IRS Notices
In IR-2007-170, Oct. 17, 2007, "IRS Warns Taxpayers About Certain Trust Arrangements Sold As Welfare Benefit Funds", the IRS and Treasury announced the issuance of three new rulings (collectively, the "IRS Rulings") relative to welfare benefit plans:
1. Notice 2007-83, in which the IRS identified certain trust arrangements involving cash value life insurance policies, and substantially similar arrangements, as listed transactions. If a transaction is designated as a listed transaction, affected persons have disclosure obligations and may be subject to applicable penalties. Taxpayers who otherwise would be required to file a disclosure statement prior to Jan. 15, 2008, as a result of Notice 2007-83 have until Jan. 15, 2008, to make the disclosure.
2. Notice 2007-84, in which the IRS cautioned taxpayers that the tax treatment of trusts that, in form, provide post-retirement medical and life insurance benefits to owners and other key employees may vary from the treatment claimed, specifically identifying trust arrangements involving purported welfare benefit funds that in operation, result in the owner's or owners' receiving all or a substantial portion of the post-retirement or other benefits, and/or all or a substantial portion of any assets distributed from the trust. The IRS may issue further guidance to address these arrangements, and taxpayers should not assume that the guidance will be applied prospectively only;
3. Revenue Ruling 2007-65 was also issued to address situations where an arrangement is considered a welfare benefit fund but the employer's deduction for its contributions to the fund is denied in whole or part for premiums paid by the trust on cash value life insurance policies. For purposes of deductions allowable to an employer under IRC §419, a welfare benefit fund's qualified direct cost does not include premium amounts for cash value life insurance policies paid by the fund, whenever the fund is directly or indirectly a beneficiary under the policy within the meaning of IRC §264(a).
Many life insurance companies, financial planners and clients have requested our explanation of the IRS Rulings and their collective impact, particularly with respect to welfare benefit plans we administer. Our analysis is contained herein.
CIRCULAR 230 DISCLAIMER
The opinions set forth in this Memorandum are subject to the following disclaimer:
Unless expressly stated otherwise in this Memorandum, (1) nothing contained herein was written or intended to be used, and may not be used or relied upon by any taxpayer for the purposes of avoiding penalties that may be imposed on the taxpayer under the Internal Revenue Code of 1986, as amended (the "IRC"); (2) any statement contained in this Memorandum relating to any federal tax transaction or matter may not be used by any person to support the promotion or marketing or to recommend any federal tax transaction or matter; and (3) any taxpayer should seek advice based on the taxpayer's particular circumstances from an independent tax advisor with respect to any federal tax transaction or matter contained herein. No one, without our express written permission, may use any part of this Memorandum in promoting, marketing or recommending an arrangement relating to any federal tax matter to one or more taxpayers.
ISSUES
1. To what extent do the IRS Rulings expand or extend the current laws and regulations?
2. Do the IRS Rulings make all welfare benefit plans "listed transactions"? How is Notice 2007-83 to be understood?
3. Do the IRS Rulings eliminate tax deductions for plans that primarily benefit owners? How is Notice 2007-84 to be understood?
4. Do the IRS Rulings eliminate cash value life insurance from welfare benefit plans? How is Revenue Ruling 2007-65 to be understood?
CONCLUSIONS
1. Although the IRS Rulings generally restate the current law, they extend the law in that many of the purported "welfare benefit plans" they have now designated as "listed transactions". They also threaten to apply listed transaction sanctions against promoters of plans that are not in fact listed transactions.
2. No, the IRS Rulings do not make all welfare benefit plans "listed transactions." Notice 2007-83 is to be understood as laying out the 4 criteria that will make a plan a "listed transaction".
3. No, Notice 2007-84 is to be understood as denying tax deductions for certain so-called welfare benefit plans that are simply arrangements to provide cash value life insurance policies or cash benefits to business owners and executives. It does not eliminate tax deductions for all welfare benefit plans per se, but only to plans which employ questionable strategies to circumvent the intended effect of the law.
4. While the IRS Rulings do not entirely close the door on the purchase of cash value life insurance, the rulings are problematic to promoters of such arrangements and may end up eliminating such contracts from WBPs altogether, as insurance companies seek to avoid classification as promoting or aiding and abetting the promotion of abusive welfare benefit plan arrangements.
