There are a few things that the practitioner should know about how the IRS conducts audits of Section 412(i) defined benefit retirement plans. NOTE: the author is aware of the fact that this denomination is not technically correct. These plans are now technically called Section 412(e)(3) plans. However, as a practical matter, the majority of practitioners and others, still refer to them as 412(i) plans. In deference to that, they will be referred to in that manner here. More a little later on (i) somehow becoming (e)(3).
Whatever you want to call them, these defined benefit plans are quite popular, despite extensive regulation by the Service. They tend to be funded by life insurance, annuities, or a combination thereof, and they often allow participating employers to realize substantial tax deductions, which accounts in large part for their popularity among business owners.
In auditing these plans, Service personnel have often discovered discrimination in favor of owners and key, highly compensated employees. There is also the general feeling that claimed tax relief is disproportionate to the economic realities of the transactions.
In conducting Section 412 audits, auditors have essentially divided the plans into two categories. First are the plans that are substantially in compliance, to varying degrees, as many auditors were initially surprised to discover, having apparently initially had the mindset that all of these plans were tax avoidance schemes of varying levels of sophistication. That proved not to be the case, as many of these plans are at least in substantial compliance with the tax laws. The Service refers to these plans as “merely non-compliant”.
The second category would be those plans that the Service regards as “abusive”. the service demand in the case of these plans is generally that the plan be revoked. This, of course, would entail back taxes, interest, and penalties being assessed against the plan sponsor. The treatment of non-compliant plans, often featuring only technical violations, is considerably less severe.
But neither category is particularly well defined, which makes it unpredictable how the Service will proceed in a given situation. Some factors, however, if present, greatly increase the chances of being regarded as abusive. These include, but are not limited to, insurance policies with “springing cash values”, manipulation of life insurance coverage by means of questionable “firings” and/or the use of sham, bogus entities, often on a multiple basis, and, not surprisingly, the type of discrimination in favor of owners and key, highly compensated employees previously alluded to.
You are in for a special degree of difficulty should the plan in question be regarded as a “listed transaction”. A taxpayer, corporate or otherwise, who has engaged in such a transaction must disclose such participation by means of a form attached to the tax return, which many feel is likely to trigger an audit. But if you fail to disclose, you are almost automatically liable for severe penalties simply for failing to disclose, penalties which are not subject to appeal and which the Tax Court lacks jurisdiction to overturn or even to reduce.
What alternatives are available to the plan sponsor of a plan that is merely non-compliant? There are essentially two of them. The first is quite unattractive. It entails, basically, treating the plan as if it never existed, and of course triggers, to the fullest extent possible, back taxes, penalties, and interest on all contributions that were made, not to mention leaving behind no pension plan whatsoever. This is exactly how abusive plans are treated, as the reader may be thinking. But there is a much better alternative.
This other alternative is to convert to a traditional defined benefit pension plan. This is possible because it is permissible to change the benefit formula and other terms, so long as no participant’s benefits are reduced. However, to the extent that funding amounts are lower under the converted plan, back taxes, interest, and penalties will be triggered. The penalty will be 25 percent of the tax amount, and a ten percent excise tax will also be imposed. Finally, there will be a totally separate monetary sanction, based on the underlying facts and circumstances. This is to be negotiated directly with the Service. Nothing more than the obvious can really be said about this. An experienced, competent negotiator should be hired for this purpose.
What, if anything, can be done to salvage something when a plan has been deemed “abusive”? The answer seems to be not much. The option of converting to a traditional defined benefit plan is available, and even then probably only after extensive negotiating, only if the restructured plan is “beneficial” to rank and file employees. The precise problem, at present, is that the term “beneficial”, in this context, lacks a precise definition.
Recent History of IRS Audits
The Service has been aggressively auditing these plans since at least 2004. At first, the IRS perceived widespread abuses in these plans, particularly among smaller companies. The audits, somewhat surprisingly, failed to uncover the level of abuse and/or fraud that had been thought to exist. But those plans found to be ouit of compliance have sustained back taxes, interest, and penalties, often in considerable amounts.
The audits have tended to focus on smaller plans. And, for some reason, the Service has been inordinately interested in those plans funded with a high percentage of life insurance, as opposed to annuities or some combination of life insurance and annuities. Prominent on the radar screen are plans featuring life insurance with high premium costs over a fixed number of years, particularly where there is evidence of the transfer of these policies at some point to key, highly compensated employees, a sure sign of discrimination, always likely to result in audit activity.
On February 13, 2004 , specific guidance was finally issued, at least in the areas of discrimination and the deductibility of insurance premiums. Certain plans made the IRS list of abusive tax transactions. These are also known as listed transactions, of course, and, as previously noted, failure to disclose participation in them leads to severe penalties that the Service cannot waive and which the Tax Court lacks jurisdiction to overturn or reduce. The court, in its own decisions, had admitted that it lacks such jurisdiction. And all of this also extends to advisor professionals. “Material advisors” to these plans, as they are called, must maintain certain records and turn them over to the IRS upon demand. More critically, they must disclose their participation and involvement in these transactions by means of completely, accurately, and correctly filling out a form. Should they either completely fail to file or file incorrectly, they can expect penalties for nondisclosure of $100,000 for individuals and $200,000 for corporations, which can add up, obviously, to $300,000.
