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IRS Welfare Benefit Plan Notices


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For those who aren't yet aware, on October 17, 2007, the IRS issued Notice 2007-83, Notice 2007-84 and Rev Rul 2007-65. Each of these attacks a different part of single-employer welfare benefit plans that IRS considers to be abusive.

Notice 2007-83 names as "listed transactions" (potentially abusive tax shelters) those welfare benefit plans that provide and fund for cash value life insurance contracts.

Notice 2007-84 lists concerns about plans which purport to be non-discriminatory but which in fact result in the owners and key employees receiving all or most of the benefits. IRS threatens to re-characterize such arrangements as deferred compensation, disqualified benefits or other onerous tax treatment.

Rev Rul 2007-65 disallows tax deductions for purported welfare benefit plans that are really the purchase of cash value life insurance policies, as well as deductions taken for disability reserves when no disability payments have been made.

Under both Notices IRS threatened severe penalties against tax return preparers, promoter of the arrangements and those who aid and abet such promotion. This would conceivably include insurance companies who allow their products to be issued and banks whose trustee services facilitate the transaction.

As a result: (1) Most life insurance companies have announced that they will no longer issue insurance policies (or cash value insurance policies) under welfare benefit plans; (2) Most of the plan promoters have to register as such and provide a client list to IRS; and (3) Innocent clients have no way to get out of such plans (other than death), since one of the abusive practices IRS expressed concerns about was closing plans down and distributing assets.

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vebaguru:

When the IRS opined to disallow deductions for cash value life insurance, I assume they were referring to non current benefits. If that is the case, then the cost of the current benefits (yearly renewable term life premiums) should be deductible.

In the case of non current benefits (post-retirement life and health benefits), if the premiums were within the bounds of the reserves allowed for such benefits, then deductions would seem to be in order.

I think the problems the IRS cite revolve around 2 areas, both of which entail non permissible benefits:

1. Benefits which discriminate in favor of HCEs.

2. Life insurance proceeds used for benefits other than death benefits.

If these 2 issues are not satisfied, then deductions are not available, in my opinion.

Don Levit

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Vebaguru et al.

I am a pension actuary trying to establish an understanding of this 419 stuff.

I will do my best to be clear and concise.

My understanding is that prior to these recent IRS notices and rev ruling on 419 deductions there were plans that were cash value death benefit only plans that purported to be welfare plans.

Let's assume a one person owner/employee with a death benefit only welfare benefit plan.

And with these plans, some promoters suggested that the cost of insurance could be an employer deduction and the remaining portion of the premium would be compensation to the owner/employee.

My understanding is that one reasonable calculation of the term cost would be the one year term cost based on the person's age and face amount.

However, some promoters were claiming that a very large portion (say 75%) of the annual premium could have been deemed as the insurance cost by computing the annual cost as a level premium based on the entire life of the policy. Apparently this is when the IRS determined that the situation was being abused.

Based on the recent IRS guidance my interpretation prospectively, regarding cash value insurance is as follows:

No portion of the premium for a pre-retirement death benefit can be deducted. Previously a reasonable amount for the term insurance cost could have been deducted.

A portion of the premium to fund up to $50,000 for post ret life insurance can be deducted.

A portion of the premium to fund claims incurred, but not paid (such as someone on disability with future sef insured claims to be paid) can be deducted.

A portion of the premium to pre fund for popst ret medical, health type benefits can also be deducted.

What are your thoughts re: my understanding above?

Now, for example say a premium of 100k per year was paid for a death benefit only WBP prior to the IRS guidance, where 75k was a direct employer deduction as computed above (per promoters) and the remaining 25k is compensation to the owner.

It seems that according to IRS Notice 2007-83 a listed transaction has occurred and s/b reported.

Would you agree?

How else do you think this s/b handled?

Alternatively, what about amending a tax return to provide for a deduction limited to the amount under IRS Notice 2007-83 and thus avoiding a listed transaction. Does this seem like a feasible approach?

So if the premium were 100k and the Notice 2007-83 limit were 25k then 25k would be an employer deduction. What about the remaining 75k? Corporate income? Comp to employee?

This is a lot, but it is current and important probably to many people, so I am curious to hear your interpretation.

Thanks.

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Don-

"* * *I assume they were referring to non current benefits. If that is the case, then the cost of the current benefits (yearly renewable term life premiums) should be deductible."

You are correct, although I would argue that the premium cost of a lifetime term policy (rather than ART) is deductible.

"In the case of non current benefits (post-retirement life and health benefits), if the premiums were within the bounds of the reserves allowed for such benefits, then deductions would seem to be in order."

Correct again.

