409A requirements applicable to such benefits.

8. Some vendors permit participation by employees who are self-employed, such as sole proprietors, partners or members of an LLC or LLP taxed as a partnership. This issue was also addressed in the Neonatology case where contributions on behalf of such persons were deemed to be dividends or personal payments rather than welfare benefit plan expenses.

[Note: bona fide employees of an LLC or LLP that has elected to be taxed as a corporation may participate in a plan.]

9. Most of the plans fail under §419 itself. §419(c) limits the current tax deduction to the “qualified cost”, which includes the “qualified direct cost” and additions to a “qualified asset account” (subject to the limits of §419A(b)). Under Regs. §1.419-1T, A-6, “the "qualified direct cost" of a welfare benefit fund for any taxable year * * * is the aggregate amount which would have been allowable as a deduction to the employer for benefits provided by such fund during such year (including insurance coverage for such year) * * *.” “Thus, for example, if a calendar year welfare benefit fund pays an insurance company * * * the full premium for coverage of its current employees under a term * * * insurance policy, * * * only the portion of the premium for coverage during [the year] will be treated as a "qualified direct cost" * * *.” (Italics added)

Most vendors pretend that the whole or universal life insurance premium is an appropriate measurement of cost for Key Employees, and those plans that cover rank and file employees use current term insurance premiums as the appropriate measure of cost for such employees. This approach doesn’t meet any set of nondiscrimination requirements applicable to such plans.

10. Some vendors claim that they are justified in providing a larger deduction than the amount required to pay term insurance costs for the current tax year, but, as cited above, the only justification under §419(e) itself is as additions to a qualified asset account and is subject to the limitations imposed by §419A. In addition, §419A adds several additional limitations to plans and contributions, including requirements that:
A. contributions be limited to a safe harbor amount or be certified by an actuary as to the amount of such contributions (§419A(c)(5));
B. actuarial assumptions be “reasonable in the aggregate” and that the actuary use a level annual cost method (§419A(c)(2));
C. benefits with respect to a Key Employee be segregated and their benefits can only be paid from such account (§419A(d));
D. the rules of subsections (b), (c), (m), and (n) of IRC section 414 shall apply to such plans (§419A(h)).
E. the plan comply with §505(b) nondiscrimination requirements (§419A(e)).

Circular 230 Issues

Circular 230 imposes many requirements on tax professionals with respect to tax shelter transactions. A tax practitioner can get into trouble in the promotion of such plans, in advising clients with respect to such transactions and in preparing tax returns. IRC §§6707 and 6707A add a new concept of “reportable transactions” and impose substantial penalties for failure to disclose participation in certain reportable transactions (including all listed transactions).

This is a veritable minefield for tax practitioners to negotiate carefully or avoid altogether. The advisor must exercise great caution and due diligence when presented with any potential contemplated tax reduction or avoidance transaction. Failure to disclose could subject taxpayers and their tax advisors to potentially Draconian penalties.

Summary

Key points of this article include:

· Practitioners need to be able to differentiate between a legitimate §419(e) plan and one that is legally inadequate when their client approaches them with respect to such plan or has the practitioner to prepare his return;
· Many plans incorrectly purport to be exempt from compliance with ERISA, IRC §§414, 505, 79, etc.
· Tax deductions must be claimed under an authorizing section of the IRC and are limited to the qualified direct cost and additions to a qualified asset account as certified by the plan’s actuary.

Conclusion

Irresponsible vendors such as most of the promoters who previously promoted IRC §419A(f)(6) plans were responsible for the IRS’s issuing restrictive regulations under that Section. Now many of the same individuals have elected simply to claim that a life insurance plan is a welfare benefit plan and therefore tax-deductible because it uses a single-employer trust rather than a "10-or-more-employer plan".

This is an open invitation to the IRS to issue new onerous Regulations and more indictments and legal actions against the unscrupulous promoters who feed off of the naivety of clients and the greed of life insurance companies who encourage and endorse (and even own) such plans.

