Tag Archives: tax deductions

What is a Section 79 Plan Anyway?

Tax free zone.Simply put, it is a tax plan where small business owners are allowed to take a 20 percent to 40 percent deduction through their business to purchase an individually owned cash-value life (CLV) insurance policy.  If you just read the above paragraph, you’d think that a Section 79 Plan is the nirvana of plans (a tax deductible way to buy CVL insurance). However, when you break down the math and the sales pitch, you’ll know why I despise these plans.

Group underwriting for businesses with fewer than 10 employees For businesses with fewer than 10 employees, the law prohibits full medical underwriting of the policies that are issued (“group” underwriting is required, which is much more risky for an insurance company). Amazingly, one of the insurance companies offering these plans doesn’t have the ability to issue non-medically underwritten policies. This is laughable and pathetic all at the same time.  Why are the finances of Section 79 Plans so marginal? Section 79 Plans are up to 40 percent deductible because the life insurance policy purchased is a crummy policy by design. That’s right, by design, the policy is a terrible cash accumulator. The better the policy, the less the deduction. A good policy, Retirement Life(TM), for example, would receive only a 5 percent to 8 percent deduction through the plan.

Converting the crummy policy after year five  Section 79 Plans are funded into a crummy cash accumulating policy for five years. Then, the client is typically shown how the policy can be converted to a variable life policy or EIUL policy earning 9 percent annually going forward. Besides that, this is not a conservative example, the numbers are financially marginal even assuming a 9 percent rate of return.  Why are so many agents trying to sell Section 79 Plans? This is what really moved me to write this article?

Agents are pitching Section 79 Plans to clients for two simple reasons:

  1. Many small business clients will buy any plan that is “deductible” because they so despise paying income taxes,
  2. Insurance advisors want to sell life insurance.

This brings up an interesting issue. If the plan is marginal from a wealth-building standpoint, then why are agents selling it? Again, there are two reasons:

1) Most advisors have not broken down the math so they can come to a correct conclusion, which is that the plans are not worth implementing from a pure financial standpoint.

2) Some advisors know the plan is marginal from a financial standpoint and don’t care because they know they can still sell it to business owners who are looking for deductions.

The first reason is somewhat excusable (or was, before you knew the truth). The second reason is what helps gives life insurance agents a bad reputation.  Clients would be better off paying tax on their money and funding a “good” EIUL policy for wealth building. It sounds crazy, but it’s true. The math does not lie. Clients would be better off paying tax on their money and taking it home to buy a “good” cash accumulating policy.

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IRS Increases Audits of Section 79, 419, 412i and Captive Insurance

by Lance Wallach
by Lance Wallach

In recent years, the IRS has identified many of these arrangements as abusive devices to funnel tax deductible dollars to shareholders and classified these arrangements as “listed transactions.”

These plans were sold by insurance agents, financial planners, accountants and attorneys seeking large life insurance commissions. In general, taxpayers who engage in a “listed transaction” must report such transaction to the IRS on Form 8886 every year that they “participate” in the transaction, and you do not necessarily have to make a contribution or claim a tax deduction to participate. Section 6707A of the Code imposes severe penalties ($200,000 for a business and $100,000 for an individual) for failure to file Form 8886 with respect to a listed transaction.But you are also in trouble if you file incorrectly.I have received numerous phone calls from business owners who filed and still got fined. Not only do you have to file Form 8886, but it has to be prepared correctly. I only know of two people in the United States who have filed these forms properly for clients. They tell me that was after hundreds of hours of research and over fifty phones calls to various IRS personnel.

There is no doubt that while the public doesn’t really think much about buying life insurance, they have a need for it. Life insurance serves the purpose of funding the family’s continuation at death, and prevents the financial shock from the loss of the family’s main provider.

