Illegal 412(i) plans finally get slammed by the Tax Court
By Nick Paleveda MBA J.D. LL.M
National Pension Partners
Moral of the story? Don't go at this alone. Retirement plans are tricky. Be reasonable. Remember, the "reasonable tax court judge" is looking at your plan.
The U.S. Tax Court finally slammed illegal 412(i) plans. No mercy rule was installed in Soni v. Commissioner, and all penalties were placed on the plan [6662(a) and 6664(d)]. If you read the case, the court stressed the importance of review by a CPA or attorney.
"Soni Inc. obtained neither legal advice nor tax advice from a CPA with expertise in the area of defined benefit plans regarding the tax implications of operating the plan."
The problem is that the taxpayer failed to send a timely 8886 and did not know it needed to be sent to two places: the IRS and the OTSA. (By the way, they sent it to the IRS but not the OTSA — a nasty trick by our friends at the IRS. Many taxpayers did not know this form needed to be sent to two places.) What did the court say about this?
"Ignorance of the law is not excuse for noncompliance with the applicable law," citing McGehee family Clinic P.A. v. Commissioner.
So the taxpayer asked to rely on the determination letter. What did the court say?
"The determination letter only addresses the qualified status of the plan under section 401(a) and does not address plan operation. A determination letter does not address whether actuarial assumptions are reasonable for funding purposes or whether a specified contribution is deductible," citing IRS Publ'n 794 (rev. July 2001).
I found it interesting that the court cited an IRS publication as the law. In the future, they may cite this case (not discussing it came from an IRS publication). Seek to comply
So the taxpayer argued "substantial compliance." Here is what the Court said:
"Substantial compliance is a narrow doctrine that may be applied to avoid hardship where a party establishes that the party intended to comply with a provision and did everything reasonably possible to comply with the provision but did not comply with the provision because of a failure to meet the provision's specific requirements."
How does this happen? The promoter sold a basically springing cash value life policy in the plan.
Attack 1: The service attacked the plan, as the death benefit of the policy is $100,000 greater than the death benefit in the plan. The IRS has used this argument for legitimate plans as well. If you have a life insurance policy in the plan, there's a good chance it does not match the benefits in the plan. The prototype plans and volume submitter language will not track the policy. The only way I can see to solve this problem is to draft custom language into the plan that follows the policy, which would not be part of the volume submitter or prototype.
Attack 2: For those who have done audits, my friends at the IRS also argue that the benefits of the policy do not match the plan. Once again, you need a savings clause not part of the volume submitter. Why? They almost never match due to timing reasons and interest adjustments, etc.
Moral of the story? Don't go at this alone. Retirement plans are tricky. Be reasonable. Remember, the "reasonable tax court judge" is looking at your plan. Hope this was helpful.