"I think the problems the IRS cite revolve around 2 areas, both of which entail non permissible benefits:

1. Benefits which discriminate in favor of HCEs.

2. Life insurance proceeds used for benefits other than death benefits."

I agree with 1., but we disagree on 2. IRS primarily objects to claims that a deduction may be taken for the entire premium for cash value insurance contracts, not the use of the cash value for benefits other than death benefits.

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I am a pension actuary trying to establish an understanding of this 419 stuff.

I am a pension actuary who has been working with 419 since 1993.

My understanding is that prior to these recent IRS notices and rev ruling on 419 deductions there were plans that were cash value death benefit only plans that purported to be welfare plans.

Correct.

* * * some promoters suggested that the cost of insurance could be an employer deduction and the remaining portion of the premium would be compensation to the owner/employee.

That approach would work under the rulings. The problem is that many promoters ignored the amount that was currently taxable to the owner/employee, or glossed over the fact that the scenario you described is a split dollar arrangement which did not comply with the split dollar regs.

My understanding is that one reasonable calculation of the term cost would be the one year term cost based on the person's age and face amount.

Correct.

However, some promoters were claiming that a very large portion (say 75%) of the annual premium could have been deemed as the insurance cost by computing the annual cost as a level premium based on the entire life of the policy. Apparently this is when the IRS determined that the situation was being abused.

While this is one of the abuses they looked at, it certainly was not the only one. The current term premium for a lifetime term premium should be currently deductible. However, the method of calculation of the current cost was being done without an actuary's statement in most cases, so no determination of the reasonableness of the assumptions and methods could be made.

No portion of the premium for a pre-retirement death benefit can be deducted. Previously a reasonable amount for the term insurance cost could have been deducted.

Wrong. The current term premium is still deductible so long as the plan does not discriminate in favor of Key Employees. A corporation can purchase group term life insurance and claim a deduction without a welfare benefit plan, so it can certainly do so with one.

A portion of the premium to fund up to $50,000 for post ret life insurance can be deducted.

The excess over $50,000 may also be deducted but taxable income is imputed to the employee based on Table I.

A portion of the premium to fund claims incurred, but not paid (such as someone on disability with future sef insured claims to be paid) can be deducted.

Premiums paid to insurance companies are deductible. The portion of self-insured amounts that may be deducted may not exceed 25% of current claims. If current claims are $0, the set aside is also $0.

A portion of the premium to pre fund for popst ret medical, health type benefits can also be deducted.

100% of current health insurance premiums (or current health claims, if self-funded) is deductible. Prefunding of post-retirement medical benefits may be deducted levelly over the employee's working lifetime based upon current medical costs (premiums or claims) with no COLA.

[Example.] It seems that according to IRS Notice 2007-83 a listed transaction has occurred and s/b reported. Would you agree?

Absolutely.

How else do you think this s/b handled?

By the taxpayer or the promoter? It is already a listed transaction and the penalty for failure to report it is substantial to either.

Alternatively, what about amending a tax return to provide for a deduction limited to the amount under IRS Notice 2007-83 and thus avoiding a listed transaction. Does this seem like a feasible approach?

No. As I read the Notice, the entire premium less the Table I amount on the first $50,000 would have to be included on the employee's W-2. And they don't even get the $50,000 exclusion if the plan discriminates in favor of the Key Employees. The split dollar rules would be much better than this.

So if the premium were 100k and the Notice 2007-83 limit were 25k then 25k would be an employer deduction. What about the remaining 75k? Corporate income? Comp to employee?

Either taxable to the corporation or to the employee depending on who owns or is entitled to the increase in value of the policy. You are describing a non-compliant split dollar plan, NOT a welfare benefit plan.

Interestingly enough, you have not asked for a legal way to operate a welfare benefit plan, but simply a way of legalizing a split dollar arrangement. The easy way to legitimize a split dollar arrangement is to comply with the split dollar regs using either the economic benefit regime or the loan regime described in the regs.

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vebaguru:

Can you support your theory that a lifetime term policy premium would be deductible?

It seems to me that the higher premium required would provide a benefit exceeding the current year.

We know that there are 2 separate reserve accounts in the VEBA: a reserve for current benefits and a reserve for post-retirement benefits.

Even the post-retirement benefits can provide deductions actuarially calculated on a level basis only over the working lives of the covered employees.

You seem to be suggesting that the current life insurance deductions can be extended even farther actuarially, over the entire lifetime of the active employee.

When you wrote that the IRS did not object to using the cash values for other than death benefits, I disagree.

The recent Revenue Ruling 2007-83 stated that "any deduction with respect to uninsured benefits (for example, uninsured medical benefits) is not based on the premiums of the life insurance policies."

In other words, premiums for life insurance policies used to pay for medical benefits will not be deductible.

This also means that life policy cash values cannot be set aside to pay for medical benefits.