Uncle Sam Wants You To Pay TaxesLife insurance is also sold as a tax shelter of sorts. Because the investment growth on the cash value of a life insurance policy is not taxed, and in fact may never be taxed, life insurance can sometimes be a very efficient investment. (And sometimes not — eventually, the cost of insurance which increases dramatically with age can significantly eat away at investment returns, and more often than not the investment returns somehow never quite match the pollyannaish predictions of the illustrations shown to prospective buyers — those illustrations with unrealistic financial projections being known in the industry as “liar ledgers”).

The problem with life insurance as a tax shelter is that typically it must be purchased with post-tax dollars. Historical attempts by creative attorneys and financial advisers to manipulate various tax-free strategies to encompass a life insurance policy have nearly all ended in disaster: VEBAs, 412(i) plans, and 419 plans all ended with the taxpayers often paying more tax in the end than if they had done nothing in the first place, and lawsuits against advisers for professional negligence nearly hit the epidemic point.

For somewhat obvious reasons, the IRS has typically gone after arrangements that were pitched to clients that they could purchase a large amount of life insurance with pre-tax dollars like a heat-seeking missile. Yet, advisers persist in trying to wed life insurance to things that it shouldn’t be hitched to, so as to obtain the result of a pre-tax purchase of life insurance — and big commissions to the advisers, who if in good with their insurance company, might make upwards of 40% of the first-year’s premiums paid in on a Universal Life policy, and upwards of 80% on a Whole Life policy (they almost never disclose these commissions to their clients, of course).

The latest attempt to wed life insurance to something that will result in a pre-tax purchase of life insurance is that involving smallish captive insurance companies. These companies make the 831(b) election so that they are not taxed on their premium income, with the result that the underlying company can quite lawfully pay some reasonable amount of premiums to the captive and take a current-year deduction for it, but the captive does not pick up the premiums received as income.

From a tax standpoint, the benefits of an 831(b) captive are not that great — most of the money should be used to pay claims if the actuarial calculations of the premiums are anything like close, and then the balance of the money is subject to capital gains taxes when the company is liquidated. In the meantime, an 831(b) captive is not allowed to deduct all, or even most, of its operating costs.

Plus — and here is where life insurance re-enters the picture — an 831(b) captive is internally taxed annually on its investment income, which further eats into the tax efficiency of the captive. But what if the captive could purchase life insurance — which grows tax-free — and thus avoid the tax on its investment income? Welcome to the life insurance tax shelter du jour.

There are now tax shelter promoters out there (many of them the same ones who sold VEBAs, 412(i), and 419A(f)(6) plans in past years) actively marketing and selling 831(b) companies as a conduit to purchase life insurance with pre-tax dollars. Sometimes they try to disguise the transaction by having the captive do a split-dollar transfer to a trust that buys the life insurance, or having the captive invest in a preferred share of an LLC that buys the life insurance. This is just putting lipstick on the pig. Others just tell their clients to purchase life insurance directly inside the captive.

The truth is that it is probably fine for a mature captive, meaning one that has been around for some years and has large reserves and surplus, to use a small amount of its investable assets to purchase a key-man policy, or maybe invest in life settlements or the like.

But this is not how the 831(b) captives are being sold; instead, clients are being shown illustrations where the life insurance is being purchased soon after the first premiums are paid to the captive (the advisers want their commissions now, not later), and the efficiency of the captive is being measured not in its effectiveness as a risk-management tool (it’s proper purpose) but rather as an investment and estate planning tool (the improper tax shelter purpose).

In reviewing these transactions, the presence of the 831(b) captive is simply a sham. Premiums in these deals are rarely calculated based on anything like real-world risks, but the promoters are making a determination of how big of a deduction the client wants, and then “backing in” the premium amounts with the help of actuaries who will testify that a $500,000 premium for $2 million worth of terrorism insurance for a business in Lenexa, Kansas, is reasonable, and, oh, also that the world is flat, water is dry, hot is cold, and the sun comes up in the West.

Using Insurance to Reduce a Couple’s Taxes

The couple’s business had a banner year, generating about $1 million in profits–much of which they planned to take as personal income.

