Federal Court Rules Against IRA Conversion Plans Using Life Insurance and Annuities

December 15, 2008

SOURCE: InsuranceNewsNet, Inc.

A San Francisco federal judge ordered to stop promoting two unlawful tax schemes known as Pension Asset Transfer (PAT) and Financed Roth Conversion Strategy (FROCO). The IRS filed a lawsuit against GSL Advisory Solutions, saying the company’s schemes improperly used untaxed retirement dollars in IRA accounts to underreport income generated by taxable transactions.

On its Web site, the company described PAT as a program where part of the retirement assets in traditional tax deferred IRAs plan can be converted into a tax free inheritance using second-to-die life insurance policy. The scheme required clients to set up a business for the purpose creating a self-employed retirement plan under IRC § 401(a), according to court papers. The company advised clients to transfer their untaxed money out of the IRA and into the clients’ self-employed retirement plan, which is not a taxable transaction, the decision said.

The company then sold clients specially designed life insurance plans with high surrender penalties equal to 30 percent to 50 percent of the total value of the policy if cashed in within three to five years after its purchase, the court said. The clients appoint themselves as the sole beneficiaries of the life insurance policy.

While the life insurance policy is still subject to surrender penalties, clients directed the self-employed retirement plan to distribute the insurance policy to themselves, the court said. For this distribution, clients must report as income the value of the life insurance plan that was distributed but instead of reporting the full and actual value of the life insurance policy. The company advised clients to subtract the surrender penalty amount (i.e., 30 percent to 50 percent) from the total value of the life insurance policy, and report only the difference as income, according to court papers.

As a result, the customer improperly reported as income only 50 percent to 70 percent of the actual value of the life insurance assets that were distributed, according to the court.  The company argued the reduction in value for income reporting purposes is acceptable because, at the time the life insurance policy is distributed to the customer, it is not worth the full amount but only worth the potential cash-in value at the time of the transaction. Using the PAT scheme, the customer can cash in the policy for the true and actual value without paying any more taxes after the surrender penalty period expires.

The FROCO scheme is similar to PAT but uses specially designed annuities with surrender penalties 10 percent to 25 percent of the value of the annuity. The annuity is initially kept inside the traditional IRA and then transferred to a Roth IRA. 

The IRS estimated that clients that used the PAT and FROCO schemes failed to report at least $25 million in federal income tax. The court ruled the company has sold, promoted and organized tax-fraud schemes that falsely promise tax benefits to customers and made false or fraudulent statements to customers regarding the tax benefits of the schemes. The defendants agreed to the permanent injunction order without admitting the government's allegations against them.

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