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IRS Audits Focus on Captive Insurance Plans
April 2011 Edition

By Lance Wallach

The IRS started auditing § 419 plans in the 1990s, and then
continued going after § 412(i) and other plans that they considered
abusive, listed, or reportable transactions, or substantially similar to
such transactions. If an IRS audit disallows the § 419 plan or the §
412(i) plan, not only does the taxpayer lose the deduction and pay
interest and penalties, but then the IRS comes back under IRC
6707A and imposes large fines for not properly filing.

Insurance agents, financial planners and even accountants sold
many of these plans. The main motivations for buying into one were
large tax deductions. The motivation for the sellers of the plans was
the very large life insurance premiums generated. These plans,
which were vetted by the insurance companies, put lots of insurance
on the books. Some of these plans continue to be sold, even after
IRS disallowances and lawsuits against insurance agents, plan
promoters and insurance companies.

In a recent tax court case, Curcio v. Commissioner (TC Memo 2010-
115), the tax court ruled that an investment in an employee welfare
benefit plan marketed under the name “Benistar” was a listed
transaction in that the transaction in question was substantially
similar to the transaction described in IRS Notice 95-34. A
subsequent case, McGehee Family Clinic, largely followed Curcio,
though it was technically decided on other grounds. The parties
stipulated to be bound by Curcio on the issue of whether the
amounts paid by McGehee in connection with the Benistar 419 Plan
and Trust were deductible. Curcio did not appear to have been
decided yet at the time McGehee was argued. The McGehee opinion
(Case No. 10-102, United States Tax Court, September 15, 2010)
does contain an exhaustive analysis and discussion of virtually all of
the relevant issues.

Taxpayers and their representatives should be aware that the IRS
has disallowed deductions for contributions to these arrangements.
The IRS is cracking down on small business owners who participate
in tax reduction insurance plans and the brokers who sold them.
Some of these plans include defined benefit retirement plans, IRAs,
or even 401(k) plans with life insurance.

In order to fully grasp the severity of the situation, one must have an
understanding of IRS Notice 95-34, which was issued in response to
trust arrangements sold to companies that were designed to provide
deductible benefits such as life insurance, disability and severance
pay benefits. The promoters of these arrangements claimed that all
employer contributions were tax-deductible when paid, by relying on
the 10-or-more-employer exemption from the IRC § 419 limits. It was
claimed that permissible tax deductions were unlimited in amount.

In general, contributions to a welfare benefit fund are not fully
deductible when paid. Sections 419 and 419A impose strict limits on
the amount of tax-deductible prefunding permitted for contributions to
a welfare benefit fund. Section 419A(F)(6) provides an exemption
from § 419 and § 419A for certain “10-or-more employers” welfare
benefit funds. In general, for this exemption to apply, the fund must
have more than one contributing employer, of which no single
employer can contribute more than 10 percent of the total
contributions, and the plan must not be experience-rated with respect
to individual employers.

According to the Notice, these arrangements typically involve an
investment in variable life or universal life insurance contracts on the
lives of the covered employees. The problem is that the employer
contributions are large relative to the cost of the amount of term
insurance that would be required to provide the death benefits under
the arrangement, and the trust administrator may obtain cash to pay
benefits other than death benefits, by such means as cashing in or
withdrawing the cash value of the insurance policies. The plans are
also often designed so that a particular employer’s contributions or
its employees’ benefits may be determined in a way that insulates the
employer to a significant extent from the experience of other
subscribing employers. In general, the contributions and claimed tax
deductions tend to be disproportionate to the economic realities of
the arrangements.

Benistar advertised that enrollees should expect to obtain the same
type of tax benefits as listed in the transaction described in Notice 95-
34. The benefits of enrollment listed in its advertising packet included:
·        Virtually unlimited deductions for the employer;
·        Contributions could vary from year to year;
·        Benefits could be provided to one or more key executives on a
selective basis;
·        No need to provide benefits to rank-and-file employees;
·        Contributions to the plan were not limited by qualified plan rules
and would not interfere with pension, profit sharing or 401(k) plans;
·        Funds inside the plan would accumulate tax-free;
·        Beneficiaries could receive death proceeds free of both income
tax and estate tax;
·        The program could be arranged for tax-free distribution at a
later date;
·        Funds in the plan were secure from the hands of creditors.

The Court said that the Benistar Plan was factually similar to the
plans described in Notice 95-34 at all relevant times.