The last line of defense of the innocent client is the accountant or attorney who is asked by a client to review such arrangement or prepare a tax return claiming a deduction for contributions to such a plan. Under these circumstances accountants and attorneys should be careful not to rely upon the materials made available by the plan vendors, but should review any proposed plan thoroughly, or refer the review to a specialist.


Ron Snyder practices as an ERISA attorney and Enrolled Actuary in the field of employee benefits.

Lance Wallach speaks and writes extensively about VEBAs retirement plans, and tax reduction strategies. He speaks at more than 70 conventions annually and writes for more than 50 publications. For more information and additional articles on these subjects, call 516-938-5007 or visit www.vebaplan.com..

This information 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.

Draconian Fines by the IRS

The IRS may call you a material advisor and fine you $200,000.00. The IRS may fine your clients over a million dollars for being in a retirement plan, 419 plan, etc. As you read this article, hundreds of unfortunate people are having their lives ruined by these fines. You may need to take action immediately.

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. The bill seeks to scale back the scope of the Section 6707A reportable/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 of transactions (e.g. confidential transactions, transactions with tax protection, certain loss generating transaction and transactions of interest arbitrarily so designated as by the IRS) that have the potential for tax avoidance. Listed transactions are specified transactions which 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 small business seeking to provide retirement income or health benefits to their employees.

Strict liability requires the IRS to impose the 6707A penalty regardless of innocence of a person (i.e. whether the person knew that the transaction needed to be reported or not or whether the person made a good faith effort to report) or the level of the person’s reliance on professional advisors. A Section 6707A penalty is imposed when the transaction becomes a reportable/listed transaction. Therefore, a person has the burden to keep up to date on all transactions requiring disclosure by the IRS into perpetuity for transactions entered into the past.

Additionally, the 6707A penalty strictly penalizes nondisclosure irrespective of taxes owed. Accordingly, the penalty will be assessed even in legitimate tax planning situations when no additional tax is due but an IRS required filing was not properly and timely filed. It is worth noting that a failure to disclose in the view of the IRS encompasses both a failure to file the proper form as well as a failure to include sufficient information as to the nature and facts concerning the transaction. Hence, people may find themselves subject to the 6707A penalty if the IRS determines that a filing did not contain enough information on the transaction. A penalty is also imposed when a person does not file the required duplicate copy with a separate IRS office in addition to filing the required copy with the tax return. Lance Wallach Commentary. In our numerous talks with IRS, we were also told that improperly filling out the forms could almost be as bad as not filing the forms. We have reviewed hundreds of forms for accountants, business owners and others. We have not yet seen a form that was properly filled in. We have been retained to correct many of these forms.

The imposition of a 6707A penalty is not subject to judicial review regardless of whether the penalty is imposed for a listed or reportable transaction. Accordingly, the IRS’s determination is conclusive, binding and final. The next step from the IRS is sending your file to collection, where your assets may be forcibly taken, publicly recorded liens may be placed against your property, and/or garnishment of your wages or business profits may occur, amongst other measures.

The 6707A penalty amount for each listed transaction is generally $200,000 per year per each person that is not an individual and $100,000 per year per individual who failed to properly disclose each listed transaction. The 6707A penalty amount for each reportable transaction is generally $50,000 per year for each person that is not an individual and $10,000 per year per each individual who failed to properly disclose each reportable transaction. The IRS is obligated to impose the listed transaction penalty by law and cannot remove the penalty by law. The IRS is obligated to impose the reportable transaction penalty by law, as well, but may remove the penalty when the IRS determines that removal of the penalty would promote compliance and support effective tax administration.

The 6707A penalty is particularly harmful in the small business context, where many business owners operate through an S corporation or limited liability company in order to provide liability protection to the owner/operators. Numerous cases are coming to light where the IRS is imposing a $200,000 penalty at the entity level and them imposing a $100,000 penalty per individual shareholder or member per year.

The individuals are generally left with one of two options:

1. Declare Bankruptcy

2. Face a $300,000 penalty per year.

Keep in mind, taxes do not need to be due nor does the transaction have to be proven illegal or illegitimate for this penalty to apply. The only proof required by the IRS is that the person did not properly and timely disclose a transaction that the IRS believes the person should have disclosed. It is important to note in this context that for non-disclosed listed transactions, the Statue of Limitations does not begin until a proper disclosure is filed with the IRS.

