Pension Trends   Volume VI, No. 1, February 2005     Download/view PDF version

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If It Sounds Too Good To Be True …

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If It Sounds Too Good To Be True

It is difficult for any business to succeed if it does not work at minimizing its tax liability. Tax planning is a necessary and important part of a business strategy. It is unfortunate, however, that there have always been and probably will always be business “advisors” whose tax minimization schemes sound too good to be true, and in fact, are.

Because a qualified retirement plan can be an effective tax minimization tool for the small business, our industry is not exempt from the occasional too-good-to-be-true scheme. We have seen two such schemes that were presented to our clients and are aware of other schemes making the rounds. Here are a couple of examples.

Scheme No 1. The excessive 412(i) plan. 412(i) plans have been around for decades. They are a legitimate approach to funding a defined benefit plan. In general terms, a 412(i) plan is a defined benefit plan funded with a guaranteed investment, specifically a life insurance or annuity product or both. In the right situation, a 412(i) plan is a better planning tool than a traditional defined benefit plan.

The too-good-to-be-true 412(i) plan we have encountered is one that purports to generate a significantly larger deductible contribution than is available under a comparable traditional defined benefit plan. These aggressive 412(i) designs incorporate a significant amount of specially designed life insurance coverage. The insurance premium is quite high relative to the cash value that accumulates in the early years of the policy; and this high premium is much of what creates the overly large deduction. After a few years in these special contracts, the plan sells the life insurance to the insured; the sale price is the low cash surrender value. Miraculously, shortly after the sale, the cash value increases dramatically, giving the owner a large tax deferred gain outside the plan. Since most of the (hidden) value was transferred out of the plan with the life insurance, the plan still has plenty of benefit to fund and can continue to create substantial deductions for at least several more years.

The IRS does not like these arrangements and has ruled on a couple of the issues that allowed some practitioners to justify designing them. For example, the IRS has reiterated its long-held position against using so-called “springing cash value” policies in these plans. It has also clarified its position on how the taxable value of insurance contracts should be determined when they are sold. Finally, the IRS now includes plans with excessive life insurance as a “listed transaction” for tax shelter purposes and requires the plan sponsor to notify the IRS that they are involved in such a transaction when they file their annual tax return. This is not a comfortable place for most business owners to be.

We have set up many 412(i) plans. Cathy MacLeod at IAI is an authority on 412(i) plans. If you or your client is presented with a 412(i) proposal, we encourage you to call Cathy. She can tell you if you have been presented with a solution or a problem.

Scheme No. 2. The self-directed defined benefit plan. Let’s start with the fact that there is no such thing as a self-directed defined benefit plan. Professional organizations with multiple shareholders or partners (owners) are the typical target for this scheme. The scheme proposes that each owner set up a defined benefit plan of his or her own. Each owner is named the trustee for his or her plan and as trustee directs how the funds in the plan are invested. You can invest your defined benefit funds in corporate bonds with your broker, and I can invest in bio-chem start-ups with my broker.

Assuming for a minute that proper arrangements are made to satisfy IRC Section 401(a)(26) minimum participation requirements and a few other significant hurdles, there remains one fundamental flaw. The obligation to fund a defined benefit plan is the responsibility of the employer, not the individual shareholder or partner. If a defined benefit plan fails – that is if the plan terminates with insufficient assets – the employer has the obligation to make up any shortfall. So, the risky investments one partner uses to fund his or her plan creates a potential liability for all the owners. Any claim that each shareholder or partner is not liable for the adequate funding of every other shareholder or partner’s defined benefit plan is pure fiction.

Imagine the consternation of the remaining partners in a situation where a departing partner leaves behind a severely underfunded plan. Even if there are “outside agreements” intended to cover just such a scenario, possible complications abound, and as we all know, complications are often a precursor to lawsuits.

There is good reason why the adage “If it sounds too good to be true, it probably is” has been around forever. There will always be schemes proposed by the uninformed and unscrupulous that cross the line from being aggressive planning to being a problem waiting to happen. The excessive 412(i) plan and the self-directed defined benefit plan are just two of the latest examples.

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View Past Issues of Pension Trends

This newsletter along with past Pension Trends issues can be viewed on our website www.independentactuaries.com. Simply click on the Pension Trends Newsletter button on the left of the screen. Once the current Pension Trends appears, you will see a link to the list of back issues.

Some of the issues that have generated a lot of interest are “Helping Your Client Choose the Right Plan” (August, 2003), and the “The Retirement Planning Tax Ideas for 2002” series (February, May, August 2002). The topics discussed in these issues are still relevant today and the information has been useful as a resource for our contacts and their clients in evaluating tax planning strategies.

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This newsletter has been published in order to share general information with our professional contacts. The information presented in this newsletter should not be relied upon without first seeking the advice of a CPA, Attorney or other benefit professional.