I’m not sure why this 419 case hasn’t been talked about much, but it certainly got my attention when it came across my desk.
If you’ll remember, 419 plans were the darling of the life insurance industry for years. The plans were sold as a way to buy cash-value life insurance in a 100 percent tax-deductible manner in which the death benefit would pay out tax-free. Additionally, individuals (usually business owners) could exit from the plans, at which time the cash-value life insurance policies would be distributed to the individuals. The individuals then could borrow from the policies tax-free in retirement.
If you know the history of 419 plans, you know that the Internal Revenue Service has despised them for over a decade. For the most part, the courts have ruled against taxpayers in cases involving 419 plans, and the IRS has acted several times to curb their use. The IRS essentially killed multi-employer plans, which spawned the use of single employer plans which were subsequently killed (or so we thought).
Scorpion and the frog -- If you have never read the story of the scorpion and the frog, I highly recommend it. Many 419 administrators (such as Section 79 plan administrators) are scorpions. They do what they do, no matter the consequences to clients or to the advisors who recommend them.
Tax court sounds death knell on 419 plans?
On July 13, the same tax court that issued the landmark 419 case back in the day (Neonatology Associates v. Commissioner of Internal Revenue) came down hard on one of the few remaining 419 plans in the industry. It seems the judge was trying to send a message in his opinion, and I hope it will be received loud and clear.
The case involved several taxpayers who were in a 419 plan called the Sterling Benefit Plan.
As usual, the employers took deductions when their businesses paid premiums for “welfare benefits” to the Sterling Plan. The money was used mainly to purchase life insurance (which provided death benefits and other living benefits to covered employees). Employees who retired could elect to receive their life policy from the plan in satisfaction of a retirement death benefit.
What did the court hold?
1) It denied the deductions (meaning that the individuals who were in the plan had to recognize premium payments as income).
2) It hit taxpayers with a 30 percent penalty for not disclosing that they were involved in a listed tax transaction.
The following is from the conclusion of the opinion and should tell you everything you need to know:
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.
Why is this court case important?
I knew that few in the industry were aware of this recent 419 plan case, and I believe it is worth bringing it to your attention.
The select few still selling these plans or some version of them should worry about what could happen to their clients. I hope they will stop peddling this nonsense.
This case is important to me because it can be used as a reminder that many third-party administrators of tax plans are scorpions (meaning they only care about selling their plans/making money, not what’s best for your clients).
Section 79 plans are another situation in which overly aggressive marketers got the IRS’s attention, which subsequently moved the agency to go after them.
Captive insurance companies (CICs) are another tool coming under scrutiny because of aggressive marketing and poor administration. I plan to share some information about proposed changes to CICs in the near future.
Roccy DeFrancesco, JD, CWPP, CAPP, CMP, is the founder of the Wealth Preservation Institute and author of several books on financial planning and wealth management. Roccy may be contacted at firstname.lastname@example.org.