Tax News

CCH (cch.taxgroup.com) reports:

The IRS has issue three pieces of guidance with regard to certain trust arrangements that are being sold to business owners as welfare benefit funds, and has identified some of those arrangements as listed transactions. The arrangements typically involve a trust wherein cash-value insurance policies on the lives of the owner and/or key employees are purchased with the owner's contribution. Other arrangements involve purported welfare benefit funds that, in form, provide post-retirement medical and life insurance benefits to employees on a nondiscriminatory basis but, in operation, primarily benefit the owners or other key employees of the business.
Notice 2007-83
Some of the arrangements identified by the IRS involve a trust wherein cash-value insurance policies on the lives of the owner and/or key employees, are purchased with the owners contribution. The proceeds are then distributed to participants when the plan is terminated. Advocates of such arrangements are telling business owners that, under such arrangements, the contributions being used to purchase the life insurance policies are deductible as qualified costs without a corresponding inclusion in the employer's income. Business owners are warned by the IRS that such transactions are subject to the disclosure requirements of Code Sec. 6111 and could be listed transactions, subjecting the employer to penalties.The IRS has warned investors that it intends to challenge these types of transactions.
Notice 2007-84
The tax treatment of certain trust arrangements involving purported welfare benefit funds may vary from the claimed tax treatment. The arrangements involve purported welfare benefit funds that, in form, provide post-retirement medical and life insurance benefits to employees on a nondiscriminatory basis but, in operation, will primarily benefit the owners or other key employees of the business. Advocates of these plans claim that employer's contributions for the post-retirement medical and life benefits are deductible under Code Secs. 419 and 419A
as additions to a qualified asset account and that the business owners or key employees receive the economic benefits from the contributions with little or no inclusion in income.
Caution: According to the IRS, taxpayers should not assume that any further IRS guidance addressing these arrangements will be applied prospectively only.
The arrangements are being promoted to and used by small businesses to avoid federal income and employment taxes. Usually, they are sold to the business as a way to provide post-retirement medical benefits, post-retirement life insurance, and cash and other property to the business owners or key employees on a tax-favored basis through the use of a trust. They may involve either a taxable trust or a tax-exempt trust, i.e., a voluntary employee's beneficiary association (VEBA) that has received a determination letter from the IRS that it is described in Code Sec. 501(c)(9). Often, employer's contributions will be used by the trust to purchase cash value life insurance policies on the lives of owner-employees or, sometimes, other key employees. Also, the employer's deduction for contributions is frequently based on calculation of a reserve associated with each of the plan participants that may be based on an unreasonable assumption or other actuarial assumptions that either are not reasonable or may not be reflected in the reserve calculations for purposes of Code Secs. 419 and 419A.
The plan documents of some arrangements may indicate that post-retirement benefits will be provided on a nondiscriminatory basis, even though only a few employees will ever, in fact, receive those benefits. Further, the owner will receive a substantial portion of the excess assets not needed to pay the original benefits. This may be accomplished under some arrangements by the use of a "loan" to the owners. Under some arrangements, the plan will be amended to provide plan benefits other than the original post-retirement medical or life insurance benefits. In others, the timing of a plan termination and method of allocating the remaining assets are structured so that a substantial portion of trust assets is received, directly or indirectly, by owners and other key employees.
The IRS may challenge the claimed tax benefits of these arrangements for various reasons:
--Contributions on behalf of an owner-employee may be characterized as dividends or as nonqualified deferred compensation subject to Code Sec. 404(a)(5) or Code Sec. 409A or both, depending on the facts and circumstances.
--The arrangement may be subject to the rules for split-dollar arrangements, depending on the facts and circumstances.
--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 Code Secs. 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.
--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.
--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.
--Some of 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 Code Sec. 4976.
The IRS may impose penalties on persons involved in these or similar arrangements, and, as applicable, on persons who participate in the promotion or reporting of these or similar arrangements. These include:
--the accuracy-related penalty under Code Sec. 6662.
--the return preparer penalty under Code Sec. 6694.
