419 plans: A victory for the taxpayer in 2013 where the IRS was pinned
By Nick Paleveda MBA J.D. LL.M
National Pension Partners
However beat up section 419 has been over the last decade, a victory — or should I say “a stunning victory” — recently took place in court. The ruling was in favor of the taxpayer who set up a 419 plan in Pinn v. Commissioner Doc Nos. 767-07 (Feb. 11, 2013).
A "welfare benefit" or 419 plan is an employee benefit other than those to which IRC sections 83(h), 404 and 404A apply. The most common types of welfare benefits are medical, dental, disability, severance and life insurance benefits. It is important to remember that an examination of an employer’s deduction for its contribution to a welfare benefit fund is not an examination of the trust itself. The actual examination of a VEBA trust itself must be handled by an agent from the Tax Exempt and Government Entities division.
There are many closely held businesses claiming deductions for contributions to welfare benefit funds that claim to be exempted from the deduction limitations of sections 419 and 419A because they meet the requirements of sections 419A(f)(5) (for separate funds under collective bargaining agreements) or 419A(f)(6) (for 10 or more employer plans). In 1995, the IRS issued Notice 95-34, warning taxpayers about potential problems with promoter claims regarding 10 or more employer plans. In 2000, the Service issued Notice 2000-15, classifying such arrangements as abusive corporate tax shelters.
The Treasury issued proposed regulations covering 10 or more employer plans on July 11, 2002. A frequently cited tax court case involving such plans, Neonatology Associates, P.A., et al., v. Commissioner, 115 T.C 43 (2000) aff’d 299 F. 3d 221 (3rd Cir. 2002), found that the majority of the contributions to one such plan were actually constructive dividends and thus nondeductible to the corporation, and they are currently includible in the shareholder’s income. The court upheld the Service’s imposition of penalties on both the corporate and individual entities. Since promoters of these arrangements tend to promise business owners current deductions for benefits to be received in the future, we expect that the popularity of these products will increase if Congress enacts tax legislation prospectively reducing the individual federal income tax rates. For more information on the types of plans being marketed, you can go to any Internet search engine and search the terms: welfare benefit funds, VEBA, section 419A(f)(6) or section 419A(f)(5).
In general, sections 419 and 419A limit an employer’s deduction for contributions to a welfare benefit fund to the amount of the benefits actually paid during the year by the fund (determined using the cash-basis method of accounting), plus a limited allowance for reserves for incurred-but-unpaid claims and post-retirement medical and life insurance benefits. Section 419A(c)(1) allows a limited reserve for incurred-but-unpaid claims for disability, medical, SUB or severance pay, and life insurance benefits. If the fund qualifies as a separate fund under a collective bargaining agreement, in general, section 419A(f)(5) provides that there is no “account limit” for such reserves. Section 419A(f)(6) provides, in general, that the deduction limitations under sections 419 and 419A do not apply if the fund qualifies as a 10 or more employer plan. In order to qualify, the plan must not maintain “experience-rating arrangements” with respect to individual employers, nor can any employer normally contribute more than 10 percent of the total contributions made by all employers.
Sections 419 and 419A are not applicable if the benefits provided by the plan are determined to be deferred compensation. In these situations, IRC section 404 controls. In general, section 404(a)(5) provides that an employer’s deduction takes place in the year in which the amount attributable to the contribution is includible in the employees’ gross income. However, if more than one employee participates in the plan, an employer can only take a deduction if separate accounts are maintained for each employee.
In all situations, sections 419 and 419A come into play only if the contributions to the fund are otherwise deductible under the code. For example, if the contribution was determined to be a constructive dividend and thus not otherwise deductible, then sections 419 and 419A would not be applicable.
In practice, 419 plans are routinely disqualified by the IRS in a cat and mouse game where the rules are confusing and never followed, at least according to our friends at the IRS. The tax court has often stated, “The IRS determination is presumed to be correct and the burden of proof is on the taxpayer”.
In the case Mark Curcio and Barbara Curcio v. Commissioner of Internal Revenue, T.C. Memo. 2010-115 (U.S. Tax Court 2010), the court stated:
Section 419(a) provides that an employer’s contributions to a welfare benefit fund are deductible, but only if they are otherwise deductible under chapter 1 of the Code. The deductibility of an employer’s contributions to a welfare benefit fund is further limited by section 419(b) to the fund’s qualified cost for the taxable year. Section 419A(f)(6) provides that contributions paid by an employer to a multiple-employer welfare benefit fund are not subject to the deduction limitation of section 419(b). Petitioners argue that (1) contributions to Benistar Plan are ordinary and necessary business expenses deductible under section 162(a) (which is in chapter 1 of the Code) and (2) Benistar
Plan is a multiple-employer welfare benefit plan under section 419A(f)(6), so that the deduction limits of section 419(b) are not applicable. We first consider whether the contributions made by the participating companies are ordinary and necessary business expenses deductible under section 162(a). We conclude that the contributions are not ordinary and necessary business expenses deductible under section 162(a). Our decision turns on our factual findings regarding the mechanics of Benistar Plan and our conclusion that petitioners had the right to receive the value reflected in the underlying insurance policies purchased by Benistar Plan. Petitioners used Benistar Plan to funnel pretax business profits into cash-laden life insurance policies over which they retained effective control. As a result, contributions to Benistar Plan are more properly viewed as constructive dividends to petitioners and are not ordinary and necessary business expenses under section 162(a).
