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.
But how do you know that the plan meets these requirements? Though this may seem counter-intuitive, you have to get an actuary to do a series of calculations. When a 412(i) plan is funded with a combination of the cash surrender value of life insurance policies and the value of annuity contracts, it takes an actuary to certify that the amount promised under the terms of the plan and the amount guaranteed by the insurance contracts are equal. The issue is even more complicated if the plan offers insurance policies providing for lump sum payments calculated using actuarial equivalents.
Taxes! Everybody hates them. And as a professional who spent years in school earning your credentials, you have more reasons to hate them than most. You didn’t luck into a six figure salary. Your life was consumed getting there – interminable schooling fueled by endless loans, followed by years of jobs to learn your craft at meager wages. You worked hard to earn a salary to compensate for your hard work only to meet…the tax man, who wants more than a third of what you earn annually and a bigger chunk of your estate one day.
One day when you were complaining about what you pay the government, your cousin Tilly suggested that she knew a life insurance agent who could help you with your taxes. You met with him, you listened to his pitch about a deferred benefit plan, and you asked a lot of questions. He suggested a 412i plan, whatever that is. From the initial description it sounded as if you would have to fund retirement for your rotating staff which you weren’t interested in doing, but he told you that he could arrange an executive carve out. You really didn’t have the income to fund it initially but he convinced you to sell your investment real estate, declare your gain as ordinary income, and then buy the plan to offset that.
You’ve been hearing that the IRS is after “listed transactions” and you’re worried. Suddenly you’re having a tough time having cousin Tilly’s friend return your calls. The insurance company whose products fund your plan has taken your calls, but for the fourth time in as many months a representative has promised to get back to you. Honest he will!
In 2004, Congress enacted Section 6707A of the Internal Revenue Code authorizing the imposition of penalties for failure to provide the IRS information with respect to "reportable transactions."1 The penalties apply not only to taxpayers, but also material advisors (i.e., those that assist taxpayers such as attorneys, accountants, etc.). Penalty amounts for noncompliance can be severe – up to $200,000 as well as criminal prosecution.
In late 2016, the IRS published Notice 2016-66 (Notice), which identified certain micro-captive transactions as "transactions of interest," a type of reportable transactions. Stated simply, micro-captive transactions are a form of self-insurance through a related (or "captive") party. In the Notice, the IRS explained that such transactions have a potential for tax avoidance or evasion. Characterizing micro-captive transactions as transactions of interest triggered the reporting requirement for taxpayers and their material advisors under Section 6707A.
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 these requirements? Though this may seem counter-intuitive, you have to get an actuary to do a series of calculations. When a 412(i) plan is funded with a combination of the cash surrender value of life insurance policies and the value of annuity contracts, it takes an actuary to certify that the amount promised under the terms of the plan and the amount guaranteed by the insurance contracts are equal. The issue is even more complicated if the plan offers insurance policies providing for lump sum payments calculated using actuarial equivalents.
Taxes! Everybody hates them. And as a professional who spent years in school earning your credentials, you have more reasons to hate them than most. You didn’t luck into a six figure salary. Your life was consumed getting there – interminable schooling fueled by endless loans, followed by years of jobs to learn your craft at meager wages. You worked hard to earn a salary to compensate for your hard work only to meet…the tax man, who wants more than a third of what you earn annually and a bigger chunk of your estate one day.
ReplyDeleteOne day when you were complaining about what you pay the government, your cousin Tilly suggested that she knew a life insurance agent who could help you with your taxes. You met with him, you listened to his pitch about a deferred benefit plan, and you asked a lot of questions. He suggested a 412i plan, whatever that is. From the initial description it sounded as if you would have to fund retirement for your rotating staff which you weren’t interested in doing, but he told you that he could arrange an executive carve out. You really didn’t have the income to fund it initially but he convinced you to sell your investment real estate, declare your gain as ordinary income, and then buy the plan to offset that.
You’ve been hearing that the IRS is after “listed transactions” and you’re worried. Suddenly you’re having a tough time having cousin Tilly’s friend return your calls. The insurance company whose products fund your plan has taken your calls, but for the fourth time in as many months a representative has promised to get back to you. Honest he will!
In 2004, Congress enacted Section 6707A of the Internal Revenue Code authorizing the imposition of penalties for failure to provide the IRS information with respect to "reportable transactions."1 The penalties apply not only to taxpayers, but also material advisors (i.e., those that assist taxpayers such as attorneys, accountants, etc.). Penalty amounts for noncompliance can be severe – up to $200,000 as well as criminal prosecution.
ReplyDeleteIn late 2016, the IRS published Notice 2016-66 (Notice), which identified certain micro-captive transactions as "transactions of interest," a type of reportable transactions. Stated simply, micro-captive transactions are a form of self-insurance through a related (or "captive") party. In the Notice, the IRS explained that such transactions have a potential for tax avoidance or evasion. Characterizing micro-captive transactions as transactions of interest triggered the reporting requirement for taxpayers and their material advisors under Section 6707A.