A taxpayer’s contention that obtaining a determination letter with regard to defined benefit pension plan funded with insurance policies (a §412(i) plan) should represent adequate disclosure of a listed transaction was rejected in the case of Soni v. Commissioner, TC Memo 2013-30 (http://www.ustaxcourt.gov/InOpHistoric/SoniMemo.TCM.WPD.pdf).
The taxpayers had established a defined benefit pension plan in their S corporation that was funded with insurance policies. The IRS found the policies purchased were substantially in excess of what was needed to fund the plan and assessed a 30% penalty on the underpayment of tax under §6662A. That penalty relates to understatements that arise from undisclosed listed transactions. The taxpayers had not sought independent actuarial advice about the reasonability of their funding of the plan.
The taxpayers conceded that their arrangement was of the type described in Revenue Ruling 2004-20, which identified such §412(i) defined benefit plan arrangements involving the purchase of excessive life insurance as a listed transaction. The taxpayers also conceded they had not attached a Form 8886 to their individual income tax returns, though one was eventually filed on an amended S corporation return.
The taxpayers had applied for a determination letter from the IRS with regard to the plan and that they had received a favorable letter back from the IRS. The taxpayers argued both that a) the IRS was apprised of the existence of the plan by the determination letter application and b) the taxpayers had reasonably relied upon that letter when preparing the corporate and individual income tax returns in question.
The Court rejected both views. First, the Court pointed out that a determination letter only addresses whether the plan as written meet the requirements under §401(a) to be a qualified plan, but does not address any potential issues that may arise from the operation of the plan.
The funding of the plan’s obligation with specific insurance products is an operational matter not covered by the determination letter. In fact, the letter itself noted that “[c]ontinued qualification of the plan under its present form will depend on its effect in operation.”
The taxpayers noted that the S corporation had (eventually) disclosed the transaction. However, there is an independent requirement for the shareholders to make such a disclosure and the taxpayers failed to do so. They could not attempt to use the separate disclosure made at the corporate level as creating “substantial compliance” with their own individual requirement to disclose.
Advisers must understand the nature and limitation of IRS determination letters as they related to employee benefit plans. Taxpayers looking at a potential major tax benefit may leap to the conclusion that such letters amount to a blessing of the entire arrangement being suggested to them. However such letters are of extremely limited value, and clearly of virtually no value if the question involves whether a proposed §412(i) plan transaction is one that might be seen as being of the type described in Revenue Procedure 2004-20
Publication - Mar-08 IRS 412(i) Audit Initiative: Are All the Plans Bad? The ERISA Audit Report
Defined benefit pension plans funded with annuities and life insurance have been around for a long time. Given an exemption from the normal pension funding rules by Internal Revenue Code section 412(i) (now section 412(e) after the Pension Protection Act), nobody paid them much attention until the late 1990s and early 2000s. Then insurance agents started to market them heavily, and the IRS began to pay attention. In early 2004, it issued several Revenue Rulings and proposed regulations intended to curb what the IRS viewed as “abuses” – that is, plans that did not, in the IRS view, meet the 5 or 6 key requirements for 412(i) plans under the Code – and not long thereafter it started a sweeping audit initiative to eliminate abusive 412(i) plans.
The IRS is currently processing hundreds of these audits. The vast majority of the cases have not been resolved.
It will come as no shock to the benefits community if we say that a number of the plans under audit fail to meet all of the rules under section 412(i). At the same time, it is also fair to say that many of the rules that the IRS is now seeking to enforce weren’t clear when the plans were set up. But what may come as a surprise is that there are many plans that do meet the requirements. Unfortunately, under the audit initiative, these plans are being lumped together with the non-compliant and abusive ones, and the taxpayers are being forced to spend significant sums defending their retirement funds.
We are currently handling the audits of a number of these plans. We discuss two examples below, but first let’s look at the background.
Background If a plan meets the requirements of section 412(i), the deductible contribution to the plan equals the premiums on the insurance contracts used to fund the benefits. You don’t need an actuary to calculate the funding contributions. To be a valid 412(i) plan, the law requires, among other things, that the benefit promised at normal retirement age under the plan be equal to the benefit provided under the insurance contracts used to fund the plan and guaranteed by a domestic insurance carrier. It also requires, according to the IRS position developed during the audit process, that every form of benefit provided for in the insurance contracts (i.e., life annuities, joint and survivor annuities, period certain annuities, lump sum benefits) is equivalent to every form offered as an option in the plan. And finally, there is a requirement that the death benefit provided by the plan be no greater than an “incidental” limit as permitted under IRS guidance.