They’d worked with financial adviser Michael Turner to defer $100,000 of that income by establishing a Safe Harbor 401(k) and a profit-sharing plan. But the couple was interested in reducing their income taxes even further.

Unbeknown to Mr. Turner, they hatched an unusual plan to buy a second home in an income tax-free state, thinking it would exempt them from taxes. Mr. Turner had to explain that the laws regarding cross-state taxation meant that the second home likely wouldn’t have the effect they assumed.

“I told them that could still buy a second home if they wanted one, but if their goal was to reduce their income taxes, there were likely more effective options,” says Mr. Turner of Franklin Chase Wealth Management, which manages $5 million for 75 clients in Charlotte, N.C.

Putting additional money into their retirement plans wasn’t a good option, because the plan structures required that they also contribute more to their employees’ accounts at the same time. That wasn’t the couple’s immediate priority. So Mr. Turner found a solution that specifically benefited them: a Section 79 insurance plan.

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Taxpayers Who Previously Adopted 419, 412i, Captive Insurance or Section 79 Plans are in Big Trouble

by Lance Wallach
by Lance Wallach

In recent years, the IRS has identified many of these arrangements as abusive devices to funnel tax deductible dollars to shareholders and classified these arrangements as listed transactions.” Insurance agents, financial planners, accountants and attorneys seeking large life insurance commissions sold these plans.

In general, taxpayers who engage in a “listed transaction” must report such transaction to the IRS on Form 8886 every year that they “participate” in the transaction, and you do not necessarily have to make a contribution or claim a tax deduction to participate. Section 6707A of the Code imposes severe penalties for failure to file Form 8886 with respect to a listed transaction. But you are also in trouble if you file incorrectly. I have received numerous phone calls from business owners who filed and still got fined. Not only do you have to file Form 8886, but it also has to be prepared correctly. I only know of two people in the U.S. who have filed these forms properly for clients. They tell me that was after hundreds of hours of research and over 50 phones calls to various IRS personnel. The filing instructions for Form 8886 presume a timely filling. Most people file late and follow the directions for currently preparing the forms. Then the IRS fines the business owner. The tax court does not have jurisdiction to abate or lower such penalties imposed by the IRS.

“Many taxpayers who are no longer taking current tax deductions for these plans continue to enjoy the benefit of previous tax deductions by continuing the deferral of income from contributions and deductions taken in prior years.”

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Business Owners in 419, 412i, Section 79 and Captive Insurance Plans Will Probably Be Fined by the IRS Under Section 6707A

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by Lance Wallach

Taxpayers who previously adopted 419, 412i, captive insurance or Section 79 plans are in big trouble. In recent years, the IRS has identified many of these arrangements as abusive devices to funnel tax deductible dollars to shareholders and classified these arrangements as “listed transactions.” These plans were sold by insurance agents, financial planners, accountants and attorneys seeking large life insurance commissions. In general, taxpayers who engage in a “listed transaction” must report such transaction to the IRS on Form 8886 every year that they “participate” in the transaction, and the taxpayer does not necessarily have to make a contribution or claim a tax deduction to be deemed to participate.

Section 6707A of the Code imposes severe penalties ($200,000 for a business and $100,000 for an individual) for failure to file Form 8886 with respect to a listed transaction. But a taxpayer can also be in trouble if they file incorrectly. I have received numerous phone calls from business owners who filed and still got fined. Not only does the taxpayer have to file Form 8886, but it has to be prepared correctly. I only know of two people in the United States who have filed these forms properly for clients. They told me that the form was prepared after hundreds of hours of research and over fifty phones calls to various IRS personnel. The filing instructions for Form 8886 presume a timely filing. Most people file late and follow the directions for currently preparing the forms. Then the IRS fines the business owner. The tax court does not have jurisdiction to abate or lower such penalties imposed by the IRS.

Many business owners adopted 412i, 419, captive insurance and Section 79 plans based upon representations provided by insurance professionals that the plans were legitimate plans and

they were not informed that they were engaging in a listed transaction. Upon audit, these taxpayers were shocked when the IRS asserted penalties under Section 6707A of the Code in the hundreds

of thousands of dollars. Numerous complaints from these taxpayers caused Congress to impose a moratorium on assessment of Section 6707A penalties.