ANALYSIS
The announcement of the IRS Rulings includes guidance as to their proper interpretation. It states, "There are many legitimate welfare benefit funds that provide benefits, such as health insurance and life insurance, to employees and retirees. However, the arrangements the IRS is cautioning employers about primarily benefit the owners or other key employees of businesses, sometimes in the form of distributions of cash, loans, or life insurance policies."
"The guidance targets specific abuses involving a limited group of arrangements that claim to be welfare benefit funds," said Donald L. Korb, Chief Counsel for the IRS. "Today's action sends a strong signal that these abusive schemes must stop."
The IRS, therefore, specifically acknowledges that both legitimate arrangements and abusive arrangements exist. The key is in differentiating between the two. While the IRS Rulings do not contrast compliant plans with abusive plans, they do attempt to list and identify their specific concerns about many such arrangements.
Notice 2007-83
In Notice 2007-83, the IRS listed the characteristics of plans that they deem to be listed transactions. Plans that meet all of the following conditions are listed transactions:
(1) The arrangement is a fund that purports to exist under IRC §419(e)(3); (2) The plan does not rely on the exception in IRC §419A(f)(5); (3) the fund pays premiums on one or more cash value life insurance policies; and (4) Tax deductions claimed must have exceeded the amounts allowed under the various listed subsections of IRC §§419 and 419A. Since almost all of the purported welfare benefit plans extant meet the first 3 requirements, the real test here is whether excessive tax deductions for life insurance policies have been claimed.
This Notice is specifically directed at those plans that claimed that a deduction may be taken for a whole life or a universal life premium and ignored the limitations of IRC §§419 and 419A. In fact, we have issued warnings relative to this issue in published articles.
For the plans we administer, including the Sterling Benefit Plan and single-employer plans and trusts, we carefully limit the amount of tax deduction that may be claimed with respect to life insurance benefits to the current term insurance premium amount. For this reason, our SBP and single employer plans are not listed transactions.
The Notice cross references to IRC §6011 for a determination of whether a person has participated in a listed transaction and requirements for disclosure. It also threatens to impose penalties against "persons involved in these arrangements or similar arrangements" for claiming the deduction (IRC §6662), preparing the return (IRC §6694), promoting (IRC §6700) or aiding and abetting such schemes (IRC §6701).
Notice 2007-84
In this Notice, the IRS expresses concern with plans that provide all or a substantial portion of the benefit to owners, key and highly compensated employees. This concern would ostensibly apply to several of our clients, since they don't have rank and file employees, or the employees they have receive a small percentage of the benefits due to lower compensation and younger ages. However, IRS identifies what their specific concerns are: (1) granting loans to participants; (2) provision of deferred compensation; (3) unreasonable actuarial, funding or forfeiture allocation methods and assumptions;
(4) plan terminations that result in distribution of assets rather than being used post-retirement as originally established; (5) fund reserves in excess of those permitted under section §419A (life insurance policies in excess of $50,000); (6) violation of the nondiscrimination requirements of IRC §505(b) or IRC §105(h); (7) failure to comply with the controlled group and affiliated service group rules under IRC §414(b),(c),(m) and (n); and (7) permitting the transfer of life insurance policies to participants.
[NOTE: The Sterling Benefit Plan at one time permitted insurance policy transfers, but had eliminated them due to the enactment of IRC §409A.]
IRS intends to re-characterize such arrangements as: (1) dividends; (2) non-qualified deferred compensation (under IRC §404(a)(5) or §409A); (3) split-dollar life insurance arrangements, or (4) disqualified benefits under IRC §4976.
Finally, IRS threatens to impose penalties against "persons involved in these arrangements or similar arrangements" for claiming the deduction (IRC §6662), preparing the return (IRC §6694), promoting (IRC §6700) or aiding and abetting such schemes (IRC §6701). NOTE: THESE PENALTIES MAY APPLY EVEN IF THE PARTICULAR PLAN IS NOT A LISTED TRANSACTION!
IRS's analysis in this Notice seems to focus on the intent of the employer or the owners, as ascertained from the actions of the employer, the administrator and the trustee. If the plan actually results in any of the behaviors listed, it will be challenged. If the plan or administrator has a pattern of such behavior, even clients with good intentions could have their tax treatment challenged.
