Abusive 412(i) Plans Are Tainting Legitimate Programs
By Thomas B. Higgins
Why is it that whenever something “good” starts to become popular some people tinker with it to make it better? Many times, the result is they make it “bad” for all concerned.
This is the situation that confronts those agents who sell 412(i) defined benefit plans.
Two months ago IRS officials made various public comments that they would be looking into certain “abusive” 412(i) schemes that they considered did not pass muster under IRS interpretation. Since then there has been only silence from the IRS officials, while some client advisors have adopted a wait-and-see stance even toward legitimate 412(i) plans. This article will examine the distinction between legitimate programs and the “abusive” aspects under IRS scrutiny.
The key focus is the extraordinary contribution levels claimed as tax deductions under the “abusive” plans. Furthermore, it is how the promoters of these plans make this happen, versus the method used under the more traditional 412(i) plans.
Exhibit 1 provides a look at a typical plan funded 100% with cash value life insurance. A 55-year-old participant adopts a plan with normal retirement at age 65. His defined monthly pension is $10,000, and under the insurance carriers annuity rates it takes $1.7 million at age 65 to guarantee this benefit.
The promoter for this plan has interpreted that this 412(i) program may be funded 100% using an individual life insurance contract. The promoter even has an opinion letter from a large, well-known firm of tax attorneys that states the program he is selling “more than likely” is defensible in gaining the claimed benefits against any IRS objections. In addition, they have covered all the contingent aspects of the program in their 23-page letter and are fairly certain (“more than likely”) that it satisfies all the required IRS Code sections and regulations.
Now, here comes the magic! Because the promoter has interpreted that his proposed 412(i) program may be funded 100% using an individual life insurance contract, he calculates how much face amount must be purchased to get to the guaranteed cash value needed–$1,739,130. The face amount is $8,544,835 for an annual tax-deductible premium of $568,232.
Well, thats an awful lot of life insurance. I suppose if the participant dies, his wife and family will be well taken care of.
But maybe not. The promoter says they only get $1 million because the “incidental limit” in the plan document limits payment of survivor benefits to 100 times the monthly pension. Any “excess” is kept in the plan for funding benefits for other participants, which, in this case, there are none.
Otherwise, the excess death proceeds will revert to the company, be taxed, then paid to the family and then taxed again.
Promoters of this type of arrangement contend that most plans will only last for five years, and then the plan distributes the insurance contract to the participant, or he can buy it for its current cash value. See Exhibit I again.
The fifth year cash value is $630,523. Now, the plan has been funded five years with a tax-deductible premium outlay of a whopping $2,841,160. Thats quite a difference between premium paid in versus cash value accumulated.
“Not to worry.” the promoter says, just wait five more years and the contracts cash value will grow back to $2,883,690 (with no more premiums paid). The participant would have paid only $630,523 or the tax on that value.
In addition, beginning after year 10, when the participant turns age 65, promoters will explain that he can take tax-free loans out of this contract in the amount of $248,980 each year over the next 15 years until age 80. Thats a total of $3,734,700 of tax-free income.
Is there any wonder why IRS has a problem with this scenario?
Now, lets take a look at a more traditional 412(i) arrangement.
Exhibit II provides the same benefits as the plan shown in Exhibit I. However, instead of 100% funding with life insurance, we limit the face amount to $1 million for a premium of $70,120 and a guaranteed cash value of $588,060. The balance of $1,151,070 will be funded by an annuity that has a guaranteed crediting interest rate of 4.5%. The annuity annual premium is $89,639.
Total annual premium for both life insurance and annuity equals $159,759. Thats a reduction of over $408,000 from the plan described in Exhibit I.
The annual premiums are reduced by any “excess” credited interest over the annuity guaranteed rate and by the life insurance dividends. The overall net total premium paid over 10 years is $1,462,280 and the guaranteed cash at age 65 is $1,739,130.
If someone is motivated to have a higher deduction, it is possible to retire at age 60–instead of age 65. For half the monthly pension ($5,000), a deductible contribution of $258,899 can be generated using the “incidental limit” method under Revenue Ruling 74-307. This develops $1,537,850 of life insurance with a life premium of $107,780.
Given this legitimate method of developing a high deductible life insurance premium and tax-deductible pension contribution under a traditional 412(i) arrangement, why spoil a good thing by “abusing” it and incurring IRS scrutiny?
Thomas B. Higgins, CLU, is president of Creative Pension Concepts Inc., Barre, Vt. Contact him via e-mail at CPCPension@aol.com.
Reproduced from National Underwriter Edition, May 5, 2003. Copyright 2003 by The National Underwriter Company in the serial publication. All rights reserved. Copyright in this article as an independent work may be held by the author.