The moratorium on IRS fines expired on June 1, 2010. The IRS immediately started sending out notices proposing the imposition of Section 6707A penalties along with requests for lengthy extensions of the Statute of Limitations for the purpose of assessing tax. Many of these taxpayers stopped taking deductions for contributions to these plans years ago, and are confused and upset by the IRS’s inquiry, especially when the taxpayer had previously reached a monetary settlement with the IRS regarding the deductions taken in prior years. Logic and common sense dictate that a penalty should not apply if the taxpayer no longer benefits from the arrangement.

Treas. Reg. Sec. 1.6011-4(c)(3)(i) provides that a taxpayer has participated in a listed transaction if the taxpayer’s tax return reflects tax consequences or a tax strategy described in the published guidance identifying the transaction as a listed transaction or a transaction that is the same or substantially similar to a listed transaction. Clearly, the primary benefit in the participation of these plans is the large tax deduction generated by such participation. It follows that taxpayers who no longer enjoy the benefit of those large deductions are no longer “participating” in the listed transaction.

But that is not the end of the story. Many taxpayers who are no longer taking current tax deductions for these plans continue to enjoy the benefit of previous tax deductions by continuing the deferral of income from contributions and deductions taken in prior years. While the regulations do not expand on what constitutes “reflecting the tax consequences of the strategy,” it could be argued that continued benefit from a tax deferral for a previous tax deduction is within the contemplation of a “tax consequence” of the plan strategy. Also, many taxpayers who no longer make contributions or claim tax deductions continue to pay administrative fees. Sometimes, money is taken from the plan to pay premiums to keep life insurance policies in force. In these ways, it could be argued that these taxpayers are still “contributing,” and thus still must file Form 8886.

It is clear that the extent to which a taxpayer benefits from the transaction depends on the purpose of a particular transaction as described in the published guidance that caused such transaction to be a listed transaction. Revenue Ruling 2004-20, which classifies 419(e) transactions, appears to be concerned with the employer’s contribution/deduction amount rather than the continued deferral of the income in previous years. This language may provide the taxpayer with a solid argument in the event of an audit.

 

About Section 79 Plans…

While many employers offer life insurance and 401(k) plans to their employees, most don’t realize that there are additional benefits available within the IRS Code that provide specific benefits to business owners, executives, and key employees on a voluntary basis. Section 79 Plans are a part of the employee benefit section of the IRC (Internal Revenue Code) and include benefits that are offered to business owners and employees at almost all companies.


Some important features of available benefits:

  • Plan contributions are 100% deductible to the corporation as an employee benefit.
  • Plan participants can fund their plans with pre-tax earnings.
  • Contributions will reduce participant’s income and also lower payroll taxes for both the participant and organization.
  • Plans grow on a tax-deferred basis during the working years.
  • Section 79 Permanent Insurance plans allow for IRS penalty-free access to funds before age 59½.
  • Permanent plans include a tax-free death benefit for surviving beneficiaries.
  • Distribution may be made on a tax-free basis utilizing policy loan provision.

Don’t Get Caught in the Section 79 Trap!

One doctor almost lost everything ………..

In 2006 Doctor X found himself in what he thought was the pleasant position of having a substantial amount of cash on  hand that was not essential to the operation of his practice. That comfortable feeling did not last long. He quickly fell  prey to a predatory insurance agent who sold him on the idea of Section 79 scam as a vehicle to obtain tax deductions.
Of course what really interested the insurance agent was the funding vehicle, a large life insurance contract with  American General as the insurance carrier, which just happened to net the agent a large commission.

Unfortunately, the large, questionable tax deductions claimed by Doctor X indeed attracted the attention of the IRS. As a result of their audit, the IRS not only disallowed all of the tax deductions, but also imposed back taxes, an array of penalties, and interest, turning the doctor’s anticipated investment vehicle into something that could cost him everything he was saving and more. As if that weren’t bad enough, even that Draconian action was not the end of the story.