Only the actual expenses for medical benefits will be deductible.

However, if the medical benefits were insured, then a medical policy (not a life policy) would be the funding vehicle.

Here, the premiums would be deductible, because the benefits are insured, not uninsured.

Whether or not premiums are deductible also enters into whether or not the expenses are able to be set aside in a reserve.

We know that some employee-pay-all VEBAs have no account limits.

This is because employee-pay-all VEBAs incur after-tax, not before tax, expenditures.

In addition, the income in excess of the amount properly set aside, is taxable as unrelated business income, at the trust rates.

You wrote that the excess over $50,000 of post-retirement life insurance may be deducted.

This seems to contradict Revenue Ruling 2007-83 which state that "account limits for reserves for post-retirement may not take into account life insurance benefits in excess of $50,000."

Are you suggesting that premiums are still deductible, if they exceed the account limits?

Don Levit

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Can you support your theory that a lifetime term policy premium would be deductible?

Support it logically or legally? There are no definitive rulings or caselaw on the subject, but as an actuary operating under 419 and 419A, it appears to me that the law implies the need for a level funding. There is no requirement that a policy terminate at NRA even though we are only permitted to prefund a $50,000 paid up policy. In accordance with the statute the employer may provide a lifetime death benefit, with the contributions for the excess over $50,000 to be deductible in the participant's year of retirement (or subsequent thereto). However, in order to provide a lifetime death benefit, it is necessary to assure that insurance can be provided in the amount promised. This can be done through obtaining policy that will continue in force after retirement (ie, a lifetime term or term to 100 policy). The difference in the premium isn't prefunding, it is the cost of providing guaranteed insurability for the participant. ART and YRT will not provide that assurance.

You seem to be suggesting that the current life insurance deductions can be extended even farther actuarially, over the entire lifetime of the active employee.

No, I am suggesting that the current premiums for the lifetime term are deductible in the current year, a contribution to build up a conversion fund for a $50,000 is deductible over years of employment and the cost of the balance of the premiums for post-retirement coverage in excess of $50,000 after NRA is deductible at or after the participant's NRD.

When you wrote that the IRS did not object to using the cash values for other than death benefits, I disagree.

The recent Revenue Ruling 2007-83 stated that "any deduction with respect to uninsured benefits (for example, uninsured medical benefits) is not based on the premiums of the life insurance policies."

In other words, premiums for life insurance policies used to pay for medical benefits will not be deductible. This also means that life policy cash values cannot be set aside to pay for medical benefits.

You are misreading the ruling. In RR 2007-65, IRS was referring to deductions for cash value life insurance policies (example I) and for cash value life insurance policies plus self-funded disability benefits where no benefits were paid (example 2). It specifically excludes post-retirement medical benefits from that holding.

Only the actual expenses for medical benefits will be deductible.

However, if the medical benefits were insured, then a medical policy (not a life policy) would be the funding vehicle.

Here, the premiums would be deductible, because the benefits are insured, not uninsured.

You are correct, but this only applies to current (419), not reserves for post-retirement benefits.

You wrote that the excess over $50,000 of post-retirement life insurance may be deducted.

This seems to contradict Revenue Ruling 2007-83 which state that "account limits for reserves for post-retirement may not take into account life insurance benefits in excess of $50,000."

Are you suggesting that premiums are still deductible, if they exceed the account limits?

There is not limit in the amount of paid up life insurance that may be provided to a participant under IRC 419A. There is only a limit on how much of the insurance may be pre-funded on a tax-deductible basis, $50,000.

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vebaguru:

You mentioned that the law implies the need for level funding for post-retirement benefits.

You are correct.

Section 419A©(2) provides that the account limit for any taxable year may include a reserve funded over the working lives of the covered employees and actuarially determined on a level basis for post-retirement medical and life insuranc e benefits.

The level funding is calculated over the working lives of the covered employees.

The policy doesn't terminate at the employee's retirement, but the employer funding for that policy does.

Where in 419A does it allow for contributions for permanent life benefits subsequent to the participant's retirement?

Don Levit

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  • 2 weeks later...

An employer can pay a bonus, severance benefit, accumulated sick leave, accumulated vacation pay, etc. at an employee's retirement. The payment is current income to the employee and is deductible under IRC 162 so long as it does not exceed the amount permitted under Section 162(p). There have been several cases where employers have chosen to fund medical benefits for retirees in a lump sum and claimed the deduction in one year (including one of my clients). This is no different.

Section 419 permits a deduction for the current cost. Section 419A©(2) permits a deduction for the future years portion. Section 419A(e) limits medical and death benefit reserves to nondiscriminatory amount, and limits that amount of death benefits that can be provided tax free to participants to $50,000, consistent with Section 79.

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