In late 2005, plan sponsors of listed transactions were invited by the IRS to participate in a settlement program, which involved essentially acting as if the plans never existed, paying the income taxes that would have been due and owing had the plan never been adopted (and therefore no tax deductions had been claimed), together with interest. At about the same time, the systematic auditing of these plans was commenced, and it continues to this day.
What does the Service consider most important in these audits? Compliance with nondiscrimination rules appears to be a critical inquiry, as does compliance by the plan sponsor with applicable deduction limits. Another question that is of critical importance : is the plan sponsor actually doing what it purports in its written documentation to do? After all, even in the event that the plan document complies with current law, the plan must still actually be operated according to its terms.
Beginning in 2008, the Pension Protection Act moved the Internal Revenue Code section for “insurance contract plans” (as 412(i) plans are also known) to IRC Section 412(e)(3). As previously noted, however, this has never really caught on, even with professionals in this area. The term 412(i( plan remains in widespread use, which is why the author has been referring to these plans by that name in this chapter.
As previously noted, these plans are also sometimes referred to as insurance contract plans. Whatever you choose to call them, one of their most attractive aspects is that the often substantial investment risk of guaranteeing all plan benefits falls not upon the trustee of the plan, but upon the often deeper pockets and generally more substantial presence of an insurance carrier.
Should You Be Licensed To Sell Life Insurance?
Should you become licenses to sell life insurance, mutual funds, and other products? Many CPAs think that they will earn a large additional income by selling life insurance and other products. This usually does not happen. After they have sold products to some of their clients, their sales usually stop. What many do not realize at this point is that they still have to maintain errors and omissions insurance.
The CPA needs to fulfill his or her continuing education requirements, which are becoming more time consuming, and their clients need to remain happy with the product. Most insurance salespeople leave the business within three years, due to lack of income. Almost all successful insurance salespeople are outgoing and aggressive. Many CPAs are not. Most insurance salespeople receive years of training. This is not just product training. Some of the training is sales training. Most CPAs spend substantially all of their time doing their jobs.
Almost all CPAs have the best interests of their clients as their first consideration.. Many of them think that they will be good at helping their clients select an insurance or investment product. This may be true in many instances, and with proper training, which takes a lot of time, a CPA can gain product knowledge. What takes a lot of time and certain skills and training is to develop the ability to sell things that people do not think that they want, like life insurance. Selling investments is easier, but many clients develop selective memory failure. If the investment makes money, it was their idea, but if the investment does not do well, some clients may be reluctant to take the blame. The CPA who sold the product may beblamed. Not only can that result in a lawsuit, but a valuable client is lost. In the rush to become insurance licenses, the problems discussed in the last two paragraphs are often overlooked.
When the CPA runs out of clients to help with insurance and/or investments, who does he or she talk to? Many insurance agents have found this out the hard way, and after a few years are doing something else. Why would a CPA be more successful?
And with respect to your tax practice, may products that the IRS regards as abusive are being marketed. A CPA who prepares and signs a tax return disclosing a client’s participation in such a transaction and claiming a tax deduction may find himself in difficulty. Unfortunately, many of these products do not look like abusive products. Knowledge and skill are required to identify them. The result is usually worse if a CPA sells an abusive product and his or her clients take a tax deduction. He or she should have definitely known better. Just because an insurance company sells a product does not necessarily make that product legal. Sometimes the use of a product to reduce taxes makes it abusive. The author constantly receives calls from CPAs about questionable products.
Rule 503
Rule 503 of the AICPA’s Code of Professional Conduct sets forth the circumstances under which the CPA receiving commissions and/or referral fees must disclose this fact to a client. In pertinent part, it states:” A member in public practice who is not prohibited by this rule from performing services for or receiving a commission and who is paid or expects to be paid a commission shall disclose that fact to any person or entity to whom the member recommends or refers a product or service to which the commission relates”.
The CPA must therefore fully disclose any commissions or referral fees received in connection with his representation of the client, particularly when they arise from the purchase by the client of a product or service that the CPA recommended or referred the client to. Probably the most likely time when the CPA might encounter this situation would entail the purchase by the client of some kind of insurance product. It is perfectly above board for the CPA to receive a commission and/or a referral fee in this type of situation assuming, of course, that the CPA is insurance licenses.
This complete disclosure, when required, must take the form of a signed document that is given to the client and which must be maintained in the client’s file. While no particular language is required, the disclosure should specifically refer to and cite Rule 503 and must unequivocally state the practitioner’s intention and expectation to receive part of the commission in the event that any insurance transaction is consummated.
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