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Negative IRS Notices On 419 And VEBA Plans.

By Roccy M. DeFrancesco, JD, CWPP™, CAPP™ - Email Editor

Date :01-Nov-2007

We debated whether this subject merited space in a Trustmaker's newsletter and came to the conclusion that it did for a few reasons:

1) If you are a small business owner and have a 419 or VEBA Plan, you need to know about the IRS's new actions;

2) If you are an advisor and have small business clients, you need to know about the IRS's new actions;

3) As this is an educational newsletter, there is a lot that can be attained by learning what the IRS did to kill an otherwise allowable tax-planning tool even when it can't move congress to pass new laws to do so.


History of 419 and VEBA Welfare Benefit Plans (hereinafter 419 plans)
419 plans have been around for many years. After some time, clever promoters figured out how to twist the tax code into what affectively became a nice income tax reduction/wealth building tool for small business owners.

In essence, the plans were set up where an employer would make a 100% tax deductible contribution to a 419 trust (in the old days multiple employer) where the main benefit provided to the employees was a large death benefit. Employers implemented the plans because of the tax deduction, because if set up correctly, the death benefit would pass income and estate tax free to the beneficiaries, and because the plans could ultimately be terminated (or the employer from a plan) at which time the life insurance policy, which was usually stocked with significant cash, would come out to the owner/employer as an individual. With conservative plans, the employer would pay tax on the fair market value of the life policy upon termination (usually the cash surrender value of the policy) and then would borrow "tax-free" from the life insurance policy in retirement.

In essence the plans were used as quasi-deferred compensation plans that were significantly slanted towards the owner/employee.

The IRS was forced to curb the use of 419 plans due to the many abuses that were occurring around the country. Therefore, in 2002, the IRS talked congress into passing new laws basically killing the use of multiple employer 419 plans. FYI, this topic was one of the darling topics of the life insurance industry as life agents routinely sold large life insurance policies where the commissions could easily be in excess of $100,000 per case.

The phoenix rises as many in the life insurance industry were licking their wounds over the loss of this concept, some TPAs (third party administrators) found that they could use single employer VEBAs and 419(e) plans because Congress forgot to include them when they passed the negative laws essentially shutting down multiple employer plans.

As you may have imagined, those same TPAs that abused multiple employer plans also abused single employer plans. What did that force the IRS to do? Issue two chilling notices and one Revenue Ruling that for all intents and purposes killed the viability of the plans again (except for the funding of post-retirement medical expenses which are a tremendous benefit to many owners of small businesses).

The IRS came out with Notices (2007-83 and 2007-84) and Rev. Ruling (2007-65). To read the notices, please click here.

The IRS made one thing clear in its notices: If a 419 plan is funded with cash value life insurance to provide the benefits offered by the plan, NO deduction is allowed by the employer, AND the plan is now officially on the listed tax transaction list (requiring clients to file form 8886 telling the IRS the client made a contribution to a listed tax transaction).

I am currently working on a formal summary that will hopefully be done in the next few weeks. If you would like the summary, please e-mail us at info@trustmakers.com and we will e-mail it to you when it comes out.

I've had many e-mails and calls asking me to interpret the new IRS guidance and how it affects clients in plans and who were once thinking of implementing plans. In an effort to make this newsletter as practical as possible, I'm just going to list the frequently asked questions that I've been getting over the last week about the affects of the new IRS guidance.

Questions and Answers

Question: Are the IRS Notices and Rev. Ruling binding or as good as statutory law or case law?

Answer: Notices and Rev. Rulings are not binding when, and if, a client ultimately gets into a court of law.

Question: Can a business make a tax deductible contribution to a 419 or VEBA plan if the trust uses the money to buy cash value life insurance?

Answer: This is really the million-dollar question. The IRS guidance is clear that no deduction, in the IRS's opinion, is available for contributions used to pay premiums for death benefits provided under the plan. It is not clear if cash value life insurance can be used if the client ONLY takes a deduction for other allowable expenses such as post-retirement benefits (so the expenses allocated towards the cost of insurance for the death benefit would not be deductible). Most think this can be done (although it won't make much financial sense)

Question: Can an employer carve-out and only offer benefits to key employees?

Answer: Under the new IRS guidance the answer is absolutely not. You must include all eligible employees.

Question: If commentators believe the IRS guidance is faulty, then must the guidance be followed?

Answer: Technically speaking the answer is no. Having said that, you run a big risk by not following the notices and Rev. Ruling.

Question: Are all 419/VEBA plans now listed tax transactions?

Answer: No. It seems that only plans that use cash value life insurance have been added to the listed tax transaction list.

Question: If I were to sell a 419e or single employer VEBA today, how would I sell it? (This was my most popular question.)

Answer: I would only be selling 419 Plans for pre- and post-retirement medical benefits.

Question: Would I sell cash value life insurance to fund the plans?

Answer: No, but I would use annuity only VEBAs to fund for post-retirement medical benefits (that can be funded in a tax deductible manner where the benefits are tax free). For more information on annuity only VEBAs, e-mail info@trustmakers.com

Question: What do you do if you or your clients are in 419/VEBA plans and they have cash value life insurance in them?

Answer: In my opinion you can do the following:

1) Keep the status quo and continue to have clients contribute based on the fact that you believe, if they get audited and lose, that on appeal a tax court will find in the client's favor

2) Freeze the plan and make no further contributions

3) Terminate the plan and have the vested benefits come out to the employees. This will most likely result in a cash value life policy coming out to the owner/employee who will then have to pay income taxes on the fair market value of the policy

No matter what you do, you need to counsel your clients to file their form 8886 to tell the IRS the client is in a listed tax transaction.

What would I do? I'd either freeze the plan or terminate depending on how long the plan has been in place. This would start the statute of limitations on the audit, and I'd hope that an audit doesn't happen any time soon.

Summary

The new guidance from the IRS on 419/VEBA plans is not good for anyone. Much of the guidance is not based on anything reasonable such as the tax code or prior case law. It's like the IRS said to themselves, "We know we don't have much to go on to kill the use of these plans, but if we throw out several scary Notices and a Rev. Ruling, the chilling affect should be similar to if we had the power to pass similar laws."

The non-compliant plans forced the IRS to act and have temporarily killed the use of 419/VEBA plans for death benefit planning. They are still viable to fund pre- and post-retirement medical benefits, but that will not create significant enough commissions for many agents who I imagine will stop selling these plans.

As for alternative tax deductible plans, I think for some Captive Insurance Companies (CIC) will be a viable alternative, and I'll be doing some more education on CICs in the near future. If you would like information on CICs, contact info@trustmakers.com

Roccy M. DeFrancesco, JD, CWPP, CAPP

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ABOUT THIS EDITOR:

Roccy DeFrancesco, JD, CWPP, CAPP, MMB - Author and lecturer, Roccy specializes in advanced estate and asset protection planning. Roccy's passion is to teach advisors how to implement lawful strategies that will hold up for the test of time.

Full Bio - Email Roccy