Retirement plans for self-employed workers
By Lance Wallach
Self-employed workers have the same retirement needs as anyone else, and maybe they have more money to invest and deduct. The problem is that they don’t have a beneficent employer who offers carrots in the form of retirement benefits so they have to grow their own. Below are a few ideas.
SIMPLE IRA is just that – simple. The name is an acronym for Savings Incentive Match Plan for Employees. SIMPLE IRA plans are designed for small businesses with no more than 100 employees who earned $5,000 or more on the payroll for the previous calendar year, but some advisers and tax professionals think these plans are more suited for much smaller companies. They typically recommend them for employers that have seven or less employees and for someone who is not making a lot of money, and who consequently don’t have a lot to put into retirement. Even those advisors agree, however, that they are easy and simple. Including instructions, the account application is about four pages to fill out, and you can probably do it in 10 minutes.
Q & A
Who can open one? Generally an employer with no more than 100 employees.
Cost and complexity? Low.
Employer contribution limit? Three percent of employees' pay, matching, or two percent nonelective.
Employee contribution limit? $11,500 for 2009.
Annual reporting requirements? None.
A SEP IRA, or Simplified Employee Pension plan, is as easy and low cost to set up and maintain as the SIMPLE IRA. But instead of the employee making contributions to the plan with a match from the employer, the employer makes the entire contribution.
Self-employed workers may find the SEP ideal due to its low setup and maintenance costs. Business owners can save quite a bit more in a SEP than the SIMPLE or other IRAs. For 2009, the contribution limit is 25 percent of net income up to $49,000.
Q & A
Who can open one? Any employer or self-employed person.
Cost and complexity? Low.
Employer contribution limit? 25 percent of employees' net income up to $49,000.
Employee contribution limit? Not applicable.
Annual reporting requirements? None.
Similar to a 401(k), a Solo 401(k) lets small-business owners share the fun and benefits in a slightly different way. The business must be very small, limited to the owners of the business and their spouses.
The Solo 401(k) allows business owners to put away more money than a SIMPLE or SEP IRA, and there is some flexibility when it comes to contributions. You can contribute more or less every year, but a maximum of $16,500 for 2009, and a profit sharing component can also be added to the Solo-K.
Business owners can add the profit sharing part to maximize contributions to the plan. The employer can make a maximum tax-deductible contribution to the plan of up to 25 percent of compensation.
Q & A
Who can open one? Self-employed business owners with no employees other than a spouse.
Cost and complexity? Medium.
Employer contribution limit? $16,500 of salary deferral plus 25 percent of compensation, or $49,000, whichever is less, if a profit sharing component is added to the plan.
Employee contribution limit? Not applicable.
Annual reporting requirements? Yes.
Defined benefit plan
The most expensive and complicated retirement plan for the self-employed, the defined benefit plan is most appropriate for someone looking for a large tax deduction.
Employers can save a maximum of $195,000 per year. But you usually need an actuary to determine the amount that can be contributed.
It is worth noting that the defined benefit plan will give you your largest contributions, but it comes with strings attached. For instance, you have to have a plan document and probably with an actuary. It will be the most expensive to do and will usually require you to make a contribution every year.
In contrast, the Solo-K, SEP and SIMPLE IRAs allow more flexibility by allowing employers to reduce contributions in a year with poor cash flow.
Defined Benefit plans can still be a good option for business owners who want to save the most money on a tax-deferred basis as possible.
You need to be careful with most retirement plans. The IRS is cracking down on many plans sold by insurance agents and stockbrokers that have life insurance in them. If they call your retirement plan a listed, or similar transaction you will have big problems. Not only will the IRS disallow your deductions and charge you interest and penalties, but you will also be fined for not telling on yourself.
The IRS has various task forces auditing all section 419, section 412(i), and other plans that tend to be abusive. Most insurance agents sell these plans. The IRS is looking to raise money and is not looking to correct plans or help taxpayers. The IRS calls accountants, attorneys, and insurance agents “material advisors” and also fines them the same amount, again unless the client’s participation in the transaction is reported. An accountant is a material advisor if he signs the return or gives advice and gets paid. More details can be found on www.irs.gov and vebaplan.org.
