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CPA’s Guide to Life Insurance
Author/Moderator: Lance Wallach, CLU, CHFC, CIMC
Below is an exert from one of Lance Wallach’s new books. It deals with how
What attracted the most attention with respect to it, until very recently, were the penalties for failure to file, which were $100,000 annually for individuals and $200,000 annually for corporations. Recent legislation has reduced those penalties in most cases. However, there is still a minimum penalty of $5,000 annually for an individual and $10,000 annually for a corporation for failure to file. And those are the MINIMUM penalties. If the minimum penalties do not apply, the annual penalty becomes 75 percent of whatever tax benefit was derived from participation in the listed transaction, and the penalty is applied both to the business and to the individual business owners. Since the form must be filed for every year of participation in the transaction, the penalties can be cumulative; i.e., applied in more than one year. For example, a corporation that participated in five consecutive years could find itself, depending on the amount of claimed tax deductions, looking at several hundred thousand dollars in fines, even under the recently enacted legislation, before even thinking about back taxes, penalties, interest, etc., that could result from an audit. Even the minimum fine would be $15,000 per year, again in addition to all other applicable taxes and penalties, etc. So even the minimum fines could mount up fast.
The penalties can also be imposed for incomplete, inaccurate, and/or misleading filings. And the Service itself has not provided totally clear, unequivocal guidance to those hoping to avoid errors and penalties. To illustrate this point, Lance Wallach, a leading authority in this area who has received hundreds of calls and whose associates have literally aided dozens of taxpayers in completing these forms, reports that his associates, on numerous occasions, have sought the opinions and assistance of Service personnel, usually from the Office of Chief Counsel, with respect to questions arising while assisting taxpayers in completing and filing the form. The answers are often somewhat vague, and tend to be accompanied by a disclaimer advising not to rely on them.
One popular type of listed transaction is the so-called welfare benefit plan, which once relied in IRC Section 419A(F)(6) for its authority to claim tax deductions, but now more commonly relies on Section 419(e). The 419A(F)(6) plans used to claim that that section completely exempted business owners from all limitations on how much tax could be deducted. In other words, it was claimed, tax deductions were unlimited. These plans featured large amounts of life insurance and accompanying large commissions, and were thus aggressively pushed by insurance agents, financial planners, and sometimes even accountants and attorneys. Not to mention the insurance companies themselves, who put millions of dollars in premiums on the books and, when confronted with questions about the outlandish tax claims made in marketing these plans, claimed to be only selling product, not giving opinions on tax questions.
In the summer of 2003, the Service issued guidance that had the effect of severely curtailing those plans, and they began to largely, though not completely, disappear from the landscape. Most welfare benefit plans now claim Section 419(e) as the authority to claim a corporate tax deduction, though the promoters of these plans no longer claim that tax deductions are unlimited. Instead, they acknowledge that the amount of possible tax deductions is limited by the limitations of Section 419A, which Code section is a limitation on tax deductions that are authorized by other sections.
With respect to Section 419(e) welfare benefit plans, and of particular importance in this listed transaction/penalties arena, were the events of October 17, 2007, which over time have had roughly the same effect on Section 419(e) welfare benefit plans as the aforementioned 2003 developments had on Section 419A(F)(6) plans. On that date, the Service issued Notice 2007-83, which identified certain trust arrangements involving cash value life insurance policies, and substantially similar arrangements, as listed transactions. Translation: Section 419(e) welfare benefit plans that are funded by cash value life insurance contracts are listed transactions, at least if a tax deduction is taken for the amount of premiums paid for such policies. On that same day, the Service also issued Notice 2007-84 and Revenue Ruling 2007-65. The combined effect of these three IRS pronouncements was that not only was the use of cash value life insurance in welfare benefit plans, if combined with claiming tax deductions for the premiums paid, sufficient to cause IRS treatment of these plans as listed transactions, but that discrimination as between owners and rank and file employees in these plans was also being targeted.