None of his so-called financial advisors had told Doctor X about IRC Section 6707A. Under this section of the Code, huge fines can be imposed on those who fail to inform the Service about participation in listed or reportable transactions, or transactions substantially similar to listed transactions. Loosely defined, a reportable transaction is any transaction that has the potential for tax avoidance or evasion. Since he had no knowledge of this requirement, the doctor did not make the proper filings under Section 6707A, and is now also being threatened with monstrous fines for that failure to submit the proper forms in the proper format.

Although these issues had the potential for great disaster and great financial loss for this doctor, all the anxiety and stress he has been suffering over this matter may soon have a happier ending than he expected at its onset because he had the sense to contact us for help, perhaps just in the nick of time. As a result of putting experts with a great deal of experience on his case, he now stands an excellent chance of having at least some of the penalties from the original audit abated. He will probably be able to recover the money that he sank into that large American General life insurance contract as well. Sometimes a properly worded letter to the insurance company is all it takes. Last, but certainly not least, Doctor X also has an excellent chance of avoiding the large Section 6707A penalties, as our experts in the art of filing late without paying fines are currently at work on that as well.

IRS Attacks Business Owners in 419, 412 , Section 79 and Captive Insurance Plans Under Section 6707A

By Lance Wallach, CLU, ChFC, CIMC
By Lance Wallach, CLU, ChFC, CIMC

Taxpayers who previously adopted 419, 412i, captive insurance or Section 79 plans are in big trouble.
In recent years, the IRS has identified many of these arrangements as abusive devices to funnel tax deductible dollars to shareholders and classified these arrangements as listed transactions.” These plans were sold by insurance agents, financial planners, accountants and attorneys seeking large life insurance commissions. In general, taxpayers who engage in a “listed transaction” must report such transaction to the IRS on Form 8886 every year that they “participate” in the transaction, and you do not necessarily have to make a contribution or claim a tax deduction to participate.

Section 6707A of the Code imposes severe penalties for failure to file Form 8886 with respect to a listed transaction. But you are also in trouble if you fi le incorrectly. I have received numerous phone calls from business owners who filed and still got fined. Not only do you have to file Form 8886, but it also has to be prepared correctly. I only know of two people in the U.S. who have filed these forms properly for clients. They tell me that was after hundreds of hours of research and over 50 phones calls to various IRS personnel. The filing instructions for Form 8886 presume a timely filing. Most people file late and follow the directions for currently preparing the forms. Then the IRS fi nes the business owner. The tax court does not have jurisdiction to abate or lower such penalties imposed by the IRS.

Many business owners adopted 412i, 419, captive insurance and Section 79 plans based upon representations provided by insurance professionals that the plans were legitimate plans and were not informed that they were engaging in a listed transaction.
Upon audit, these taxpayers were shocked when the IRS asserted penalties under Section 6707A of the Code in the hundreds of thousands of dollars. Numerous complaints from these taxpayers caused Congress to impose a moratorium on assessment of Section 6707A penalties.
The moratorium on IRS fines expired on June 1, 2010. The IRS immediately started sending out notices proposing the imposition of Section 6707A penalties along with requests for lengthy extensions of the Statute of Limitations for the purpose of assessing tax. Many of these taxpayers stopped taking deductions for contributions to these plans years ago, and are confused and upset by the IRS’s inquiry, especially when the taxpayer had previously reached a
monetary settlement with the IRS regarding its deductions. Logic and common sense dictate that a penalty should not apply if the taxpayer no longer benefits from the arrangement.