In rendering its decision the court heavily cited Curcio, in which the
court also ruled in favor of the IRS. As noted in Curcio, the insurance
policies, overwhelmingly variable or universal life policies, required
large contributions relative to the cost of the amount of term
insurance that would be required to provide the death benefits under
the arrangement. The Benistar Plan owned the insurance contracts.

Following Curcio, as the Court has stipulated, the Court held that the
contributions to Benistar were not deductible under § 162(a) because
participants could receive the value reflected in the underlying
insurance policies purchased by Benistar—despite the payment of
benefits by Benistar seeming to be contingent upon an unanticipated
event (the death of the insured while employed). As long as plan
participants were willing to abide by Benistar’s distribution policies,
there was no reason ever to forfeit a policy to the plan. In fact, in
estimating life insurance rates, the taxpayers’ expert in Curcio
assumed that there would be no forfeitures, even though he admitted
that an insurance company would generally assume a reasonable
rate of policy lapses.

The McGehee Family Clinic had enrolled in the Benistar Plan in May
2001 and claimed deductions for contributions to it in 2002 and 2005.
The returns did not include a Form 8886, Reportable Transaction
Disclosure Statement, or similar disclosure.

The IRS disallowed the latter deduction and adjusted the 2004 return
of shareholder Robert Prosser and his wife to include the $50,000
payment to the plan. The IRS also assessed tax deficiencies and the
enhanced 30 percent penalty totaling almost $21,000 against the
clinic and $21,000 against the Prossers. The court ruled that the
Prossers failed to prove a reasonable cause or good faith exception.

Other important facts:

·        In recent years, some § 412(i) plans have been funded with life
insurance using face amounts in excess of the maximum death
benefit a qualified plan is permitted to pay.  Ideally, the plan should
limit the proceeds that can be paid as a death benefit in the event of
a participant’s death.  Excess amounts would revert to the plan.  
Effective February 13, 2004, the purchase of excessive life insurance
in any plan is considered a listed transaction if the face amount of the
insurance exceeds the amount that can be issued by $100,000 or
more and the employer has deducted the premiums for the insurance.
·        A 412(i) plan in and of itself is not a listed transaction; however,
the IRS has a task force auditing 412(i) plans.
·        An employer has not engaged in a listed transaction simply
because it is a 412(i) plan.
·        Just because a 412(i) plan was audited and sanctioned for
certain items, does not necessarily mean the plan engaged in a listed
transaction. Some 412(i) plans have been audited and sanctioned for
issues not related to listed transactions.


Companies should carefully evaluate proposed investments in plans
such as the Benistar Plan. The claimed deductions will not be
available, and penalties will be assessed for lack of disclosure if the
investment is similar to the investments described in Notice 95-34. In
addition, under IRC 6707A, IRS fines participants a large amount of
money for not properly disclosing their participation in listed,
reportable or similar transactions; an issue that was not before the
tax court in either Curcio or McGehee. The disclosure needs to be
made for every year the participant is in a plan. The forms need to be
properly filed even for years that no contributions are made. I have
received numerous calls from participants who did disclose and still
got fined because the forms were not filled in properly. A plan
administrator told me that he assisted hundreds of his participants
with filing forms, and they still all received very large IRS fines for not
properly filling in the forms.

IRS has targeted all 419 welfare benefit plans, many 412(i) retirement
plans, captive insurance plans with life insurance in them and Section
79 plans.

Lance Wallach, National Society of Accountants Speaker of the Year
and member of the American Institute of CPAs faculty of teaching
professionals, is a frequent speaker on retirement plans, financial
and estate planning, and abusive tax shelters.  He speaks at more
than ten conventions annually and writes for over fifty publications.
Lance has written numerous books including Protecting Clients from
Fraud, Incompetence and Scams published by John Wiley and Sons,
Bisk Education's CPA's Guide to Life Insurance and Federal Estate
and Gift Taxation, as well as AICPA best-selling books, including
Avoiding Circular 230 Malpractice Traps and Common Abusive Small
Business Hot Spots. He does expert witness testimony and has never
lost a case. Mr. Wallach may be reached at 516/938.5007,
wallachinc@gmail.com, or at www.taxaudit419.com or www.
lancewallach.com.

The information provided herein is not intended as legal, accounting,
financial or any type of advice for any specific individual or other
entity. You should contact an appropriate professional for any such
advice.