To illustrate, in many of these promoted arrangements, these Section 419(e) welfare benefit plans, cash value life insurance policies are purchased on the lives of the owners of the business, and sometimes on key employees, while term insurance is purchased on the lives of the rank and file employees. The plans in question tend to anticipate that the plan will be terminated within five years or so, at which time the cash value policies will be distributed to the owners, and possibly key employees, with very little distributed to rank and file employees. In general, the Internal Revenue Code will not countenance the claiming of a tax deduction in connection with a welfare benefit plan where such blatant unequal treatment (discrimination) is exhibited. Nevertheless, plan promoters claim that insurance premiums are currently deductible by the business, and that the insurance policies, when distributed to the owners, can be done so virtually tax free. And this also despite the fact that 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 sections 419 and 419A, including the use of reasonable actuarial assumptions and the satisfaction of nondiscrimination requirements.
With respect to the preparation and filing of Form 8886, incidentally, it should not surprise that welfare benefit promoters have been active in this area. This would include both the promoters of plans that have been listed transactions for years as well as those that became listed transactions, at least arguably, by virtue of the previously discussed October 2007 IRS activities. Some promoters take the position that their plans are completely compliant and that, therefore, there is no need to file Form 8886. Others take a more precautionary approach. While never admitting to being a listed transaction, they do urge clients to file on a protective basis. At least one went so far as to offer plan participants complete guidance and instructions about precisely how to file protectively. Many, if not most, plan promoters have, at the very least, forwarded completed sample forms to plan participants for guidance and use in completing Form 8886. It is certainly possible to file protectively. Any remotely good faith belief that the transaction is not a listed one justifies the protective filing. In fact and practice, the Service is actually treating protective filings in the same manner as other filings.
But while many plan promoters have recognized the filing obligation and recommended filing, this has led to another problem. As previously noted, they have been instructing taxpayers on how to complete and file the form, and the problem is that their guidance, in many cases, has not been particularly helpful and sometimes dangerous. In some cases, though this is difficult if not impossible to ascertain, the suggestions of the plan promoters seem designed more to protect the promoters than to assist the taxpayer. While this is a difficult call to make, it is absolutely clear, Wallach says, that more than one promoter, whether carelessly or otherwise, has sent taxpayers outdated forms to complete and file. Wallach, who you may recall has, between himself and his associates, aided dozens of taxpayers in completing and filing Form 8886, notes that his associates have frequently reported this problem. They also report never having seen a Form 8886 prepared completely correctly, especially where a promoter’s instructions were relied on. So, because the fines may be imposed for incomplete, misleading, or incorrect filings, the danger to plan participants can be clearly seen. And the taxpayer who discovers errors subsequent to filing must decide whether to amend the filing or not, which some plan participants are reluctant to do.
Burdens On Professionals With Clients In Welfare Benefit Plans And Other Listed Transactions
Form 8918 must be filed with the Internal Revenue Service by all “material advisors” to clients who are participating in listed transactions. Exactly who, then, is a material advisor? You are a material advisor if three requirements are satisfied. First, the client must actually be participating in the listed transaction. Second, you must have given the client tax advice with respect to the transaction. This does not necessarily mean that you recommended participation. For example, signing off on a tax return claiming a tax deduction for participation in the listed transaction surely qualifies as having given tax advice with respect to the transaction. In fact, even if you recommended against participation, you would satisfy this threshold so long as you rendered tax advice, be it positive, negative, or neutral.