Revenue Ruling 2007-65
This ruling specifically dealt with two fact patterns and disallowed tax deductions under both:
(1) A plan that provides a nondiscriminatory death benefit to eligible plan participants, both owners and rank and file, that is funded through the purchase of cash value life insurance contracts; and
(2) A plan that provides the foregoing death benefits, but also provides a self-funded disability benefit to such participants.
The rationale for disallowance of the life insurance premium focused on the fact that life insurance premiums are not inherently tax deductible, and interposing a trust doesn't change the nature of the transaction. IRC 264(a) specifically disallows tax deductions for life insurance.
The rationale for disallowance of the amounts paid to fund the disability benefits relied on the language of §§419 and 419A, which limit current deductions and reserves to the year's disability benefit payments plus current disability insurance premiums. Those were zero and no deduction was allowed.
In a section entitled "PROSPECTIVE APPLICATION", the Ruling states that IRS will not disallow deductions for such arrangements for prior tax years, except to the extent that deductions claimed exceeded the amount of insurance included on the participant's Form W-2 for a year (excluding amendments made after October 17, 2007).
ADDITIONAL CONCERNS
Analysis of these IRS Rulings raised many additional questions to be resolved:
1. Insurance companies now are on notice that they are potentially liable for promoting or aiding and abetting the promotion of welfare benefit plans. Will they now cease to permit their products to be used inside such plans, or will they carefully police the plans that do apply for policies to make sure those plans are in compliance? Early indications are that some companies will go each way. Some companies may request a tax opinion relative to the plan.
2. Banks that act as trustees of such plans are also now on notice that they are potentially liable for promoting or aiding and abetting the promotion of welfare benefit plans. Will they now cease to provide trustee services with respect to such plans, or will they carefully police the plans that do apply for policies to make sure those plans are in compliance? It appears that most banks and trust departments are oblivious to their potential liabilities under such arrangements and will blithely continue to offer their trustee services until they are sued and it costs them more than the fees are worth to them.
3. If an IRS field auditor audits a plan, even a plan that is totally-compliant, will he/she be able to discern whether or not the plan is compliant? It seems likely that field auditors may soon be instructed to ascertain: (1) Whether the plan provides cash value life insurance policies; and (2) Whether the plan primarily benefits owners, key and highly-compensated employees? If the answer to either is yes, the auditor is likely to disallow tax deductions, notwithstanding the legitimatacy of the arrangement. How many plans will pass the "field auditor test"?
4. As with the Proposed Regs. under IRC §419A(f)(6), the IRS Rulings may have the effect of encouraging plans to close down. While IRS would likely be thrilled at the discontinuance of all of those plans, it is not clear under the rulings that a promoter of a plan can close the plan down without exposing himself and all parties involved to significant and severe penalties. One of the signs of a defective plan described in Notice 2007-84 is that the trust can close and distribute the assets. And, even though such plans may not be listed transactions, the Notice threatens promoters and those who aid and abet them (attorneys, administrators, financial planners, accountants, bank trustees and insurance companies which assist with the transfers of policies and assets to individual participants) with significant fines and sanctions. Moreover, IRS reserves the right to its choice of alternative tax scenarios including dividend, noncompliant deferred compensation, disqualified benefits, etc., that may subject the employer and/or the participant to significant excise taxes in addition to income taxes and penalties.
5. What type of welfare benefit plan could survive in the new environment? Some commentators have suggested a combination of term insurance and annuities would work, so long as deductions are limited to the amounts permitted. However, even this approach may be problematic, as it appears that IRS can now capriciously and arbitrarily label anything they want as a "listed transaction" or apply the same sanctions to other "similar transactions" that may not be listed transactions. It is therefore dangerous in this current environment to promote or aid and abet even compliant welfare benefit plans. It appears that the language used in the IRS announcement ("There are many legitimate welfare benefit funds * * *. * * * The guidance targets specific abuses involving a limited group of arrangements * * *") is simply a smokescreen to foster the illusion that only abusers will be impacted when in fact IRS is really sending a chilling message to ALL welfare benefit plans, legitimate or not.