From the April 2006 issue of Investment Advisor • Subscribe!

April 1, 2006

Solving the 419 Plan Puzzle

Not all 419 plans are created equally, or have the same legal standing

Don't you suspect that if you could afford the best accountants, you, too, would be privy to the tax-saving secrets reserved for the business elite? Aren't you just a little intrigued by promoters who will reveal their unique and highly effective tax-reduction technique only after you sign an agreement not to reveal the details to others? Your clients are just as curious.

Tax loopholes are based on an interpretation of our complex and often undecipherable Internal Revenue Code. The more popular the technique, the more it catches the attention of the IRS--and the more likely the law will be changed to curb abuse. Some promoters who have built businesses on these techniques may protest, claiming their particular arrangement is not affected by the new tax regulations. More prudent tax planners will adapt their programs or move on to other types of tax shelters.

The 419 welfare benefit plan is a tax planning technique currently experiencing an evolution. Knowing its history and what is different today will help you make better recommendations to your clients.

Welfare Benefit Plans of the Past

One of the more popular tax reduction techniques of the last couple of decades was the multiple employer welfare benefit plan. Better known as the 419 plan, this tax shelter was particularly attractive to owner/employees who were worried about taxes and their retirement security. For the small business, the 419 plan promised unlimited tax deductions for benefits reserved for favored employees, including the owner. On paper, the plan was limited to medical, disability, death, or involuntary termination (severance) benefits. But in reality, the 419 plan promised retirement benefits for owners of S corporations and other pass-through tax entities that had little opportunity for deferred compensation or other fringe benefits.

In 1984, Congress eliminated the tax-deductible contribution limits for welfare benefit plans that consisted of groups of 10 or more employers. Congress believed that, by grouping employers into one plan, each employer would contribute the minimum necessary to fund the desired benefits. There would be no incentive to overfund the plan and thus no need to place limits on contributions. In practice, individual employer contributions were not commingled, and participating employers were protected from the risk of paying for benefits triggered by other members' employees.

As beneficial as Congress viewed welfare benefits, many employers were less interested in funding severance and death benefits than they were in securing retirement benefits for themselves. A skilled salesperson, however, could explain how to manipulate the 419 plan to benefit the business owner. The plan would be dismantled at the convenience of the business owner and the plan assets would be distributed pro rata to the participating employees. A good example would be a doctor winding down his practice prior to retirement. It is likely that he would be the last employee out the door and therefore the sole benefactor of the 419 plan. The distribution would be taxed like any other compensation.

If It Looks Like a Duck . . .

Some promoters spent more time illustrating the plan termination in their presentations than on the potential welfare benefits for the employees. The true intent of the plan did not escape the courts, and negative decisions resulted in thousands of employers paying back taxes and penalties. The 419 plan abuses got the attention of Congress, and, in 2003, new regulations were put into place to make them less attractive to businesses looking for tax-deductible fringe benefits intended to favor the business owner and key employees. Existing plans reacted by modifying their terms, reclassifying themselves, or closing altogether.

Voluntary Employee Benefit Associations (VEBAs), the welfare plan's little sister, stepped in, touting their IRS determination letter. The VEBA didn't have the popularity of the 419 plan because contributions were subject to limits and there were fewer opportunities to exclude the rank-and-file employee. Every VEBA must qualify as a tax-exempt trust at its inception by obtaining an IRS determination. The determination letter does not guarantee that the employer's contributions will qualify for tax deductions. Many employers who unwittingly participated in the most aggressive VEBA arrangements found themselves also paying back taxes and penalties.

Welfare Benefit Plans Today

In light of the recent 419 regulations, creative plans have emerged that may legitimately provide the tax deductions your business-owning clients seek and offer valuable benefits to their employees. Most of today's plans are built on a single employer welfare benefit plan chassis, which is also called a 419(e) plan. Some provide traditional welfare benefits during the employee's working years. Others limit the preretirement benefit to life insurance but also offer post-retirement medical, long-term care, and death benefits. Because there is no standard template, different versions come with different levels of tax deductibility and risk.

Single-employer plans are more restrictive than the multiple-employer plans. As a general rule, employer tax deductions are only available to pre-fund anticipated post-retirement claims of the employee, the spouse, and any dependents. Note: It is not the long-term care insurance premium that is deductible under 419(e), but the long-term care benefits that the plan pre-funds.

If life insurance is provided, the employee is taxed on the current value of the benefits, but the death benefit will be income tax free. Medical and long-term care benefits are also received tax-free by the retiree. With the inflation rate of medical, prescription drug, and long-term care benefits outpacing the Consumer Price Index, the benefits of the 419(e) plan can be very attractive to both the employer and the employee.

Note: A 419(e) plan offering a post-retirement medical benefit may limit contributions for key employees participating in some qualified plans.

Look Beyond the Plan Document

Even still, you will hear "Our plan is different. It is conservative. It was created to comply with the IRS code." Word to the wise: If it looks, walks, and quacks like a duck, it will probably be treated as a duck by the IRS and the courts.

Here is an example: One 419 plan currently marketed does not hold any investments and can never provide cash distributions to the employer or the employees when the plan is terminated. Ostensibly, it only provides employee death benefits. A key employee purchases cash-value life insurance and "rents" the death benefit to the 419 trust. The business contributes an "actuarially determined" tax-deductible premium to the trust to cover its share of the death benefit. At plan termination, the assignment ends and the trust holds no assets to distribute. The employee, on the other hand, walks away with the policy's cash value. In reality, since the trust's share of the premium is far greater than the costs charged by the insurance carrier, the excess subsidizes the cash value and enriches its policyowner.

This version of 419 plans is strikingly similar to a reverse split dollar arrangement. IRS Notice 2002-59 has put a cloud on these types of arrangements and neither P.S. 58 rates, Table 2001 rates, nor "actuarially determined" rates can be relied on to determine the trust's premium.

The non-discriminatory 419(e) plan that limits its benefits to pre-retirement death benefits with post-retirement medical and long-term claims are more likely to meet this guideline. When the plan is terminated, the benefits are frozen and available to the participants after retirement from a health care reimbursement account.

Does this make the more conservative 419(e) approach less attractive? Not when you consider that a pre-retirement termination distribution is taxable as compensation. Post-retirement medical and long-term care benefits are received income tax-free. Properly designed, the 419(e) plan can provide valuable tax deductions today and the promise of tax-free benefits tomorrow.

Tere D'Amato is the director of advanced planning, Wealth Management, at Commonwealth Financial Network in Waltham, Massachusetts. She can be reached at tdamato@commonwealth.com.

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