Bruce Hink, who has given me written permission to use his name and circumstances, is a perfect example of what the IRS is doing to unsuspecting business owners. What follows is a story about how the IRS fines him each year for being in what they called a listed transaction. Listed transactions can be found at www.irs.gov. Also involved are what the IRS calls abusive plans or what it refers to as substantially similar. Substantially similar to is very difficult to understand, but the IRS seems to be saying, “If it looks like some other listed transaction, the fines apply.” Also, I believe that the accountant who signed the tax return and the insurance agent who sold the retirement plan will each be fined as material advisors. We have received many calls for help from accountants, attorneys, business owners, and insurance agents in similar situations. Don’t think this will happen to you? It is happening to a lot of accountants and business owners, because most of theses so-called listed, abusive, or insurance agents are selling substantially similar plans. Recently I came across the case of Hink, a small business owner who is facing thousands in IRS penalties for 2004 and 2005 because of his participation in a section 412(i) plan. (The penalties were assessed under section 6707A.)
In 2002 an insurance agent representing a 100-year-old, well-established insurance company suggested the owner start a pension plan. The owner was given a portfolio of information from the insurance company, which was given to the company’s outside CPA to review and give an opinion on. The CPA gave the plan the green light and the plan was started. Contributions were made in 2003. The plan administrator came out with amendments to the plan, based on new IRS guidelines, in October 2004. The business owner’s insurance agent disappeared in May 2005, before implementing the new guidelines from the administrator with the insurance company. The business owner was left with a refund check from the insurance company, a deduction claim on his 2004 tax return that had not been applied, and no agent.
It took six months of making calls to the insurance company to get a new insurance agent assigned. By then, the IRS had started an examination of the pension plan. Asking advice from the CPA and a local attorney (who had no previous experience in these cases) made matters worse, with a “big name” law firm being recommended and over ,000 in additional legal fees being billed in three months. To make a long story short, the audit stretched on for over 2 ½ years to examine a 2-year-old pension with four participants and the 8,000 in contributions. During the audit, no funds went to the insurance company, which was awaiting formal IRS approval on restructuring the plan as a traditional defined benefit plan, which the administrator had suggested and the IRS had indicated would be acceptable.In March 2008 the business owner received a private e-mail apology from the IRS agent who headed the examination, saying that her hands were tied and that she used to believe she was correcting problems and helping taxpayers and not hurting people.
Could you or one of your clients be next?
To this point, I have focused, generally, on the horrors of running afoul of the IRS by participating in a listed transaction, which includes various types of transactions and the various fines that can be imposed on business owners and their advisors who participate in, sell, or advice on these transactions. I happened to use, as an example, someone in a section 412(i) plan, which was deemed to be a listed transaction, pointing out the truly doleful consequences the person has suffered. Others who fall into this trap, even unwittingly, can suffer the same fate.
Now let’s go into more detail about section 412(i) plans. This is important because these defined benefit plans are popular and because few people think of retirement plans as tax shelters or listed transactions. People therefore may get into serious trouble in this area unwittingly, out of ignorance of the law, and, for the same reason, many fail to take necessary and appropriate precautions. The IRS has warned against the section 412(i) defined benefit pension plans, named for the former code section governing them. It warned against trust arrangements it deems abusive, some of which may be regarded as listed transactions. Falling into that category can result in taxpayers having to disclose the participation under pain of penalties. Targets also include some retirement plans.
One reason for the harsh treatment of some 412(i) plans is their discrimination in favor of owners and key, highly compensated employees. Also, the IRS does not consider the promised tax relief proportionate to the economic realities of the transactions. In general, IRS auditors divide audited plan into those they consider noncompliant and other they consider abusive. While the alternatives available to the sponsor of noncompliant plan are problematic, it is frequently an option to keep the plan alive in some form while simultaneously hoping to minimize the financial fallout from penalties.