--the promoter penalty under Code Sec. 6700.
--the aiding and abetting penalty under Code Sec. 6701.
Finally, the IRS states that, even if a trust has received a determination letter from the IRS that it is exempt under Code Sec. 501(c)(9), this type of letter does not address the tax deductibility of contributions with respect to an employer or the inclusion of income with respect to employees.
Rev. Rul. 2007-65
The IRS ruled that a welfare benefit fund's qualified direct cost under Code Sec. 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 Code Sec. 264(a). This holding applies regardless of whether the plan benefits are provided through a taxable trust, an exempt Voluntary Employees' Beneficiary Association, or any other type of welfare benefit fund.
CCH Comment. Like Notice 2007-83 and Notice 2007-84, this ruling 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 polices on the lives of other employees covered under the plan. 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 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 a listed transaction under Notice 2007-83.
The ruling involved welfare benefit funds that purchased cash value life insurance policies to fund their obligations. In situation 1, the fund was only obligated to provide group-term life insurance to employees. The fund purchased policies on each employee, with the death benefits payable to the beneficiary named by the employee and the fund retaining all other policy rights. In situation 2, the fund was obligated to provide disability benefits to current employees. The fund was the owner and named beneficiary of these policies. The fund paid out $X during the tax year in disability benefits.
Costs of providing employee welfare benefits are deductible by an employer only if they are qualified direct costs of the fund. Costs are qualified direct costs only if they would be deductible by the employer if: (1) the employer paid them directly rather than through a welfare benefits fund, and (2) the employer used a cash method of accounting. The employer in both situations 1 and 2 could not deduct these premiums under these circumstances because under Code Sec. 264(a), a taxpayer cannot deduct premiums for life insurance if it is a direct or indirect beneficiary of the policies. In these situations, the employer is either a direct (situation 2) or indirect (situation 1) beneficiary. (The employer in situation 2, however, could deduct the $X paid out to employees during the tax year, and, hence, the fund could treat that amount as a qualified direct cost.)
An employer can deduct contributions to a welfare benefits fund that are set aside in a qualified asset account under Code Sec. 419A that are reasonably and actuarially necessary to fund claims for benefits incurred but unpaid as of the close of the tax year. In situation 1, all the benefits provided by the plan are fully insured, so no amounts are needed to fund unpaid claims. Hence, the employer in situation 1 could not deduct any of its contributions to the fund on that basis. In contrast, the obligations of the fund in situation 2 were not insured and could generate incurred but unpaid claims. The employer in situation 2 could, therefore, deduct funds set aside to satisfy these unpaid obligations, as long as the amounts were otherwise deductible. Nevertheless, if the fund had purchased the life insurance to accumulate assets to pay uninsured disability benefits, the employer could not deduct the contribution since the employer would not have been able to deduct the insurance premiums.
The rule disallowing a deduction if the employer could not deduct the amount under Code Sec. 264 is to be applied prospectively. For any tax year of an employer ending before November 5, 2007, if a deduction is otherwise allowable, a deduction for contributions to a welfare benefit fund under an arrangement that is not subject to the split-dollar life insurance arrangements will not be disallowed merely because the deduction would have been disallowed under Code Sec. 264 had the employer provided the benefits directly.
IR-2007-170, 2007FED ¶46,670
Notice 2007-83, 2007FED ¶46,671
Notice 2007-84, 2007FED ¶46,672
Rev. Rul. 2007-65, 2007FED ¶46,673
Other References:
Code Sec. 264
CCH Reference - 2007FED ¶14,008.135
Code Sec. 419
Code Sec. 419A
CCH Reference - 2007FED ¶19,301.25
CCH Reference - 2007FED ¶19,301.60
Code Sec. 6111
CCH Reference - 2007FED ¶37,002.156
Code Sec. 6112
CCH Reference - 2007FED ¶37,022.023
CCH Reference - 2007FED ¶37,022.09
CCH Reference - 2007FED ¶37,022.156
Tax Research Consultant
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