Journal of Financial Planning: February 2016
David M. Cordell, Ph.D., CFP®, CFA, CLU®, is director of finance programs at the University of Texas at Dallas.
Thomas P. Langdon, J.D., LL.M., CFP®, CFA, is professor of business law at Roger Williams University in Bristol, Rhode Island.
Tax planning often involves the use of creative structures that appear to comply with the tax laws while allowing a client the ability to achieve a desired outcome that the IRS and Congress may not like. When it comes to the payment of taxes, individual citizens and the government are adversaries, not partners.
As Judge Learned Hand famously stated in Gregory v. Helvering, (69 F.2d 809, 810 (2d Cir. 1934)), “Any one may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one’s taxes.” Creativity in tax planning can, however, push the envelope too far, creating results that, while ostensibly in compliance with the tax rules, are too good to be true.
Section 419 Welfare Benefit Plans
Due to the tax benefits associated with the use of life insurance, life insurance is often used as a key component in tax planning. One example is the use of life insurance in a Section 419 plan.
A Section 419 plan is a welfare benefit plan that permits an employer to make tax-deductible contributions to the plan that are used to purchase cash value life insurance on the lives of key employees or family and closely held business owners. The business owners and employees participating in the plan designate the beneficiaries of the life insurance policies held by the plan. When the participants reach retirement age, the plan is typically terminated, allowing the life insurance policies to revert to the participants. At that time, they can access policy cash values on a tax-free basis during their lifetime through the use of policy loans, and transfer the death benefit on the policy income tax free upon their death to the named beneficiary. In the typical 419 plan, these benefits are not available to rank and file employees.
As all planners familiar with the tax rules governing life insurance know, premium payments on life insurance policies are not generally deductible since the death benefit on the policy is received income tax free. This principal follows a general rule of income taxation, which permits deductions only for expenses that have the potential of generating taxable income. Section 419 plans, however, appear to permit business owners to purchase life insurance on an income-tax deductible basis through an employee welfare benefit plan, and still retain tax-free access to cash values through policy loans and receipt of the death benefit free of income taxes. Too good to be true? The Tax Court thinks so.
Our Country Home Enterprises Inc. et. al v. Commissioner of Internal Revenue
This past July, in its first decision of its new term, the United States Tax Court issued its opinion in Our Country Home Enterprises Inc. et. al v. Commissioner of Internal Revenue (145 T.C. No. 1).
This case involved seven individual cases before the Tax Court that were consolidated for purposes of trial, briefing, and opinion. All seven cases involved the use of the “Sterling Plan,” a specially designed Section 419 Welfare Benefit Plan. The Sterling Plan was designed to pay death, medical, and disability benefits to participating employees to the extent that his or her employer selects. The death benefit under the Sterling Plan was the face amount of a life insurance policy that the Sterling Plan purchased on each employee’s life. Non-death benefit payments under the plan were limited to the cash value of the life insurance policy related to that employee. Participating employees, upon retiring, were permitted to take the life insurance policy held on their life in the Sterling Plan in full satisfaction of any post-retirement death benefit payable to the employee. The employer sponsoring the plan could terminate the plan at any time, at which time each employee participating in the plan would be fully vested in the life insurance policy on the employee’s life, including its cash value.
This is not the first time that Section 419 plans have caught the attention of the Tax Court or the IRS. In 2000, Judge David Laro authored the Tax Court’s decision in Neonatology Assocs., P.A. v. Commissioner (115 T.C. 43(2000), aff’d, 299 F. 3d 221 (3d Cir. 2002)). The 419 plan at issue involved the use of plan contributions to purchase term life insurance and “credits” for conversion of the term policy to a universal life insurance policy on the life of the insured.
The Tax Court’s decision in Neonatology Associates denied corporate income tax deductions for plan contributions in excess of what was necessary to purchase term insurance, and it held that contributions made on behalf of company owners should be treated as constructive dividends.
In 2007, the IRS issued a series of notices designed to indicate that if an employer funded a Section 419 Welfare Benefit Plan or Voluntary Employee Benefit Plan (VEBA) with life insurance, the payments to the plan were not deductible, and plans that used any form of cash value life insurance were placed on the listed tax transactions list.
Given the outcome in the Neonatology Associates case and the issuance of the IRS notices, the Tax Court and the IRS had been asserting their belief for quite some time that tax-deductible life insurance premiums in conjunction with tax-free lifetime benefits (in the form of loans against cash value) and tax-free death benefits were, indeed, too good to be true.
In the Our Country Home Enterprises case, Judge Laro, writing for the court, again concluded that the benefits being marketed by the Sterling Plan were too good to be true. Instead of permitting the plan sponsors to receive an income tax deduction for payments to the plan, the court denied the income tax deductions to the companies and found that the life insurance policies held on shareholder/employees were split dollar life insurance arrangements. This caused the shareholder/employees whose lives were insured in the Sterling Plan to realize income in accordance with the economic benefit provisions of the regulations.
The court further found that owners who participated in the plan but who were not employees realized dividend income in accordance with the Tax Court decision in Neonatology Associates. In addition, the court found that the 419 plan constituted a listed transaction (as specified in the 2007 IRS Notices), and that taxpayers were liable for a 30 percent accuracy-related penalty under I.R.C. Sec. 6662(a).
Beyond Neonatology and Our Country Home Enterprises
The tax penalty imposed on the seven companies represented in this case was more than $3 million, but the IRS will certainly seek to apply this decision to other companies with similar Section 419 plans, potentially generating a significant amount of additional taxes and penalties. It has been estimated that there were approximately 40 other similar cases pending before the court where the parties agreed to be bound by the final decision as specified in this case.
As Judge Laro stated in the decision:
“We conclude and hold that petitioners significantly underreported income on their federal income tax returns for each subject year. In addition, the evidence shows (and we find) that petitioners consciously participated in a plan that, as advertised to them, they should have known (and probably knew) was too good to be true. A reasonable person in the position of petitioners also would not have been oblivious to the fact that the judiciary had rejected the use of cash value life insurance to fund welfare benefits in similar settings ... and would have looked for more concrete guidance on the Sterling Plan before investing significant funds in it, as petitioners did.”
Beyond Section 419: A Fair Warning
While sophisticated tax planning is a noble goal, and, as Judge Learned Hand has told us, is perfectly legal, when seeking tax savings, planners and clients must act reasonably. Flashy marketing literature and eloquent sales presentations will not insulate practitioners or clients from tax liability and penalties when, to paraphrase Judge Laro, they consciously participate in a plan they should have known was too good to be true.
Promoters of tax planning strategies are often very persuasive, and sometimes conveniently use in their marketing materials a private letter rulings from the IRS indicating that the strategy has been reviewed and approved. Remember, a private letter ruling is only binding on the taxpayer who requested it. The IRS is permitted to change its mind about the outcome of the technique as new information arises, and apply a different result to other taxpayers.
When the outcome of proposed planning appears to be too good to be true, tread carefully and act reasonably. Those who don’t may find that, instead of benefiting themselves, their actions may be too good to be true for the U.S. Treasury, as the IRS collects tax deficiencies, interest, and penalties from schemes ostensibly designed to save taxes.