The Section 419 market continues to stimulate some of the most creative plan designs in the life insurance business. This article looks at some of the most recent strategies and the implications for advisors.
To understand the present market, it is helpful to review its history.
Section 419 came into being under the Deficit Reduction Act of 1984. Its purpose was to close loopholes that were then perceived as allowing employers to accelerate deductions for welfare benefit plans–providing life insurance, retiree medical benefits, etc. Even the DEFRA Conference Committee report mentions that the goal was to prevent employers from taking premature deductions such as with a premium stabilization account.
In the ensuing years, the market has produced one type of Section 419 plan after another and another. Each focused on exceptions to the rules. As the Internal Revenue Service shut down versions it perceived to be abusive, the marketers came out with new versions.
This migratory history gave rise to the so-called multi-employer (over 10) plans (Section 419A(f)(6) plans). But when new IRS regulations essentially stopped abuses it perceived in those plans, promoters moved on to another exception under Section 419A(f)(5). This section targeted collectively-bargained plans, but the IRS later moved to close loopholes with these plans too.
In recent times, marketers have turned to the single-employer plans allowed under Section 419 in the first place. (Note: These plans were subject to limitations that marketers originally sought to avoid with multi-employer plans and collectively-bargained plans.)
It is these single-employer plans that are creating the buzz today.
Under Section 419, the deduction is limited to the “qualified cost.” This refers to the “qualified direct cost” for the benefits provided during the taxable year, plus any addition to a reserve for retiree benefits. The deduction may not exceed the amount that is a reasonable and necessary business expense under Section 162.
Due to limitations in the amount of benefits that can be reserved, and the non-discrimination rules that apply to retiree medical benefits, most of the efforts in the single employer market have tended to focus on pre-retirement life insurance.
The approach goes like this: The employer sets up a Section 419 plan that provides just pre-retirement life insurance. The employee includes in income the value of the annual life insurance benefit, usually under Table 2001. So, if the employer’s annual deduction equals the Table 2001 cost, there is probably no reason to have a Section 419 plan for this benefit. To make the plan more attractive, the employer may decide to fund the cost of the pre-retirement life insurance on a level annual basis over the participants’ lifetimes.
For example, if an employee enters the plan at age 50, and if age 65 is the normal retirement age, the employer figures out what the total cost of the benefits will be over all the years and then levelizes the cost so that it is the same for each year.
Assuming the plan may end when the key employees retire, upon plan termination the policies are transferred to the insureds. This should be a taxable disposition. But, meanwhile, the employer has gotten a substantial deduction, while the employee reports substantially less in income. If the plan were to end prior to the cross-over point, where the Table 2001 cost is more than the levelized cost, the employer has effectively accelerated its deductions.
Another possible wrinkle tries to avoid the income tax upon plan termination by having the employee buy the policy and name a beneficiary. Then, the employee assigns the policy to the 419 plan in return for the plan’s promise to provide a term insurance benefit to the employee. The plan does that by paying a portion of the premium–the portion that presumably corresponds to the value of the term insurance it is providing. This is a reverse split dollar scenario.
In either case, the key is determining whether the employer has valued the life insurance cost appropriately on an annual basis.
Some commentators believe the only permissible cost for the benefits provided during the taxable year is a one-year term cost, not a levelized cost. But, as with many tax questions, there is no precedent specifically on this point. If the cost of the term insurance is valued incorrectly, then the employer’s deduction would be invalid, and, in the reverse split dollar situation, the employee would have under-reported as income the value of the employer provided term insurance.
Another possible issue is determining whether the employer has, in effect, provided a reserve for post-retirement life insurance benefits when the plan releases its interest in the collateral assignment at time of retirement. Keep in mind that the policy is substantially funded at that point. If the answer is yes, then the amount of the reserve may not exceed what is needed to provide just $50,000 in post-retirement life insurance benefits, which corresponds to the non-taxable group term insurance limit under Section 79. In that case, the employer would presumably have provided excess benefits, and its deduction for the cost of the term insurance benefit would be disallowed.
In addition to the above, depending on plan design, a single employer 419 plan providing only pre-retirement benefits to key employees may have other hoops to jump through. But, if the hoops are negotiated successfully, the end result is that the employer gets a substantial deduction, the employee has only a Table 2001 annual cost, and the employee leaves the plan with a life insurance policy that is substantially funded.
Too good to be true? Perhaps. In view of the IRS activity in this market over the years, it is wise for customers to be vigilant in undertaking such a plan. Get good legal and tax advice. And, due to the inherent risks, they should consider whether they can achieve their goals with more conservative approaches.
That said, there probably will always be sophisticated, aggressive customers who will want to pursue these plans, as the history of multi-employer and collectively-bargained plans illustrates.
From the agent’s viewpoint, probably the most important strategy is to be sure the customer gets competent tax and legal advice. That way, if the deductions sought do not come to pass, the agent should not be subject to a claim of giving negligent tax and legal advice.
Interestingly, a commonplace aspect of these sales is the requirement that the customer agree in writing that neither the insurer nor the agent has promised any particular tax results from the plan; that the customer agrees to hold them harmless from adverse results; and that the customer indemnify the insurer and agent for any costs that may result from claims under the plan against the insurer or agent.
To say the least, everyone involved should be aware of the risks.