We acknowledge that the evidence at trial and the arguments in the briefs in large part deal with Carpenter’s attempts to fashion the Benistar Plan to qualify as a welfare benefit plan under section 419. Carpenter was trained as a tax lawyer and studied the evolving regulations issued or proposed under section 419 and the developing caselaw and amended the plan in attempts to secure deductions for the premiums paid by petitioners. He published a book in an attempt to explain the provisions of section 419 to insurance brokers. The parties presented expert testimony and opinions about the nature of Benistar Plan and the underlying policies. Petitioners’ expert, however, relied solely on representations by Carpenter, some of which were contradicted by the evidence at trial. Under the circumstances of these cases, exploration of the intricacies of section 419 would not be productive and might be misleading as applied to future cases where the benefits provided did not so clearly exceed ordinary and necessary expenses deductible under section 162. Because we do not interpret section 419A(f)(6), we do not address petitioners’ contention that section 1.419A(f)(6)-1, Income Tax Regs., is invalid.
In G. Mason Cadwell, Jr., Petitioner v. Commissioner of Internal Revenue, 136 T.C. No. 2 (U.S. Tax Court 2011), the court stated:
The issues we must decide concern the income tax consequences of employee welfare benefits. Generally, contributions to welfare benefit plans are deductible by an employer when paid if they qualify as ordinary and necessary business expenses, but only to the extent allowed by sections 419 and 419A. Secs. 162(a), 419, 419A(f)(6). In recent years, adopted multiemployer plans have been claiming to satisfy section 419A(f)(6) and purporting to generate deductions for the insurance benefits provided under the plans. Notice 95-34, supra. This Court has decided several cases regarding purported section 419A(f)(6) plans. In Booth v. Commissioner, 108 T.C. 524, 565 (1997), we held that the plan in issue did not meet the requirements of section 419A(f)(6) because it was “an aggregation of separate welfare benefit plans, each of which has an experience-rating arrangement with the contributing employer.” In Neonatology
Associates P.A. v. Commissioner, 115 T.C. 43 (2000), affd. 299 F.3d 221 (3d Cir. 2002), without deciding whether the plans in issue met the requirements of section 419A(f)(6), we held that the corporate employer/participants may not deduct contributions in excess of the cost of term life insurance. We also held that the disallowed deductions should be treated as dividend distributions to the employee-owners of the C corporations to the extent of earnings and profits.
Id. at 96-97. In V.R. DeAngelis M.D.P.C. v. Commissioner, T.C. Memo. 2007-360, affd. per curiam 574 F.3d 789 (2d Cir. 2009), similarly without ruling on whether the plan met the requirements of section 419A(f)(6), we held that payments for life insurance were essentially a distribution of S corporation profits rather than payments made with compensatory intent. In Curcio v. Commissioner, T.C. Memo. 2010-115, again without ruling on whether the plan met the requirements of section 419A(f)(6), we held that contributions were distributions of profits to the employee-owners and not deductible pursuant to section 162(a). We did not address in any of the foregoing cases the tax consequences to a non-owner employee for contributions to a plan that purportedly met the requirements of section 419A(f)(6) and subsequently was converted into a plan that no longer qualified. We must decide the consequences to petitioner of contributions to such a plan.
Bret Petrick, an “insurance expert” who advised the Pinns on employee benefit plans and Marshall Katzman, one of Petrick’s business associates, presented a slideshow entitled, “American Workers Benefit Fund, the 419 plan with a difference!” The slides outlined how the Pinns could obtain preretirement life insurance through a union-sponsored welfare benefit fund. According to the slideshow, life insurance premiums would be fully deductible to the sponsoring employer, and very little current income would have to be recognized by the employee-participants. The Pinns liked what they heard and decided to sign up.
Seems like a scam, right? However, the IRS attacked the 419 arrangement based upon cancellation of debt income. The tax court noted in their opinion:
“What made this a sweet deal is that the code doesn’t limit the deduction employers can take for contributions they make to a welfare benefit fund negotiated under a collective-bargaining agreement. See sec. 419A(f)(5)."
Never before have I seen a case where the tax court said the code does not “limit the deductions." However, in upholding the 419 arrangement the court concluded:
"We therefore find that the Commissioner has failed to prove that the Pinns had COD income in 2002. This may strike learned observers as unusual — there was some evidence in the record that the union associated with the Trust marketed similar plans widely, touting their benefits as including immediate deductions, tax-free loan proceeds, and a long-deferred recognition of income."
The court went also to disallow the service call for tax penalties. The entire case can be sent to you if you would care to read it.