The sponsor of an abusive plan can expect to be treated more harshly than participants. Although in some situation something can be salvaged, the possibility is definitely on the table of having to treat the plan as if it never existed, which of course triggers the full extent of back taxes, penalties, and interest on all contributions that were made – not to mention leaving behind no retirement plan whatsoever. Another plan the IRS is auditing is the section 419 plan. A few listed transactions concern relatively common employee benefit plans the IRS has deemed tax avoidance schemes or otherwise abusive. Perhaps some of the most likely to crop up, especially in small-business returns, are the arrangements purporting to allow the deductibility of premiums paid for life insurance under a welfare benefit plan or section 419 plan. These plans have been sold by most insurance agents and insurance companies.
IRS Attacks Business Owners in 419, 412, Section 79 and Captive Insurance Plans Under Section 6707A
By Lance Wallach
Taxpayers who previously adopted 419, 412i, captive insurance or Section 79 plans are in big trouble.
In recent years, the IRS has identified many of these arrangements as abusive devices to funnel tax deductible dollars to shareholders and classified these arrangements as listed transactions." These plans were sold by insurance agents, financial planners, accountants and attorneys seeking large life insurance commissions. In general, taxpayers who engage in a “listed transaction” must report such transaction to the IRS on Form 8886 every year that they “participate” in the transaction, and you do not necessarily have to make a contribution or claim a tax deduction to participate. Section 6707A of the Code imposes severe penalties for failure to file Form 8886 with respect to a listed transaction. But you are also in trouble if you file incorrectly. I have received numerous phone calls from business owners who filed and still got fined. Not only do you have to file Form 8886, but it also has to be prepared correctly. I only know of two people in the U.S. who have filed these forms properly for clients. They tell me that was after hundreds of hours of research and over 50 phones calls to various IRS personnel. The filing instructions for Form 8886 presume a timely filling. Most people file late and follow the directions for currently preparing the forms. Then the IRS fines the business owner. The tax court does not have jurisdiction to abate or lower such penalties imposed by the IRS.
"Many taxpayers who are no longer taking current tax deductions for these plans continue to enjoy the benefit of previous tax deductions by continuing the deferral of income from contributions and deductions taken in prior years."
Many business owners adopted 412i, 419, captive insurance and Section 79 plans based upon representations provided by insurance professionals that the plans were legitimate plans and were not informed that they were engaging in a listed transaction. Upon audit, these taxpayers were shocked when the IRS asserted penalties under Section 6707A of the Code in the hundreds of thousands of dollars. Numerous complaints from these taxpayers caused Congress to impose a moratorium on assessment of Section 6707A penalties.
The moratorium on IRS fines expired on June 1, 2010. The IRS immediately started sending out notices proposing the imposition of Section 6707A penalties along with requests for lengthy extensions of the Statute of Limitations for the purpose of assessing tax. Many of these taxpayers stopped taking deductions for contributions to these plans years ago, and are confused and upset by the IRS’s inquiry, especially when the taxpayer had previously reached a monetary settlement with the IRS regarding its deductions. Logic and common sense dictate that a penalty should not apply if the taxpayer no longer benefits from the arrangement. Treas. Reg. Sec. 1.6011-4(c)(3)(i) provides that a taxpayer has participated in a listed transaction if the taxpayer’s tax return reflects tax consequences or a tax strategy described in the published guidance identifying the transaction as a listed transaction or a transaction that is the same or substantially similar to a listed transaction.
Clearly, the primary benefit in the participation of these plans is the large tax deduction generated by such participation. Many taxpayers who are no longer taking current tax deductions for these plans continue to enjoy the benefit of previous tax deductions by continuing the deferral of income from contributions and deductions taken in prior years. While the regulations do not expand on what constitutes “reflecting the tax consequences of the strategy,” it could be argued that continued benefit from a tax deferral for a previous tax deduction is within the contemplation of a “tax consequence” of the plan strategy. Also, many taxpayers who no longer make contributions or claim tax deductions continue to pay administrative fees. Sometimes, money is taken from the plan to pay premiums to keep life insurance policies in force. In these ways, it could be argued that these taxpayers are still “contributing,” and thus still must file Form 8886.
