What Plan Are You In? - 419e,. 412i, Section 79, captive insurance

October, 2010
By Lance Wallach

For years life insurance agents and others have been selling ways to deduct life
insurance in welfare benefit plans. For years the IRS has been disallowing most of these
plans on audit.

In Notice 2007-83, the IRS identified certain trust arrangements involving cash value life
insurance policies, and substantially similar arrangements, as listed transactions. The
IRS also issued related Revenue Ruling 2007-65 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 in part for premiums paid by the trust on
cash value life insurance policies.

The IRS ruled in Revenue Ruling 2007-65 that a welfare benefit fund’s qualified direct
cost under IRC §419 does not include premium amounts paid by the fund for cash value
life insurance policies if the fund is directly or indirectly a beneficiary under the policy as
determined under IRC §264(a).

If a transaction is designated as a listed transaction, affected persons have disclosure
obligations and may be subject to applicable penalties.
Like Notice 2007-83 and Notice 2007-84, Revenue Ruling 2007-65 is aimed at promoted
arrangements under which the fund trustee purchases cash value life insurance policies
on the lives of the employees who are owners of the business (and sometimes key
employees), while purchasing term insurance policies on the lives of other employees
covered under the plan. They are currently sold as an IRC §419(e), IRC §419A(f)(6) or
IRC §419 plans. These are sometimes sold as single employer plans.

These plans anticipate that the plan will be terminated and the cash value policies will be
distributed to the owners or key employees with very little distributed to other employees.
The promoters claim the insurance premiums are currently deductible by the business,
and that the distributed insurance policies are virtually tax-free to the owners. The ruling
makes clear that, going forward, a business cannot deduct the cost of premiums paid
through a welfare benefit plan for cash value life insurance on the lives of its employees.
Some arrangements described by this ruling may qualify as listed transactions.
The IRS may challenge the claimed tax benefits of these arrangements for various
reasons:

Some or all of the benefits or distributions provided to or for the benefit of owner-
employees or key employees may be disqualified benefits for purposes of the 100-
percent excise tax under IRC §4976.

Whenever the property distributed from a trust has not been properly valued by the
taxpayer, the IRS intends to challenge the value of the distributed property, including life
insurance policies.

Under the tax benefit rule, some or all of an employer’s deductions in an earlier year may
have to be included in income in a later year if an event occurs that is fundamentally
inconsistent with the premise on which the deduction was based.

An employer’s deductions for contributions to an arrangement that is properly
characterized as a welfare benefit fund are subject to the limitations and requirements of
the rules in IRC §§419 and 419A, including the use of reasonable actuarial assumptions
and the satisfaction of nondiscrimination requirements.

Further, a taxpayer cannot obtain a deduction for reserves for post-retirement medical or
life benefits unless the employer actually intends to use the contributions for that purpose.

The arrangement may be subject to the rules for split-dollar arrangements, depending on
the facts and circumstances.

Contributions on behalf of an owner-employee may be characterized as dividends or as
nonqualified deferred compensation subject to IRC §404(a)(5) or IRC §409A or both,
depending on the facts and circumstances.
If a client approaches you with one of these plans, be especially cautious, for both of
you. Advise your client to check the promoter very carefully. Make it clear that the
government has the names of all former 419A(f)(6) promoters and, therefore, will be
scrutinizing the promoter carefully if the promoter was once active in that area, as many
current 419(e) (welfare benefit fund or plan) promoters were, thereby making an audit of
your client far riskier and more likely.

The information provided herein is not intended as legal, accounting, financial or any
other type of advice for any specific individual or other entity. You should contact an
appropriate professional for any such advice.
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