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Small business retirement plans fuel litigation
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 - $100,000 per individual and $200,000 per
entity per tax year for each failure to disclose the transaction
- often exceeding the disallowed taxes.
There are business owners who owe $6,000 in taxes but have
been assessed $1.2 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 $1 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
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 appealable 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
$860,000 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.
Last July, in response to a letter from members of Congress,
the IRS put a moratorium on collection of §6707A penalties,
but only in cases where the tax benefits were less than
$100,000 per year for individuals and $200,000 for entities.
That moratorium was recently extended until March 1, 2010.
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: LaWallach@aol.com- 516-
938-5007- or www.vebaplan.com
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Lance Wallach, CLU, ChFC, CIMC, speaks and writes about
benefit plans, tax reductions strategies, and financial plans.
He has authored numerous books for the AICPA, Bisk Total
tape, and others. He can be reached at (516) 938-5007 or
firstname.lastname@example.org. 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 Lance at 516.938.5007 or email@example.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.
Dolan Media News Wire
Small business retirement plans fuel litigation
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