Treas. Reg. Sec. 1.6011-4(c)(3)(i) provides that a taxpayer has participated in a listed transaction if the taxpayer’s tax return reflects tax consequences or a tax strategy described in the published guidance identifying the transaction as a listed transaction or a transaction that is the same or substantially similar to a listed transaction. Clearly, the primary benefit in the participation of these plans is the large tax deduction generated by such participation. Many taxpayers who are no longer taking current tax deductions for these plans continue to enjoy the benefit of previous tax deductions by continuing the deferral of income from contributions and deductions taken in prior years. While the regulations do not expand on what constitutes “reflecting the tax consequences of the strategy,” it could be argued that continued benefit from a tax deferral for a previous tax deduction is within the contemplation of a “tax consequence” of the plan strategy. Also, many taxpayers who no longer make contributions or claim tax deductions continue to pay administrative fees. Sometimes, money is taken from the plan to pay premiums to keep life insurance policies in force. In these ways, it could be argued that these taxpayers are still “contributing,” and thus still must file Form 8886.
It is clear that the extent to which a taxpayer benefits from the transaction depends on the purpose of a particular transaction as described in the published guidance that caused such transaction to be a listed transaction. Revenue Ruling 2004-20 which classifies 419(e) transactions, appears to be concerned with the employer’s
contribution/deduction amount rather than the continued deferral of the income in previous years.
Another important issue is that the IRS has called CPAs material advisors if they signed tax returns containing the plan, and got paid a certain amount of money for tax advice on the plan. The fine is $100,000 for the CPA, or $200,000 if the CPA is incorporated. To
avoid the fi ne, the CPA has to properly fi le Form 8918.

 

IRS Code Section 79 Plans and Captive Insurance History

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By Lance Wallach, CLU, ChFC, CIMC

Insurance companies, agents, financial planners, and others have pushed abusive 419 and 412i plans for years. They claimed business owners could obtain large tax deductions. Insurance companies, agents and others earned very large life insurance commissions in the process.

When trying to understand how a product becomes the focus of IRS scrutiny it helps to know its history. In the case of plans that fall under Internal Revenue Code Section 79, that history is complex.

Eventually, the IRS cracked down on the unsuspecting business owners. Not only did they lose the tax deductions, but they were also fined, in addition to being charged penalties and interest. A skilled CPA with extensive IRS experience could usually eliminate the penalties and reduce the fines. Most accountants, tax attorneys and others, however, have been unsuccessful in accomplishing this.

After the business owner was assessed the fines and lost his tax deduction, he had another huge, unforeseen problem. The IRS then came back and fined him a huge amount of money for not telling on himself under IRC 6707A. If you participate in a listed or reportable transaction, you must alert the IRS or face a large fine.
In essence, you must alert the IRS if you were in a transaction that has the possibility of tax avoidance or evasion. Not only must you file Form 8886 telling on yourself, but the form needs to be filed properly, and done every year that you are in the plan in any way at all, even if you are no longer making contributions.
According to IRC 6707A Expert Lance Wallach, “I have received hundreds of phone calls from business owners who filed Form 8886, usually with the help of their accountants or the plan promoter. They got the fine for either improperly filing, or for making mistakes on the form.”

The IRS directions about preparing the form are vague, especially if the form is filed late. They presume a timely filing. In addition, many states also require forms to be filed.

“For example, if you work in New York State and manage to properly fill out the Federal form, but do not file the State form, you may still get fined,” says Wallach, adding that he only knows of two people that know how to properly prepare and file the forms, especially forms being filed late. As an expert witness in such cases, Lance Wallach’s side has never lost.

The result of the all of the above was many lawsuits against insurance companies, including Hartford, Pacific Life, Indianapolis Life, AIG, and Penn Mutual, to name just a few. Agents, accountants, and attorneys were also successfully sued.

Lately, insurance companies, agents, accountants, and others have been selling captive insurance and Section 79 scams. The motivations are exactly the same. They push large tax deductions for business owners. There are also huge commissions for salespeople, though this is usually mentioned only in passing, if at all.
Anyone participating in a listed or reportable transaction must properly file Form 8886 or face large IRS fines. A listed transaction is any transaction specifically identified as such by published IRS guidance, or one substantially similar to that transaction. A reportable transaction is any transaction that has the potential for tax avoidance or evasion.

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