It is clear that the extent to which a taxpayer benefits from the transaction depends on the purpose of a particular transaction as described in the published guidance that caused such transaction to be a listed transaction. Revenue Ruling 2004-20, which classifies 419(e) transactions, appears to be concerned with the employer’s contribution/deduction amount rather than the continued deferral of the income in previous years. Another important issue is that the IRS has called CPAs material advisors if they signed tax returns containing the plan, and got paid a certain amount of money for tax advice on the plan. The fine is $100,000 for the CPA, or $200,000 if the CPA is incorporated. To avoid the fine, the CPA has to properly file Form 8918.
Welfare Benefit 419 Insurance Plans Named Listed Transactions
by Lance Wallach
During tax season, many accountants will unknowingly allow clients to deduct listed transactions or potentially abusive tax shelters. Under existing and new regulations, both the taxpayer and the accountant can be held accountable. For example, in February 2007 alone, we received over one thousand phone calls asking about 419, 412(i) and other potentially abusive plans.
The IRS has named most 419 welfare benefit insurance plans as listed transactions. Previously the IRS had named 419A (f)(6) plans as listed transactions. Taxpayers participating in these listed transactions must disclose such participation to the IRS.
In addition, material advisors must also disclose their involvement. This involvement might include allowing the deduction of the plan on the client’s tax return. The penalty for nondisclosure can be $200,000.
Most accountants are not aware of these plans, which are sold by many insurance agents and financial planners. I have received hundreds of phone calls after the IRS has disallowed plans on audit. The IRS is now making accountants policemen with respect to these and other abusive plans that their clients may be participating in.
When I speak at accounting conventions about abusive plans, most accountants are not aware of what I am talking about, and do not think that their clients would be involved in these types of plans. Unfortunately, once they find out that their clients have contributed to these plans much of the damage has been done.
On Oct.17, 2007, the IRS, in Notice 2007-83, identified as listed transactions certain trust arrangements involving cash-value life insurance. Also simultaneously issued was Notice 2007-84, which disallows tax deductions and imposed severe penalties for welfare benefit plans that discriminate.
Many of these plans have already or will, go out of business. At least two of these plans have stolen the participants’ money.
An accountant who has a client in one of these plans, or who is approached by a client about one of these plans should be cautious, both for the client and for himself.
More you should know
by Lance Wallach
In recent years, some section 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 412i 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 file forms, and they still all received very large IRS fines for not properly filling in the forms.
IRS has been attacking all 419 welfare benefit plans, many 412i retirement plans, captive insurance plans with life insurance in them and Section 79 plans.
IRS Auditing 412(i) Plans by Lance Wallach
The IRS started auditing 419 plans in the ‘90s, and then continued going after 412i and other plans that they considered abusive, listed, or reportable transactions, or substantially similar to such transactions.
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 Service 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 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 Section 419 and Section 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% 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:
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 section 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% 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.
By Lance Wallach
Participate in a 419 or 412i Plan or Other Abusive Tax Shelter You could be fined a large amount of Money
Did you get a letter from the IRS threatening to impose this fine? If you haven’t already, you still may. Consider yourself lucky if you have not because this means that you have more time to straighten this situation out. Do not wait for this letter to come from the IRS before you call an expert to help you. Even if you have been audited already, you could still get the letter and/or fine. One has nothing to do with the other, and once the fine has been imposed, it is not able to be appealed.
Many businesses that participated in a 412i retirement plan or the IRS is auditing a 419-welfare benefit plan. Many of these plans were not in compliance with the law and are considered abusive tax shelters. Many business owners are not even aware that the welfare benefit plan or retirement plan that they are participating in may be an abusive tax shelter and that they are in serious jeopardy of huge IRS penalties for each year that they have been in this type of plan.
Insurance companies, CPAs, sellers of these 419 welfare benefit plans or 412i retirement plans, as well as anyone that gave tax advice or recommended participation in one or more of these plans, also known as a material advisor, is in danger of being sued, fined by the IRS, or both.
There is help available if you think you may be involved with one of these 419 welfare benefit plans, 412i retirement plans, or any abusive tax shelter. IRS penalty abatement is an option if you act now. Feel free to contact me for more information.
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