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IRS Audits Focus on Captive Insurance Plans
April 2011 Edition
By Lance Wallach
The IRS started auditing § 419 plans in the 1990s, and then continued going after § 412(i) and
other plans that they considered abusive, listed, or reportable transactions, or substantially
similar to such transactions. If an IRS audit disallows the § 419 plan or the § 412(i) plan, not only
does the taxpayer lose the deduction and pay interest and penalties, but then the IRS comes
back under IRC 6707A and imposes large fines for not properly filing.
Insurance agents, financial planners and even accountants sold many of these plans. The main
motivations for buying into one were large tax deductions. The motivation for the sellers of the
plans was the very large life insurance premiums generated. These plans, which were vetted by
the insurance companies, put lots of insurance on the books. Some of these plans continue to
be sold, even after IRS disallowances and lawsuits against insurance agents, plan promoters
and insurance companies.
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 marketed under the name “Benistar” 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 Benistar
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
Taxpayers and their representatives should be aware that the IRS 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 IRS 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 § 419 and
§ 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 percent 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.
Benistar 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
· 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 Benistar 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 Benistar Plan owned the
Following Curcio, as the Court has stipulated, the Court held that the contributions to Benistar
were not deductible under § 162(a) because participants could receive the value reflected in the
underlying insurance policies purchased by Benistar—despite the payment of benefits by
Benistar seeming to be contingent upon an unanticipated event (the death of the insured while
employed). As long as plan participants were willing to abide by Benistar’s distribution policies,
there was no reason ever to forfeit a policy to the plan. In fact, in estimating life insurance rates,
the taxpayers’ expert in Curcio assumed that there would be no forfeitures, even though he
admitted that an insurance company would generally assume a reasonable rate of policy lapses.
The McGehee Family Clinic had enrolled in the Benistar 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 percent 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.
Other important facts:
· In recent years, some § 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 412(i) 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 Benistar 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 with filing forms, and they still all received very large IRS fines for not
properly filling in the forms.
IRS has targeted all 419 welfare benefit plans, many 412(i) retirement plans, captive insurance
plans with life insurance in them and Section 79 plans.
Lance Wallach, National Society of Accountants Speaker of the Year and member of the
American Institute of CPAs faculty of teaching professionals, is a frequent speaker on retirement
plans, financial and estate planning, and abusive tax shelters. He speaks at more than ten
conventions annually and writes for over fifty publications. 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 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. Mr. Wallach may be reached at 516/938.5007, firstname.lastname@example.org, or at www.
taxaudit419.com or www.lancewallach.com.
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.