The third threshold is that you must have received $10,000 or more in compensation (yourself and/or a related entity). This is not quite as simple as it sounds. The money need not all be received as a commission (as might be the case with a CPA who is insurance licensed), or even in a lump sum for accounting services rendered in connection with the client’s participation. The money could be received periodically over time. It is even possible that, so long as $10,000 in fees have been received from the client for whatever reason over whatever period of time, the threshold is met. Lance Wallach, previously referred to in the discussion about Form 8886 and whose associates are also expert in assisting CPAs and others in the preparation and filing of Form 8918, reports that one of his associates put this question directly to an attorney in the Office of the Chief Counsel who actually wrote published IRS guidance with respect to Form 8918. While the gentleman from the IRS was very courteous and professional, trying his best to be of assistance, a clear, unqualified, unequivocal answer that could be “taken to the bank” proved impossible to elicit.
Like Form 8886, however, Form 8918 can be filed protectively. Failure to file or incomplete, misleading, or inaccurate filings can lead to the penalties that used to apply to Form 8886, to wit: $100,000.00 for individuals and $200,000.00 for corporations. For this purpose, it is CRITICAL to note that the recent legislation reducing penalties applied ONLY to Form 8886. The penalties for failure to file Form 8918, or for filing it incorrectly, remain the same as they were, to wit: $100,000 for individuals and $200,000 for corporations.
A good faith belief that either you did not receive $10,000 in income or that the transaction in question is not a listed one enables you to file on a protective basis. And, in fact, as with the 8886 form, the IRS is, in fact, treating all filings identically in any event.
When the CPA files this form ( it need only be filed once, not on an annual basis, as Form 8886 must be), the CPA is assigned a number by the IRS. The CPA or other professional then gives this number to all of his affected clients, who are required to report it on the 8886 forms that they must file. Also, as a perusal of Form 8918 makes clear, there is also a section where the material advisor is to give all pertinent information with respect to other material advisors who participated in and/or advised the client with respect to the transaction in question.
As with Form 8886, this area is replete with horror stories about advisors who, mostly innocently, have fallen into this trap. One that we know of was sold by one promoter on a questionable plan, recommended it to about fifteen clients, and now has been forced to file the 8918 form, help all those involved who have to file Form 8886, and expend a fair amount of his own funds, both to find people who can assist his clients with Form 8886 and in “rescuing” clients who want to get out of this plan. Another called about something else, and was horrified to discover that he had six clients in a plan that is a listed transaction. When he was apprised of his situation, he sank into a depression. These are only two of the dozens of sad, and worse, stories in this area that we have been privy to. The second person, for example, had no idea that anything was wrong. He initially called about something totally unrelated. There have even been instances of professional discipline being imposed in connection with this area, of CPAs being threatened with and perhaps even actually suffering loss of their licenses. Such is the terrain in which the CPA must now operate.
Another problem is possible, especially if you recommended that the client participate. Most practitioners are familiar with situations where, when things go wrong, clients often develop selective memory failure. This happens here, as it does elsewhere. At best, it can lead to you spending an inordinate amount of time, and perhaps money, on what is essentially a thankless exercise. At worst, if the situation worsens to the point where a lawsuit may be in the air, you could find yourself the subject of some sort of client complaint or, worse, a named defendant in a lawsuit, in which case your malpractice carrier would become involved, with all of the negative effects upon yourself and your practice that that could entail.
Section 6707A – Past, Present, and Future
Returning now to the Form 8886 aspect of Section 6707A, the disclosure requirement that applies to actual participants in listed transactions, it has been noted, and discussed, that Congress recently reduced the penalties under Section 6707A for many taxpayers. But it is still imperative to realize that this is only a partial solution to the continuing problem caused by the penalties imposed by that section. While the penalties have been reduced from the prior patently ridiculous, and probably illegal, level that until so recently prevailed, they are still sufficient, in many cases, to put business owners out of business, just as the prior penalties obviously were. And since the new legislation did not address or affect obligations and penalties with respect to Form 8918 at all, accountants, insurance professionals and other material advisors are as likely to be hurt as ever.
Whatever the underlying Congressional intent was in enacting the original Section 6707A in 2004, whatever Congress hoped to accomplish, the statute as it was written imposed clearly unconscionable burdens on taxpayers. Penalties of up to $300,000 annually could be imposed on taxpayers who had not underpaid tax and who had no knowledge that they had entered into transactions that the IRS deems “listed”.
