Small businesses facing audits and potentially huge tax penalties over certain types of retirement plans are filing lawsuits against those who marketed, designed and sold the plans. The 412(i) and 419(e) plans were marketed in the past several years as a way for small business owners to set up retirement or welfare benefits plans while leveraging huge tax savings, but the IRS put them on a list of abusive tax shelters and has more recently focused audits on them.
The penalties for such transactions are extremely high and can pile up quickly.
There are business owners who owe taxes but have been assessed 2 million in penalties. The existing cases involve many types of businesses, including doctors’ offices, dental practices, grocery store owners, mortgage companies and restaurant owners. Some are trying to negotiate with the IRS. Others are not waiting. A class action has been filed and cases in several states are ongoing. The business owners claim that they were targeted by insurance companies; and their agents to purchase the plans without any disclosure that the IRS viewed the plans as abusive tax shelters. Other defendants include financial advisors who recommended the plans, accountants who failed to fill out required tax forms and law firms that drafted opinion letters legitimizing the plans, which were used as marketing tools.
A 412(i) plan is a form of defined benefit pension plan. A 419(e) plan is a similar type of health and benefits plan. Typically, these were sold to small, privately held businesses with fewer than 20 employees and several million dollars in gross revenues. What distinguished a legitimate plan from the plans at issue were the life insurance policies used to fund them. The employer would make large cash contributions in the form of insurance premiums, deducting the entire amounts. The insurance policy was designed to have a “springing cash value,” meaning that for the first 5-7 years it would have a near-zero cash value, and then spring up in value.
Just before it sprung, the owner would purchase the policy from the trust at the low cash value, thus making a tax-free transaction. After the cash value shot up, the owner could take tax-free loans against it. Meanwhile, the insurance agents collected exorbitant commissions on the premiums – 80 to 110 percent of the first year’s premium, which could exceed million.
Technically, the IRS’s problems with the plans were that the “springing cash” structure disqualified them from being 412(i) plans and that the premiums, which dwarfed any payout to a beneficiary, violated incidental death benefit rules.
Under §6707A of the Internal Revenue Code, once the IRS flags something as an abusive tax shelter, or “listed transaction,” penalties are imposed per year for each failure to disclose it. Another allegation is that businesses weren’t told that they had to file Form 8886, which discloses a listed transaction.
According to Lance Wallach of Plainview, N.Y. (516-938-5007), who testifies as an expert in cases involving the plans, the vast majority of accountants either did not file the forms for their clients or did not fill them out correctly.
Because the IRS did not begin to focus audits on these types of plans until some years after they became listed transactions, the penalties have already stacked up by the time of the audits.
Another reason plaintiffs are going to court is that there are few alternatives – the penalties are not appeasable and must be paid before filing an administrative claim for a refund.
The suits allege misrepresentation, fraud and other consumer claims. “In street language, they lied,” said Peter Losavio, a plaintiffs’ attorney in Baton Rouge, La., who is investigating several cases. So far they have had mixed results. Losavio said that the strength of an individual case would depend on the disclosures made and what the sellers knew or should have known about the risks.
In 2004, the IRS issued notices and revenue rulings indicating that the plans were listed transactions. But plaintiffs’ lawyers allege that there were earlier signs that the plans ran afoul of the tax laws, evidenced by the fact that the IRS is auditing plans that existed before 2004.
“Insurance companies were aware this was dancing a tightrope,” said William Noll, a tax attorney in Malvern, Pa. “These plans were being scrutinized by the IRS at the same time they were being promoted, but there wasn’t any disclosure of the scrutiny to unwitting customers.”
A defense attorney, who represents benefits professionals in pending lawsuits, said the main defense is that the plans complied with the regulations at the time and that “nobody can predict the future.”
An employee benefits attorney who has settled several cases against insurance companies, said that although the lost tax benefit is not recoverable, other damages include the hefty commissions – which in one of his cases amounted to 400,000 the first year – as well as the costs of handling the audit and filing amended tax returns.
Defying the individualized approach an attorney filed a class action in federal court against four insurance companies claiming that they were aware that since the 1980s the IRS had been calling the policies potentially abusive and that in 2002 the IRS gave lectures calling the plans not just abusive but “criminal.” A judge dismissed the case against one of the insurers that sold 412(i) plans.
