Originally published May 2015
For more than a decade, numerous promoters have touted Section 419 plans as a legitimate way to reduce taxes at the corporate level. These plans have been sold as "welfare benefit trusts" or "death benefit only trusts" for the ostensible purpose of providing non-retirement type benefits to employees. However, in most cases coverage is limited to owners, other key employees and a small number of rank and file employees. In virtually all of these cases, the plans are funded exclusively with cash-value whole life insurance.
The promoters of such arrangements initially justified tax deductions under Section 419A(f)(6) of the Internal Revenue Code, which permits "unrestricted" deductions to so-called multiple employer plans comprised of 10 or more unrelated employers who share risk in a common pool. After the IRS attacked the validity of Section 419A(f)(6) plans for a variety of reasons, most promoters converted those plans into Section 419(e) plans. This section merely defines the term "Welfare Benefit Fund" and does not explicitly authorize any deductions not otherwise authorized elsewhere in the Code.
A robust analysis of the deductibility of contributions to Section 419 plans is far beyond the scope of this article. However, the critical point is that it is the policy of the IRS to attack the legitimacy of deductions taken for contributions to Section 419 plans in all circumstances. In addition, the IRS has classified most Section 419 arrangements as "listed transactions." Any employer who currently sponsors such a plan is well advised to take immediate action to terminate such a plan and seek professional assistance regarding the tax implications of unwinding the arrangement.
Those employers who have had the misfortune of receiving an audit notice from the IRS regarding their Section 419 plan should seek the immediate assistance of a knowledgeable tax professional. Otherwise they will likely face stiff "listed transaction" penalties in addition to the additional tax, interest and customary negligence and failure to pay penalties.
In general terms, listed transactions refer to those transactions that the IRS considers "abusive" and/or "tax shelters" transactions. Under applicable Treasury Regulations, taxpayers who enter into such transactions are required to specially notify the IRS each year by filing Form 8886 with their annual tax return. Those employers who do not file Form 8886 for a particular year are liable for a penalty under Section 6707A of the Code equal to the lesser of $200,000 or 75% of the amount of the decrease in tax occasioned by the listed transaction; this comes with a minimum penalty of $10,000. Individuals may also be liable for a tax equal to the lessor of $100,000 or 75% of the decrease in tax, with a minimum penalty of $5000. It should also be noted that taxpayers may not amend their tax returns to file Form 8886 if one has not been filed with the initial return.
Those sponsors who are under audit by the IRS have reason to despair. The IRS has standardized its position on the issues and there is little "wiggle room" to dispute the automatic disallowance that will be issued by the IRS auditor. However, there is typically room for some negotiation. In cases where the deduction is relatively small and the taxpayer was simply following the instructions of a promoter or tax professional, there is a possibility that the IRS can be convinced not to assert a listed transaction penalty. It is also important to negotiate with the IRS to ensure that the taxpayer will be able to claim any additional income, included as a result of the disallowance, to the taxpayer's tax basis upon distribution of the insurance policy from the plan. Taxpayers who fail to do so face the possibility of double taxation on the benefits.
All taxpayers, whether under audit or not, should take immediate steps to disentangle themselves from the Section 419 arrangement. Most plans will return benefits and/or policies to participating employers or eligible employees upon the employer's withdrawal from participation. However, to the extent a tax deduction was taken for contributions to the plan, the employer or individual will incur taxable income and taxpayers need to plan for this eventuality. Most plan sponsors provide the individual participants the option of taking ownership of any policy held on their lives. Particularly in cases where the individual's health has deteriorated, serious consideration should be given to assuming ownership of the policy.
With the assistance of knowledgeable tax advisers, employers and business owners who participated in Section 419 arrangements can survive the ordeal with minimal cost and disruption to their business.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
