The Internal Revenue Service says it will be challenging efforts by wealthy individuals to use small welfare benefit funds to reduce their taxes.

The IRS today issued two notices and a revenue ruling challenging use of voluntary employees’ beneficiary associations, plans said to be based on sections 419 and 419(e) of the Internal Revenue Code, and other trust arrangements that use an employer’s income to buy large amounts of cash value life insurance and provide relatively modest benefits for ordinary employees.

In IRS Notice 2007-83, IRS officials warn that employers cannot deduct the premiums for the cash value life insurance policies used to fund small “welfare benefit” trust arrangements that are created mainly to reduce taxpayers’ federal income and federal employment taxes.

Officials designate some of the arrangements as “listed transactions,” which means that taxpayers who use those arrangements may have to comply with extra disclosure rules and pay penalties.

In IRS Notice 2007-84, IRS officials warn that they might issue guidance that will apply retroactively, to VEBA arrangements and other trust arrangements that are already in place.

In IRS Revenue Ruling 2007-65, officials hold that premiums paid on cash value life insurance policies by a Section 419 fund that provides life insurance benefits are not included in the fund’s deductible direct costs if the fund is directly or indirectly a beneficiary.

Officials also hold in the revenue ruling that the premiums paid are not included in the direct costs even if the benefit provided by the fund is something other than life insurance.

In practice, the ruling means that the sponsor of a Section 419 trust that uses cash value life insurance to buy term life insurance for employees, but provides no other benefits, may not be able to deduct the premium contributions for the cash value life insurance, officials write.

Officials note that they will be focusing on trust arrangements set up to reduce employers’ federal taxes.

“Businesses often maintain welfare benefit funds that compared with the intent of [the Internal Revenue Code] and do in fact provide meaningful medical and life insurance benefits to retirees on a nondiscriminatory basis, and make substantial contributions to those welfare benefit funds that are fully deductible,” officials write in Notice 2007-84. “Such welfare benefit funds are outside the scope of this notice.”

A copy of the notice dealing with “abusive trust arrangements utilizing cash value life insurance policies” is available HYPERLINK “http://www.irs.gov/pub/irs-drop/n-07-83.pdf”‘>Document Link

A copy of the notice dealing with “trust arrangements purporting to provide nondiscriminatory post-retirement medical and life insurance benefits” is available ‘>Document Link

A copy of the revenue ruling dealing with IRS treatment of Section 419 funded welfare benefit plans is available