The court said that the plaintiffs failed to show the statements made by the insurance companies were fraudulent at the time they were made, because IRS statements prior to the revenue rulings indicated that the agency may or may not take the position that the plans were abusive. The attorney, whose suit also names law firm for its opinion letters approving the plans, will appeal the dismissal to the 5th Circuit.
In a case that survived a similar motion to dismiss, a small business owner is suing Hartford Insurance to recover a “seven-figure” sum in penalties and fees paid to the IRS. A trial is expected in August.
But tax experts say the audits and penalties continue. “There’s a bit of a disconnect between what members of Congress thought they meant by suspending collection and what is happening in practice. Clients are still getting bills and threats of liens,” Wallach said. “Thousands of business owners are being hit with million-dollar-plus fines. … The audits are continuing and escalating. I just got four calls today,” he said. A bill has been introduced in Congress to make the penalties less draconian, but nobody is expecting a magic bullet.
“From what we know, Congress is looking to make the penalties more proportionate to the tax benefit received instead of a fixed amount.”
Lance Wallach can be reached at: WallachInc@gmail.com
For more information, please visit www.taxadvisorexperts.org Lance Wallach, National Society of Accountants Speaker of the Year and member of the AICPA faculty of teaching professionals, is a frequent speaker on retirement plans, abusive tax shelters, financial, international tax, and estate planning. He writes about 412(i), 419, Section79, FBAR, and captive insurance plans. He speaks at more than ten conventions annually, writes for over fifty publications, is quoted regularly in the press and has been featured on television and radio financial talk shows including NBC, National Pubic Radio’s All Things Considered, and others. 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 the 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. Contact him at 516.938.5007, wallachinc@gmail.com or visit www.taxadvisorexperts.com.
Lance
Wallach
68 Keswick Lane
Plainview, NY 11803
Ph.: (516)938-5007
Fax: (516)938-6330 www.vebaplan.com
National Society of Accountants Speaker of The Year
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.
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Buyer Beware!
Captive Insurance and
Other Tax Reduction Strategies
– The Good, Bad, and The Ugly
By Lance Wallach
Over the past decade business owners have been
overwhelmed by a plethora of choices designed to reduce the cost of
providing employee benefits while increasing their own retirement
savings. The solutions ranged from traditional pension and profit
sharing plans to more advanced strategies.
Some strategies,
such as IRS section 419 and 412(i) plans, used life insurance as
vehicles to bring about benefits. Unfortunately, the high life insurance
commissions (often 90% of the contribution, or more) fostered an
environment that led to aggressive and non compliant plans.
The
result has been thousands of audits and an IRS task force seeking out
tax shelter promotion. For unknowing clients, the tax consequences are
enormous. For their accountant advisers, the liability may be equally
extreme.
Recently, there has been an explosion in the marketing
of a financial product called Captive Insurance. These so called
“Captives” are typically small insurance companies designed to insure
the risks of an individual business under IRS code section 831(b). When
properly designed, a business can make tax-deductible premium payments
to a related-party insurance company. Depending on circumstances,
underwriting profits, if any, can be paid out to the owners as
dividends, and profits from liquidation of the company may be taxed as
capital gains.
While captives can be a great cost saving tool,
they also are expensive to build and manage. Also, captives are allowed
to garner tax benefits because they operate as real insurance companies.
Advisors and business owners who misuse captives or market them as
estate planning tools, asset protection vehicles, tax deferral or other
benefits not related to the true business purpose of an insurance
company face grave regulatory and tax consequences.
A recent
concern is the integration of small captives with life insurance
policies. Small captives under section 831(b) have no statutory
authority to deduct life premiums. Also, if a small captive uses life
insurance as an investment, the cash value of the life policy can be
taxable at corporate rates, and then will be taxable again when
distributed. The consequence of this double
taxation is to devastate the efficacy of the life insurance, and it
extends serious liability to any accountant who recommends the plan or
even signs the tax return of the business that pays premiums to the
captive.
The IRS is aware that
several large insurance companies are promoting their life insurance
policies as investments with small captives. The outcome looks eerily
like that of the 419 and 412(i) plans mentioned above.
