Section 79, captive insurance, 412i, 419, audits, problems and lawsuits

---

April 24, 2012     By Lance Wallach, CLU, CHFC

---

Captive insurance, section 79, 419 and 412i problems

WebCPA


The dangers of being "listed"
A warning for 419, 412i, Sec.79 and captive insurance

Accounting Today: October 25,
By: Lance Wallach

Taxpayers who previously adopted 419, 412i, captive insurance or Section 79 plans are in
big trouble.

In recent years, the IRS has identified many of these arrangements as abusive devices to
funnel tax deductible dollars to shareholders and classified these arrangements as "listed
transactions."

These plans were sold by insurance agents, financial planners, accountants and attorneys
seeking large life insurance commissions. In general, taxpayers who engage in a "listed
transaction" must report such transaction to the IRS on Form 8886 every year that they
"participate" in the transaction, and you do not necessarily have to make a contribution or
claim a tax deduction to participate. Section 6707A of the Code imposes severe penalties
($200,000 for a business and $100,000 for an individual) for failure to file Form 8886 with
respect to a listed transaction.

But you are also in trouble if you file incorrectly.

I have received numerous phone calls from business owners who filed and still got fined. Not
only do you have to file Form 8886, but it has to be prepared correctly. I only know of two
people in the United States who have filed these forms properly for clients. They tell me that
was after hundreds of hours of research and over fifty phones calls to various IRS
personnel.

The filing instructions for Form 8886 presume a timely filing. Most people file late and follow
the directions for currently preparing the forms. Then the IRS fines the business owner. The
tax court does not have jurisdiction to abate or lower such penalties imposed by the IRS.
Many business owners adopted 412i, 419, captive insurance and Section 79 plans based
upon representations provided by insurance professionals that the plans were legitimate
plans and were not informed that they were engaging in a listed transaction.
Upon audit, these taxpayers were shocked when the IRS asserted penalties under Section
6707A of the Code in the hundreds of thousands of dollars. Numerous complaints from
these taxpayers caused Congress to impose a moratorium on assessment of Section 6707A
penalties.

The moratorium on IRS fines expired on June 1, 2010. The IRS immediately started sending
out notices proposing the imposition of Section 6707A penalties along with requests for
lengthy extensions of the Statute of Limitations for the purpose of assessing tax. Many of
these taxpayers stopped taking deductions for contributions to these plans years ago, and
are confused and upset by the IRS's inquiry, especially when the taxpayer had previously
reached a monetary settlement with the IRS regarding its deductions. Logic and common
sense dictate that a penalty should not apply if the taxpayer no longer benefits from the
arrangement.

Treas. Reg. Sec. 1.6011-4(c)(3)(i) provides that a taxpayer has participated in a listed
transaction if the taxpayer's tax return reflects tax consequences or a tax strategy described
in the published guidance identifying the transaction as a listed transaction or a transaction
that is the same or substantially similar to a listed transaction. Clearly, the primary benefit in
the participation of these plans is the large tax deduction generated by such participation. It
follows that taxpayers who no longer enjoy the benefit of those large deductions are no
longer "participating ' in the listed transaction. But that is not the end of the story.
Many taxpayers who are no longer taking current tax deductions for these plans continue to
enjoy the benefit of previous tax deductions by continuing the deferral of income from
contributions and deductions taken in prior years. While the regulations do not expand on
what constitutes "reflecting the tax consequences of the strategy", it could be argued that
continued benefit from a tax deferral for a previous tax deduction is within the contemplation
of a "tax consequence" of the plan strategy. Also, many taxpayers who no longer make
contributions or claim tax deductions continue to pay administrative fees. Sometimes,
money is taken from the plan to pay premiums to keep life insurance policies in force. In
these ways, it could be argued that these taxpayers are still "contributing", and thus still
must file Form 8886.

It is clear that the extent to which a taxpayer benefits from the transaction depends on the
purpose of a particular transaction as described in the published guidance that caused such
transaction to be a listed transaction. Revenue Ruling 2004-20 which classifies 419(e)
transactions, appears to be concerned with the employer's contribution/deduction amount
rather than the continued deferral of the income in previous years. This language may
provide the taxpayer with a solid argument in the event of an audit. 

IRS Audits 419, 412i, Captive Insurance Plans With Life Insurance, and Section 79 Scams

IRS Audits 419, 412i, Captive Insurance Plans With Life Insurance, and Section 79 Scams

By Lance Wallach                                                                                          June 2011

The IRS started auditing 419 plans in the ‘90s, and then continued going after 412i and other plans that they considered abusive, listed, or reportable transactions, or substantially similar to such transactions.

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 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 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 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, one must have an understanding of 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 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, 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.

The 419 plan 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 419 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 419 Plan owned the insurance contracts.

The McGehee Family Clinic had enrolled in the 419 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% 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 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 412i 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 419 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 file forms, and they still all received very large IRS fines for not properly filling in the forms.

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.