Understanding Section 79 plansArticle added by Nicholas Paleveda MBA J.D. LL.M on April 16, 2012
Nick Paleveda MBA J.D. LL.M

Nicholas Paleveda MBA J.D. LL.M

Sanford, NC

Joined: March 27, 2012

While promoted highly by insurance advisors, Section 79 plans are often abused and therefore thoroughly audited and heavily penalized for unlawful practices.

The issue

Whether an employee can participate in an employer sponsored Section 79 plan (a group term life insurance plan as defined by the IRS) to obtain permanent benefits to be used for retirement.

Facts: Client A is an employee of Firm B. Firm B makes the decision to commence a Section 79 plan for its employees. Client A has been informed that up to two-thirds of their contributions to such Section 79 plan would be tax deductible. Client A is also advised that the benefits derived from the Section 79 plan may be used for retirement benefits.

The questions

1. Under Code Section 79 and Treasury Regulation §1.79, is an employee allowed a tax deduction from individual adjusted gross income for contributions made to a Section 79 plan?

2. If allowed, to what extent is tax deductible by the employee (and/or the employer)? Distinctively, may an employee deduct up to two-thirds of contributions made to this Section 79 plan?

Under Section 79 of the Internal Revenue Code, is an employee able to receive permanent benefits to be used for retirement from an employer-sponsored Section 79 plan?

Brief answer

1. Yes, an employee eligible to participate in an employer-sponsored Section 79 plan may be allowed a tax deduction on their individual tax return. A tax deduction may be available to the employee, the employer, or both. Strict adherence to the calculations of such deduction is of extreme importance to remain within legal boundaries set forth in Code Section 79 for employers (Treasury Regulation §1.79- 3(d)(2) for employees). Nonetheless, an employee may not legally capture a tax deduction in amounts as high as two-thirds of the contributions made.

2. Yes, under Section 79 of the Internal Revenue Code, an employee is able to receive permanent benefits to be used for retirement from an employer-sponsored Section 79 plan pursuant to Treasury Regulation §1.79. These benefits under the Section 79 group term life insurance plan must be designated as permanent benefits and differentiated from life insurance benefits in the plan.

The entire cost of permanent benefits, as calculated under Treasury Regulation §1.79-3(d)(2), must be included in the employees’ income (from contributions made by both employer and employee). The employee may qualify for deductions up to the amount contributed by the employee only (not including the employer’s contributions), to the designated permanent benefits portion of their Section 79 plan.

Facts

Client A is an employee of Firm B. Firm B employs more than 10 full-time employees. Firm B has been approached by an insurance broker and presented with a Section 79 group term life insurance plan. The plan advertises that the employer may claim a large tax deduction for contributions made on behalf of its employees. The plan also promises that participating employees may obtain a tax deduction for an amount up to two-thirds of the contributions made to a Section 79 plan.

Additionally, the plan provides that participants may use the benefits vested in a Section 79 plan for retirement. However, Section 79 plans have been highly scrutinized by the Internal Revenue Service over much of the past decade. The Internal Revenue Service has, and actively continues, to audit numerous Section 79 plans to uncover those of non-compliance, participation in listed transactions and formation of abusive tax shelters.
Discussion

In addressing whether or not to participate in an employer-sponsored Section 79 plan, it is imperative to research before reaching a decision.

Section 79 of the Code addresses a group term life insurance plan and provides guidance on employer tax deductions allowed under Section 162. Treasury Regulation §1.79 discusses the employee treatment of costs and contributions made to a Section 79 plan. This Treasury Regulation also discusses permanent benefits within Section 79 Plans. As we present you with the laws governing Section 79 plans, we will also present you with the interpretations of such laws by the Internal Revenue Service.

While promoted highly by insurance advisors, Section 79 plans are often abused and therefore thoroughly audited and heavily penalized for unlawful practices.

Section 79 of the Internal Revenue Code provides that as long as the employer’s group term life insurance plan is nondiscriminatory, key employees can participate and exclude from gross income the cost of term insurance up to $50,000. An employee can exclude from gross income the cost of an employer paid group term life insurance plan provided the amount of the insurance does not exceed $50,000.

Section 79(a) provides that, “There shall be included in the gross income an amount equal to the cost of group term life insurance but only to the extent that such cost exceeds the sum of (1) the cost $50,000 of such insurance, and (2) the amount (if any) paid by the employee toward the purchase of such insurance.”

An employer can offer to an employee the option of obtaining a higher amount of employer paid group term life insurance, but the employee will have to report the additional cost of the insurance as income. An employee can also decline to accept the “free” term life insurance. A nondiscriminatory plan would also benefit an employee as well as the owner of a C corporation, who would be eligible to participate.

Section 79(d)(2) provides that, “…the term ‘discriminatory group term life insurance plan’ means any plan of an employer for providing group term life insurance unless (A) the plan does not discriminate in favor of key employees as to eligibility to participate, and (B) the type and amount of benefits available under the plan do not discriminate in favor of participants who are key employees.”

The employer’s plan must meet certain nondiscriminatory eligibility classification requirements. Section 79(d)(3)(A) provides that, “a plan does not meet requirements of subparagraph (A) of paragraph (2) unless (i) such plan benefits 70 percent or more of all employees of the employer, (ii) at least 85 percent of all employees who are participants under the plan are not key employees, (iii) such plan benefits such employees as qualify under a classification set up by the employer and found by the Secretary not to be discriminatory in favor of key employees, or (iv) in the case of a plan which is part of a cafeteria plan, the requirements of section 125 are met.”