Many practitioners believe the scope and authority given to the IRS under 6707A, which allows the IRS to act as judge, jury and executioner, is unconstitutional. Numerous real life stories abound illustrating the punitive nature of the 6707A penalty and its application to small businesses and their owners. In one case, the IRS demanded that the business and its owner pay a 6707A total of $600,000 for his and his business’ participation in a Code section 412(i) plan. The actual taxes and interest on the transaction, assuming the IRS was correct in its determination that the tax benefits were not allowable, was $60,000. Regardless of the IRS’s ultimate determination as to the legality of the underlying 412(i) transaction, the $600,000 was due as the IRS’s determination was final and absolute with respect to the 6707A penalty. Another case involved a taxpayer who was a dentist and his wife whom the IRS determined had engaged in a listed transaction with respect to a limited liability company. The IRS determined that the couple owed taxes on the transaction of $6,812, since the tax benefits of the transactions were not allowable. In addition, the IRS determined that the taxpayers owed a 1,200,000 section 6707A penalty for both their individual nondisclosure of the transaction along with the nondisclosure by the limited liability company.

Even the IRS personnel continue to question both the legality and the fairness of the IRS’s imposition of 6707A penalties. An IRS appeals officer in an email to a senior attorney within the IRS wrote that “…I am both an attorney and CPA and in my 29 years with the IRS I have never {before} worked a case or issue that left me questioning whether in good conscience I could uphold the Government’s position even though it is supported by the language of the law.” The Taxpayers Advocate, an office within the IRS, even went so far as to publicly assert that the 6707A should be modified as it “raises significant Constitutional concerns, including possible violations of the Eighth Amendment’s prohibition against excessive government fines, and due process protection.”

Senate bill 765, the bill sponsored by Senator Nelson, seeks to alleviate some of above cited concerns. Specifically, the bill makes three major changes to the current version of Code section 6707A. The bill would allow an IRS imposed 6707A penalty for nondisclosure of a listed transaction to be rescinded if a taxpayer’s failure to file was due to reasonable cause and not willful neglect. The bill would make a 6707A penalty proportional to an understatement of any tax due.

Would only allow the IRS to impose a 6707A penalty on actual taxpayers.

Accordingly, non-tax paying entities such as S corporations and limited liability companies would not be subject to a 6707A penalty (individuals, C corporations and certain trusts and estates would remain subject to the 6707A penalty).

Important update as of July 2009.

In a letter dated July 6, 2009, from Douglas Shulman, Commissioner of the Internal Revenue Service, to Representative John Lewis, Chairman of the Subcommittee on Oversight of the House Committee on Ways and Means, the IRS announced that it is suspending “collection enforcement action” on penalties under section 6707A of the Internal Revenue Code. Section 6707A of the Code imposes a penalty on a taxpayer who fails to disclose participation in a reportable transaction. The term “reportable transaction” includes a “listed transaction”. In the letter, the IRS says that it will suspend collection efforts where the tax benefits resulting from a listed transaction are less than $100,000 for a person and $200,000 for all other taxpayers. The IRS will suspend such collection efforts until September 30, 2009.

There are a number of interesting points to note about this action:

1. In the letter, the IRS acknowledges that, in certain cases, the penalty imposed by section 6707A for failure to report participation in a “listed transaction” is disproportionate to the tax benefits obtained by the transaction.

2. In the letter, the IRS says that it is taking this action because Congress has indicated its intention to amend the Code to modify the penalty provision, so that the penalty for failure to disclose will be more in line with the tax benefits resulting from a listed transaction.

3. The IRS will not suspend audits or collection efforts in appropriate cases. It cannot suspend imposition of the penalty, because, at least with respect to listed transactions, it does not have the discretion to not impose the penalty. It is simply suspending collection efforts in cases where the tax benefits are below the penalty threshold in order to give Congress time to amend the penalty provision, as Congress has indicated to the IRS it intends to do. Presumably, if Congress does not act by September 30, 2009, then the IRS will resume collection efforts.

