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TAX COURT STRIKES DOWN 'SEC 419A' LIFE INSURANCE PLAN
December 06, 2007
The IRS put taxpayers on notice in October that you can't use "Section 419" welfare benefit plans to create a tax deduction for otherwise non-deductible life insurance. The Tax Court underlined their point yesterday by disallowing such deductions for a medical group's plan.
Two doctors set up S corporation professional corporations; the corporations operated their medical practice as a partnership. Each S corporation joined the "Severance Trust Executive Program Multiple Employer Supplemental Benefit Plan and Trust (STEP), a plan that was promoted to wealthy professionals as a welfare benefits fund that was part of a 10-or-more-employer plan described in section 419A(f)(6)"
The S corporations contributed funds to STEP, which they deducted as employee welfare plan contributions. The plans in turn bought whole life policies on hte doctors and their spouses. The Tax Court said this didn't work:
While the STEP plan may have been cleverly designed to appear to be a welfare benefits fund and marketed as such, the facts of these cases establish that the plan was nothing more than a subterfuge through which the participating doctors, through VRD/RTD, used surplus cash of the PCs to purchase cash-laden whole life insurance policies primarily for the benefit of the participating doctors personally.
The case highlights an obscure but occasionally useful benefit of operating as an S corporation. In addition to disallowing the deduction, the IRS asked the Tax Court to assess the doctors with additional income. The court ruled that the payments for insurance were a constructive distribution to the doctors that would be a dividends from a C corporation. Coming from an S corporation, however, they are a return of previously-taxed S corporation income. The disallowance creates taxable income, but there is no second income item for the constructive distribution.
Cite: V.R. DeAngelis M.D. P.C., T.C. Memo. 2007-360.
UPDATE, 7/7/08: A lengthy reader comment is reproduced in full here.
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Comments
Dear Mr. Kristan,
I respectfully disagree with your reading of DeAngelis. The "STEP Plan" had been previously attacked as not a welfare plan. See Daniels v Burse, 313 F. Supp. 2d 790 (N.D. Ill. 2004)(STEP alleged to be RICO enterprise; settlement for plaintiffs). There was also a previous settlement in favor of IRS in a docketed case, Coastal Neurological v Com'r (2002).It turns out that DeAngelis was not about 419A at all.
From the stipulated facts, you will see that there was no independent trustee -- in fact Benistar 419 Plan Services, Inc. was serving as "trustee" (without a license) for the plan after assets were taken from Mellon Trust by Step Services, Inc. More to the point, when Step Services, Inc, an affiliate of the Benistar companies, BOUGHT ocntrol of the STEP Plan (a prohibited transaction), they created "exit strategies" that did not exist in the original documents governing the arrangement. These strategies were designed for the sole benefit of owners.
These exit strategies, at odds with any "plan document," were evidence of a sham. As in the Neonatology case, the Tax Court took the path of least resistance. It did not recognize the existence of any plan, or else it would have been required to analyze the qualified direct cost and qualified asset addition components of sections 419(a)-(c).
Constructive distribution or dividend is the new darling argument of IRS. It actually coalesces with Grant Jacoby v Comr, TC (1981) in which the court said that a purported welfare plan which did not cover employees was in the nature of deferred compensation.
It is simply not accurate to say that contributions to plans having a primary benefit for owners cannot be deductible. Otherwise, virtually every retirement plan in this country would fail. It would also render sec. 419 and 419A repealed in contradiction to congressional intent. Rather, in both Neonatology and DeAngelis, there was no evidence of compensatory intent. Sec 419 begins with "no deduciton is allowed" but if it would be otherwise allowed, it is allowed under this seciton. You analyze whether 162 and 212 would be met before you get to 419. If IRS alleges constructive dividend, the burden of proof is on the taxpayer to show compensatory intent or something "ordinary and necessary" under 162. Most 419 arrangements will fail this test because of poor documentation practices.
The lesson of these cases should bother practitioners. Anytime IRS wants to attack an employee benefit plan for a small business, it can simply allege constructive dividend. If the business's documentation is bad, it will have a difficult time proving how a benefit plan for owners differs from a constructive distribution on account of ownership.
The courts may not realize that they are giving IRS ammunition to take us back to the days when professional corporations were constantly attacked as shams. The line between owner compensation and distributions is never clear unless there is a paper trail, and even then, the actions speak louder than the words. Nobody should wonder why corporate minutes are important, or why there should always be an employee in a plan if one wants to protect a deduction.
Posted by: John J. Koresko, Esq., CPA | July 7, 2008 11:46 AM