Tax provisions are seldom found to violate the United States Constitution, but it is certainly arguable that the imposition of such a large penalty on a taxpayer who entered into a transaction that produced little or even no tax savings and without regard to the taxpayer’s knowledge or intent violates the Eighth Amendment prohibition on excessive fines, etc. In practice, the requirement that this penalty be imposed without regard to culpability often had the effect of bankrupting middle class families who had no intention of entering into a tax shelter – an outcome that dismayed even hardened IRS enforcement personnel.
The section previously imposed a penalty of $100,000 per individual and $200,000 per entity for each failure to make special disclosures with respect to a transaction that the Treasury Department characterizes as a “listed transaction” or “substantially similar” to a listed transaction. A listed transaction is one that is specifically identified as such by published IRS guidance. The question of what is “substantially similar” to such a transaction is increasingly troublesome, especially given the ever broadening IRS definition of the term, beginning with Treasury Decision 9,000, which declared, on June 18, 2002, that, from that date forward, the term “substantially similar” would be construed more broadly by the Service than it had up until that time. This started a trend that continues to this day.
It is important for the reader to understand that the only thing that was accomplished by the new, amended Section 6707A is a reduction in the penalties. The penalties are still severe, severe enough to seriously damage or even bankrupt most small businesses. And professional readers must understand that there has been no effect on their obligations at all, and that the same (in their case, even more severe) fines still apply.
For example, the following eleven statements are equally applicable to the new Section 6707A as they are to its predecessor:
1. The penalty applies without regard to whether the small business or the small business owners have knowledge that the transaction has been listed.
2. The penalty applies even if the small business and/or the small business owners derived no tax benefit from the transaction. Even under the new legislation, there are substantial minimum penalties that are applied even if there has been no tax benefit.
3. The penalty is applied at multiple levels, which is devastating to small businesses; the result is that the small business and its owners are hit with multiple penalties. The two most common problems are that fines are imposed on both the business entity and the owners as individuals, and also that fines are imposed each year, and thus are sometimes imposed for five years or more. In the case of a small business, the penalties can easily exceed the total earnings of the business and cause bankruptcy – totally out of proportion to any tax advantage that may or may not have been realized.
4. The penalty is final, must be imposed by the IRS (this is mandatory), and cannot be rescinded. There is no right of appeal, and there is no “good faith” exception, as business advocates had hoped would be a part of the new legislation.
5. Judicial review is expressly prohibited, which raises another Constitutional issue, this time a separation of powers argument, as it amounts to one branch of government prohibiting another from functioning.
6. The taxpayer’s disclosure must initially be made twice – once with the IRS Office of Tax Shelter Analysis and again with the tax return for the year in which the transaction is first required to be disclosed. Thereafter, for each year that the taxpayer “benefits” from the transaction, it must be reflected on the tax return. Aside: As a practical matter, the form should be filed with the tax return. The IRS directions assume a timely filing. There are no directions on how to file late, which most taxpayers must do, since few realized the need to disclose in this manner when they still could have timely filed. A few experts have figured out how to file late and simultaneously avoid penalties, after months of study and numerous conversations with IRS personnel. Those conversations were with IRS people that drafted the regulations, those that receive the forms, and others.
7. A taxpayer that discloses a transaction is subject to penalty if the Service deems the disclosure to be incomplete, incorrect, and/or misleading. I have had numerous conversations with people who filed the disclosure forms and got fined. They did not properly prepare and/or file the forms.
8. If a transaction is not “listed” at the time the taxpayer files a return but it subsequently becomes listed, the taxpayer becomes responsible for filing a disclosure statement and will be penalized for failing to do so. This is true even if the taxpayer has no knowledge that the transaction has been listed. This sort of thing is exactly why business interests , albeit unsuccessfully, pushed for a “good faith” exception in the new legislation.