If an employer’s plan is found to be discriminatory, then key employees will not be able to exclude the cost of term insurance, Section 79(d)(1)(A). Having a nondiscriminatory group term life insurance plan is a necessity to being able to offer a permanent benefits plan. Treasury Regulation §1.79 allows group term life insurance plans to include permanent benefits. Permanent benefits may be used for retirement.
As Section 79 discusses the ability for an employer to deduct up to $50,000 per employee for costs associated with life insurance benefits under a Section 79 plan, Treasury Regulation §1.79 discusses the amounts which must be included an employee’s income as well as the amounts that may be eligible for a tax deduction.

An employee is allowed to exclude the first $50,000 of group term life insurance costs paid by its employer; costs in excess of $50,000 must be included in income. In addition, Treas. Reg. §1.79 states that “the cost of the permanent benefits reduced by the amount paid for permanent benefits by the employee is included in the employee's income.”

The Treasury Regulation continues to provide a formula in §1.79 (d)(2) to calculate the “cost” of permanent benefits (to be included in income): cost may not be lower than X (DDB 2 —DDB 1 ).

The amount that may be tax deductible is the amount of retirement benefit contributions made by the employee only. An employee must therefore include in income any life insurance benefits in excess of $50,000 and any permanent benefit costs provided by the employer. An employee is only allowed to deduct the portion of permanent benefit costs contributed by the employee.

The tax cost calculation mentioned above calculates the “cost” of the premiums according to IRS standards. Because of the formula, the “cost” is typically slightly less than the actual premiums paid and this “cost” is what is included in an employee’s income. Because an employee may only deduct the contributions made in excess of $50,000 and those made to permanent benefits, the tax deduction is allowed but is unlikely to reach an allowance of two-thirds of income being recognized.

However, the two-thirds deduction is possible for an employer as they are allowed to deduct up to $50,000 of costs incurred to an employee’s Section 79 plan for group term life insurance premiums as calculated.

Treas. Reg. Section 1.79-1(a) specifies that the life insurance must meet four conditions to be considered group term life insurance and qualify for special tax exclusion by employees.
    1. It must provide a general death benefit, excludable from gross income under IRC Section 101(a).

    2. It must be provided to a group of employees as compensation for personal services performed as an employee.

    3. The insurance must be provided under a policy carried directly or indirectly by the employer.

    4. The amount of the insurance provided to each employee must be computed under a formula that precludes individual selection of such amounts. The formula may be based on factors such as age, years of service, compensation or position.
Pursuant to Section 1.79- 1(b) of the regulations, under specified circumstances, group term insurance may be combined with other benefits referred to as permanent benefits. To qualify under Treasury Regulation 1.79.1 the following conditions must be met:
    1. The policy or the employer designates, in writing, the portion of the death benefit which is group term insurance and;

    2. The part of the death benefit that is designated as group term life insurance for any policy year is not less than a certain amount determined by formula in the regulations.
Under Section 1.79-1(d), the employee’s income includes the cost of those permanent benefits, reduced by the amount the employee paid for the benefits. The cost of the permanent benefits is an amount at least equal to the amount determined by the use of the deemed death benefit formula as found in Section 1.79-3(d)(2) of the Treasury Regulations.

As mentioned previously, as the IRS has become aware of the listed transactions and abusive tax shelters being created under Section 79 plans, the plans are being highly scrutinized.

Written in an article by Lance Wallach called “Be Advised Everything is not Fine”, published in the Employee Benefit Adviser, Nov. 2010, the author raises a warning that the IRS will increase its investigating into Section 79 plans. The author raised a similar warning regarding 412(i) and 419 plans, and the IRS has thoroughly been investigating those plans as well.

However, in an article written by Richard D. Landsberg, “The Section 79 Project,” published in the Journal of Financial Service Professionals, Nov. 2010, reached a different conclusion regarding Section 79 plans. The author believes that the industry supporting the use of Section 79 plans will find ways of conforming to the Code and Treasury Regulations. Nonetheless, with the IRS on guard and ready to attack Section 79 plans, the decision to participate in such plan requires commitment to ensure the legality and proper guidelines are being followed in income inclusion, tax deductions and reporting.

As the red flags are raised regarding Section 79 plans, there are court cases reflecting this as well. For example, Curcio v. Commissioner (TC Memo 2010-115), the tax court ruled that an investment in an employee welfare benefit plan named Benistar was a listed transaction in that the transaction in question was substantially similar to the transaction earlier described and designated as a listed transaction.

McGehee Family Clinic, P.A., et al. v. Commissioner, TC Memo 2010-202 was in favor of the commissioner and imposed penalties as a result of the understatement of income from the overstatement of deductions related to Section 79 plans.

These are great examples illustrating the risk Section 79 plans pose to employees who are virtually unaware of such breach but will be held responsible for participation in a listed transaction as a result. Participants of Section 79 plans must be very cautious and pay close to attention to the laws, regulations, and guidelines to properly record and report.

IRS Circular 230 Disclaimer: To ensure compliance with IRS Circular 230, any U.S. federal tax advice provided in this communication is not intended or written to be used, and it cannot be used by the recipient or any other taxpayer (i) for the purpose of avoiding tax penalties that may be imposed on the recipient or any other taxpayer, or (ii) in promoting, marketing or recommending to another party a partnership or other entity, investment plan, arrangement or other transaction addressed herein.
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