Final Regulations Help Define Legitimate 419 Plans
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.