A taxpayer’s contention that obtaining a determination letter with regard to defined benefit pension plan funded with insurance policies (a §412(i) plan) should represent adequate disclosure of a listed transaction was rejected in the case of Soni v. Commissioner, TC Memo 2013-30 (http://www.ustaxcourt.gov/InOpHistoric/SoniMemo.TCM.WPD.pdf).
ReplyDeleteThe taxpayers had established a defined benefit pension plan in their S corporation that was funded with insurance policies. The IRS found the policies purchased were substantially in excess of what was needed to fund the plan and assessed a 30% penalty on the underpayment of tax under §6662A. That penalty relates to understatements that arise from undisclosed listed transactions. The taxpayers had not sought independent actuarial advice about the reasonability of their funding of the plan.
The taxpayers conceded that their arrangement was of the type described in Revenue Ruling 2004-20, which identified such §412(i) defined benefit plan arrangements involving the purchase of excessive life insurance as a listed transaction. The taxpayers also conceded they had not attached a Form 8886 to their individual income tax returns, though one was eventually filed on an amended S corporation return.
The taxpayers had applied for a determination letter from the IRS with regard to the plan and that they had received a favorable letter back from the IRS. The taxpayers argued both that a) the IRS was apprised of the existence of the plan by the determination letter application and b) the taxpayers had reasonably relied upon that letter when preparing the corporate and individual income tax returns in question.
The Court rejected both views. First, the Court pointed out that a determination letter only addresses whether the plan as written meet the requirements under §401(a) to be a qualified plan, but does not address any potential issues that may arise from the operation of the plan.
The funding of the plan’s obligation with specific insurance products is an operational matter not covered by the determination letter. In fact, the letter itself noted that “[c]ontinued qualification of the plan under its present form will depend on its effect in operation.”
The taxpayers noted that the S corporation had (eventually) disclosed the transaction. However, there is an independent requirement for the shareholders to make such a disclosure and the taxpayers failed to do so. They could not attempt to use the separate disclosure made at the corporate level as creating “substantial compliance” with their own individual requirement to disclose.
Advisers must understand the nature and limitation of IRS determination letters as they related to employee benefit plans. Taxpayers looking at a potential major tax benefit may leap to the conclusion that such letters amount to a blessing of the entire arrangement being suggested to them. However such letters are of extremely limited value, and clearly of virtually no value if the question involves whether a proposed §412(i) plan transaction is one that might be seen as being of the type described in Revenue Procedure 2004-20
Publication - Mar-08
ReplyDeleteIRS 412(i) Audit Initiative: Are All the Plans Bad?
The ERISA Audit Report
Defined benefit pension plans funded with annuities and life insurance have been around for a long time. Given an exemption from the normal pension funding rules by Internal Revenue Code section 412(i) (now section 412(e) after the Pension Protection Act), nobody paid them much attention until the late 1990s and early 2000s. Then insurance agents started to market them heavily, and the IRS began to pay attention. In early 2004, it issued several Revenue Rulings and proposed regulations intended to curb what the IRS viewed as “abuses” – that is, plans that did not, in the IRS view, meet the 5 or 6 key requirements for 412(i) plans under the Code – and not long thereafter it started a sweeping audit initiative to eliminate abusive 412(i) plans.
The IRS is currently processing hundreds of these audits. The vast majority of the cases have not been resolved.
It will come as no shock to the benefits community if we say that a number of the plans under audit fail to meet all of the rules under section 412(i). At the same time, it is also fair to say that many of the rules that the IRS is now seeking to enforce weren’t clear when the plans were set up. But what may come as a surprise is that there are many plans that do meet the requirements. Unfortunately, under the audit initiative, these plans are being lumped together with the non-compliant and abusive ones, and the taxpayers are being forced to spend significant sums defending their retirement funds.
We are currently handling the audits of a number of these plans. We discuss two examples below, but first let’s look at the background.
Background
If a plan meets the requirements of section 412(i), the deductible contribution to the plan equals the premiums on the insurance contracts used to fund the benefits. You don’t need an actuary to calculate the funding contributions. To be a valid 412(i) plan, the law requires, among other things, that the benefit promised at normal retirement age under the plan be equal to the benefit provided under the insurance contracts used to fund the plan and guaranteed by a domestic insurance carrier. It also requires, according to the IRS position developed during the audit process, that every form of benefit provided for in the insurance contracts (i.e., life annuities, joint and survivor annuities, period certain annuities, lump sum benefits) is equivalent to every form offered as an option in the plan. And finally, there is a requirement that the death benefit provided by the plan be no greater than an “incidental” limit as permitted under IRS guidance.
But how do you know that the plan meets th