9. The penalty is imposed on transactions that the IRS, in its sole discretion, determines are “substantially similar” to a listed transaction. Accordingly , taxpayers may never know or realize that they are in a listed transaction and, accordingly, the penalties compound annually because they never made any disclosure. At least, if a transaction is specifically identified, people can find out that it is a listed transaction. But how can anyone be sure that something is “substantially similar”, or not?
10. The taxpayer must disclose each year, which can result in compounding of already large penalties; and
11. The Statute of Limitations, usually three years, does not apply. IRC 6501(c)(10) tolls the statute until proper disclosure is made.
The Treasury Department usually announces on a somewhat ad hoc basis what is a listed transaction. There is no regulatory process or public comment period involved in determining what should be a listed transaction. Once that a transaction is deemed to be a listed transaction, the Draconian Section 6707A penalties are triggered. Section 6707A penalties not only apply to specifically listed transactions, but also to transactions that are deemed by Treasury to be “substantially similar” to any of the specifically listed transactions. Some have said that under Section 6707A, IRS and Treasury are the judge, jury and executioner. Be that as it may, once again Constitutional concerns need to be addressed, this time possible due process violations pursuant to the Fourteenth Amendment.
A business owner bought a type of life insurance policy featuring what is known as a “springing cash value” as an alternative to a pension plan. Two years later, this type of transaction was specifically identified as an abusive tax shelter, a listed transaction, meaning that the business owner was now obligated to file Form 8886. But the financial advisor, who years before had actually recommended this course of action, either willfully or out of ignorance failed to advise the business owner to disclose.
The IRS demanded back taxes and interest in the neighborhood of $60,000. It also assessed $600,000 of penalties under Section 6707A for failing to disclose participation in a listed transaction for two separate years.
Another taxpayer filed Form 8886 with his tax returns, but failed to file, in the first year, with the Office of Tax Shelter Analysis. The penalty was assessed for that failure, even though the IRS had the form, though perhaps in a different place. Again, this scenario cries out for the “good faith” exception that was not included in the new legislation.
Then there was the doctor who thought that he had settled his 419 welfare benefit plan issues with the Service. He entered into a closing agreement and paid all taxes due and owing. Later, he was assessed the penalty for failing to file Form 8886. Of course, this issue had been neither raised nor even discussed in the doctor’s prior communications, negotiations, etc. with the Service.
I could go on and on with these horror stories, but the reader probably gets my drift by now. I have been urging business owners to properly file Form 8886 for years. A surprising number of accountants have little or no knowledge in this area, even being unaware of the fines that can be imposed on “material advisors” which, as previously noted, have NOT changed as a result of the new legislation. And if a professional assumes that he has no clients in “listed transactions”, he should realize that there are numerous types of listed transactions. They are not restricted to welfare benefit plans. For example, they include the popular Section 412(i) defined benefit pension plan, and even some of the ubiquitous 401(k) plans. No business owner, and especially no financial, insurance or accounting professional should ever assume that he or she is immune from any or all of the possible repercussions outlined herein.
Summing up, the new legislation does reduce possible Section 6707A penalties for most taxpayers. That, in my view, is its only benefit. And the reduction is not as great as one might expect. Depending on surrounding circumstances, penalties of hundreds of thousands of dollars are still quite possible. Even the minimum penalties, which are applied in the event that there is no tax benefit, amount to $15,000 annually. Who can afford to just brush that aside? Over a period of years, and the fines in the 8886 area are still applied annually, the minimum fines all be themselves can add up to a considerable amount.
Both the 8886 and 8918 forms must still be filed properly. The fines and penalties for failure to do so remain substantial and unfair.
The information provided herein is not intended as legal, accounting, financial or any type of advice for any specific individual or other entity. You should contact an appropriate professional for any such advice.
Disclaimer: While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer. For specific technical or legal advice on the information provided and related topics, please contact the author.