Final Regulations Help Define Legitimate 419 Plans

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In recent years, the Internal Revenue Service has taken note of plan sponsors purporting to qualify under Section 419A(f)(6) of the Internal Revenue Code.

Some of these promoters offer unlimited contributions for cash value life insurance, permit discrimination in favor of key and owner employees, and virtually guarantee the payment of benefits to each participating employee based solely on policies purchased on the life of such individual.

Its no wonder, then, that plans such as these have been the target of the Services scorn.

The Treasury Department and the Service recently fired a shot across the bow in their war against abusive “10-or-more employer plans” when final regulations under Section 419A(f)(6) were published in the Federal Register. The final regulations provide guidance regarding the requirements that an arrangement must meet in order to qualify for tax treatment as a “10-or-more employer plan” under Section 419A(f)(6).

Why is Section 419A(f)(6) and the final regulations important? Some background may be in order. In 1984, Congress enacted Sections 419 and 419A to the Internal Revenue Code. These Sections limit an employers deductions for contributions to a welfare benefit fund. In simple terms, an employers deduction for any taxable year is limited to the cost of benefits actually provided during the year, plus additional reserve amounts. The reason for the limitation is to prevent an employer from taking a deduction for expenses that have not been paid or incurred.

However, Section 419A(f)(6) contains certain exceptions to the general limitations of Sections 419 and 419A. One of these exceptions in Section 419A(f)(6) provides that contributions to a fund, which is a part of a plan to which more than one employer belongs and to which no employer normally contributes more than 10% of the total contributions to the plan, are exempt from the limitations of Sections 419 and 419A. This exemption does not, however, apply to a plan that maintains experience-rating arrangements with respect to individual employers.

The reason that Congress exempted a “10-or-more employer plan” from the limitations of Sections 419 and 419A is that an employer has no incentive to make excessive contributions to a plan that does not maintain individual experience-rating arrangements. Think of the term “experience rating” this way: An employers contributions are held by the plan in such a manner as to insulate the employer from the “experience” of other employers participating in the plan. In other words, an employers contributions are used exclusively for the benefit of its own employees. As a result, an employer is not discouraged from making excessive contributions to the plan because all of the employers contributions will ultimately inure to its benefit.

Conversely, an employer participating in a plan that does not maintain such experience-rating arrangements would lose the benefit of its excess contributions. The amount of the employers contribution in excess of that needed to provide current benefits under the plan is pooled with the contributions of other participating employers and is available to provide benefits to the employees of such other participating employers.

Consequently, there is a built-in disincentive to excessive contributions in a bona fide “10-or-more employer plan” because an employer does not benefit from it. Stated differently, an employer is less likely to overcontribute to a plan for the purpose of obtaining an accelerated deduction if its “overcontribution” does not either increase its benefits or reduce its future costs.

Section 419A(f)(6) was meant, then, to be “self-policing.” In theory an employer would, on its own, refuse to make excessive contributions to a 419A(f)(6) plan because such excess contributions would be lost forever. However, some plan sponsors have read the term “experience-rating” very narrowly. They have created plans, which very much resemble nonqualified deferred compensation plans with the promise of a current deduction for contributions.

The recently issued final regulations are designed to effectuate this “self-policing.” First, the final regulations set forth five requirements that an arrangement must meet in order to qualify under Section 419A(f)(6). See Table 1.

Second, the final regulations clarify the meaning of an experience-rating arrangement with respect to an individual employer. Finally, the final regulations list five characteristics, the presence of any one of which may indicate that the arrangement does not qualify under Section 419A(f)(6). These five characteristics can be found in Table 2.

The presence of any one of these five characteristics may indicate that an arrangement is not a single plan or that it maintains an experience-rating arrangement with respect to an individual employer.

The prohibition against experience-rating arrangements is a key “self-regulating” aspect of Section 419A(f)(6). Experience-rating arrangements with respect to individual employers occur if an employers cost or an employees benefit is based upon the employers overall experience. Examples of what constitutes “overall experience” include investment results, claims or expense experience, and over- or underfunding.

What about plans funded with cash value life insurance? There seems to be support in the final regulations for the argument that a plan may be funded with cash value life insurance. Specifically, a portion of the preamble to the final regulations contains the following language:

Neither section 419A(f)(6) nor these regulations regulate the investments of a welfare benefit fund, including investments by a trust in cash value insurance.

However, this language simply means that a plan funded with cash value life insurance is not automatically disqualified from treatment as a “10-or-more employer plan.” Such a plan must still satisfy the requirements of Section 419A(f)(6) and the final regulations, including the single plan requirement.

A plan funded with cash value life insurance may not have a single pool of assets from which the benefits of all participants will be paid. This often can be the case, as each policy constitutes a segregated asset from which the benefit on the life of only the named insured will be paid.

In addition, a plan funded with cash value life insurance must avoid maintaining experience-rating arrangements with respect to the employers participating in the plan.

However, one might argue the very reason cash value life insurance is used is to permit contributions in excess of the current cost of term insurance and to ensure that an employers excess contributions will inure to its benefit, either in the form of reduced costs or increased benefits to its employees. This is a definition of experience rating as contained in the final regulations.

So, where do the final regulations leave the 419A(f)(6) market? As expected, most plan sponsors publicly have claimed that the regulations do not affect their plans legitimacy. Yet some commentators have argued that only arrangements funded with group-term life insurance can satisfy the requirements of the final regulations. This is because a plan funded with group-term life insurance has a single pool of assets from which the benefits of all participants will be paid and, thus, constitutes a single plan.

In addition, because an employers contribution is a set amount, established by the insurance company, an employer cannot contribute an amount in excess of the current cost of the benefit. An employer may not contribute more or less than other similarly situated employers. As a result, neither the cost to any employer nor the benefit paid to its employees depends upon the employers past contributions or its investment or claim experience.

The final regulations are important because they demonstrate how the Service will enforce Section 419A(f)(6) of the Code. While the Service may desire to narrow the scope of Section 419A(f)(6), it cannot eliminate its use. As long as an arrangement is properly structured and operated, it should qualify under Section 419A(f)(6), and an employers contributions to the arrangement will be exempt from the limitations of Sections 419 and 419A.

Whether a plan is funded with group-term or cash value life insurance, it must ensure that all experience–both gains and losses–are applied on a plan-wide basis and not used to adjust the cost or the benefit of any single employer.

After the dust settles, the final regulations should create a safer and more certain environment for those legitimate Section 419A(f)(6) plans. Now that the industry can separate the wheat from the chaff what should a producer do? While it may not offer everything under the sun, legitimate, conservative Section 419A(f)(6) plans exist that can offer solutions your small business owners need.

And now that year-end is just around the corner, did someone say “deduction?”

Daniel J. Munroe, JD, CLU, is director of advanced marketing for MONY Partners, Hartford, Conn. He can be reached at dmunroe@mony.com.


Reproduced from National Underwriter Life & Health/Financial Services Edition, September 15, 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.