Remember,
if something looks too good to be true, it usually is. There are safe
and conservative ways to use captive insurance structures to lower costs
and obtain benefits for businesses. And, some types of captive
insurance products do have statutory protection for deducting life
insurance premiums (although not 831(b) captives). Learning what works
and is safe is the first step an accountant should take in helping his
or her clients use these powerful, but highly technical insurance
tools.
Lance
Wallach speaks and writes extensively about VEBAs, retirement plans,
and tax reduction strategies. He speaks at more
than 70 conventions annually, writes for 50 publications, and was the
National Society of Accountants Speaker of the Year. 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.
Accounting Today
Financial Planning
Using Captive Insurance Companies for Savings
Small
companies have been copying a method to control insurance costs and
reduce taxes that used to be the domain of large businesses: setting up
their own insurance companies to provide coverage when they think that
outside insurers are charging too much.
Often,
they are starting what is called a “captive insurance company” – an
insurer founded to write coverage for the company, companies or
founders.
Here’s how captive insurers work.
The
parent business (your company) creates a captive so that it has a
self-funded option for buying insurance, whereby the parent provides the
reserves to back the policies. The captive then either retains that
risk or pays re-insures to take it. The price for coverage is set by the
parent business; reinsurance costs, if any, are a factor.
In
the event of a loss, the business pays claims from its captive, or the re-insurer pays the captive.
Captives
are overseen by corporate boards and, to keep costs low, are often
based in places where there is favorable tax treatment and less onerous
regulation – such as
Captives
have become very popular risk financing tools that provide maximum
flexibility to any risk financing program. And the additional
possibility of adding several types of employee benefits is of further
strategic value to the owners of captives.
While
the employee benefit aspects have not emerged as quickly as had been
predicted, there is little doubt that widespread use of captives for
employee benefits is just a matter of time. While coverages like long
term disability and term life insurance typically require Department of
Labor approval, other benefit-related coverages such as medical stop
loss can utilize a captive without the department’s approval.
Additionally, some midsized corporate owners also view a captive as an
integral part of their asset protection and wealth accumulation plans.
The opportunities offered by a captive play a critical role in the
strategic planning of many corporations.
A
captive insurance company would be an insurance subsidiary that is
owned by its parent business (es). There are now nearly 5,000 captive
insurers worldwide. Over 80 percent of Fortune 500 Companies take
advantage of some sort of captive insurance company arrangement. Now
small companies can also.
By
sharing a large captive, participants are insured under group policies,
which provide for insurance coverage that recognizes superior claims
experience in the form of experience-rated refunds of premiums, and
other profit-sharing options made available to the insured.
A
true captive insurance arrangement is where a parent company or some
companies in the same economic family (related parties), pay a
subsidiary or another member of the family, established as a licensed
type of insurance company, premiums that cover the parent company.
In
theory, underwriting profits from the subsidiary are retained by the
parent. Single-parent captives allow an organization to cover any risk
they wish to fund, and generally eliminate the commission-price
component from the premiums. Jurisdictions in the
Try Sharing
There
are a number of significant advantages that may be obtained through
sharing a large captive with other companies. The most important is that
you can significantly decrease the cost of insurance through this
arrangement.
The
second advantage is that sharing a captive does not require any capital
commitment and has very low policy fees. The policy application process
is similar to that of any commercial insurance company, is relatively
straightforward, and aside from an independent actuarial and
underwriting review, bears no additional charges.
By
sharing a captive, you only pay a pro rate fee to cover all general and
administrative expenses. The cost for administration is very low per
insured (historically under 60 basis points annually). By sharing a
large captive, loans to its insureds (your company) can be legally made.
So you can make a tax deductible contribution, and then take back money
tax free. Sharing a large captive requires little or no maintenance by
the insured and can be implemented in a fraction of the time required
for stand alone captives.
If
done correctly, sharing a large captive can yield a small company
significant tax and cost savings.
If
done incorrectly, the results can be disastrous.
Buyer Beware
Stand alone captives are also likely to draw IRS attention. Another advantage of sharing a captive is that IRS problems are less likely if that path is followed, and they can be entirely eliminated as even a possibility by following the technique of renting a captive, which would involve no ownership interest in the captive on the part of the insured. (your company).
Lance Wallach speaks and writes extensively about retirement plans, estate planning and tax reduction strategies. Reach him at (516) 938-5007 or wwwtaxaudit419.com for expert assistance with tax reduction strategies.
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.