4. In a press release dated July 7, 2009, Senator Charles Grassley said that the suspension probably needs to be longer, because he does not believe that legislation can get through Congress by September 30, 2009.

It should also be noted that identical bills have been introduced in the Senate and the House to amend Section 6707A. Each bill has been referred to the appropriate committee, where no action has taken place. There are a couple of points about the proposed legislation:

1. The legislation would reduce the penalty for failure to disclose participation in a reportable transaction, other than a listed transaction, to the amount imposed by section 6662A for an understatement of tax. For a listed transaction, the penalty would equal 200% of the penalty imposed for an understatement of tax. The amount of the penalty imposed by section 6662A is 20%.

2. The proposed legislation is different than the position expressed by the IRS. The IRS would like the penalty to equal the tax benefits obtained from the transaction.

3.The legislation does not change the penalty provisions for material advisors.

Important articles for Attorneys, Accountants and Insurance Professionals.

NATP TAXPRO Journal, Winter 2009

My biggest challenge (Lance Wallach) will be finding time to educate the hundreds of accountants who are being targeted by the IRS as “material advisors”. Any accountant who allows a 419,412(i), or other type of listed transaction (or substantially similar to such a transaction) to be deducted can be labeled a material advisor by the IRS and be subject to a $200,000.00 fine. In addition, the information will be forwarded to the Office of Professional Responsibility and they could lose their licenses. This past year, I often received as many as fifty calls a week from people needing help with this problem.

For example, I recently received a phone call from an accountant whose client went into an insurance company-sponsored 412(i) retirement plan in 2003. The business owner made no contribution to the plan in 2004 or 2005, and actually tried to get out of the plan. The IRS audited the returns for 2004 and 2005 and fined the business owner $400,000.00 for failing to disclose being in a listed transaction. I believe they are now fining the accountant $200,000.00 for being a material advisor. The accountant had nothing to do with the plan, did not think anything was wrong, and still can’t understand what is going on. If you think this can’t happen to you, think again. It's happening to a lot of honest people.

- Lance Wallach

Lance Wallach, Planview NY, is a member of the AICPA faculty of teaching professionals and an AICPA course developer. He speaks at more than 70 national conventions a year on topics including retirement plans, financial and estate planning, reducing health insurance costs, and tax-oriented strategies. He writes for numerous publications, and has authored many books for the AICPA and Bisk. In addition, Lance has been named NSA “Speaker of the Year”. Congratulations Lance on being chosen NATP’s March Member of the Month!

Q. What are the biggest challenges facing tax professionals today?

A. I think the biggest challenge facing tax professionals is the IRS trying to make them policemen. Most tax professionals do not realize that they can now be subject to large fines for nondisclosure of certain activities of their clients. I have authored a few books for the AICPA on these issues. In fact, allowing an item on a client’s tax return turns out to be a listed transaction can be disastrous. This can happen even if the item became listed after the fact, and even if the tax professional never knew that it was listed or abusive. I have spoken at hundreds of conventions about abusive products that clients are buying. Most professionals think that the products are legitimate, or think that they are retirement plans, etc. Without further education, the tax pro can lose his or her career, not to mention being sued.

Lance Wallach speaks and writes about benefit plans, and has authored numerous books for the AICPA, Bisk Total tape, and others. He can be reached at (516) 938-5007 or lawallach@aol.com. For more articles on this or other subjects, feel free to visit his website at www.vebaplan.com.

Lance Wallach, the National Society of Accountants Speaker of the Year, speaks and writes extensively about retirement plans, Circular 230 problems and tax reduction strategies. He speaks at more than 40 conventions annually, writes for over 50 publications, is quoted regularly in the press, and has written numerous best-selling AICPA books, including Avoiding Circular 230 Malpractice Traps and Common Abusive Business Hot Spots. He does extensive expert witness work and has never lost a case. Contact him at 516.938.5007 or visit www.vebaplan.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.