4112 / What is an abusive 419(e) plan, and how is it taxed?

A 419(e) plan is a welfare benefit fund that is sponsored by an employer to provide welfare benefits to its employees. When a 419(e) plan meets all of the IRC’s requirements, the employer’s contributions are fully deductible with no taxation to the employee then or when benefits are provided. When these plans operate consistently with the IRC, they generally are unattractive to smaller employers.¹ These plans may involve a taxable welfare benefit fund or a tax-exempt VEBA ( Q 4113). Different deduction limits apply to 10 or more employer plans ( Q 4107) and collectively bargained plans ( Q 4097).

Abusive Arrangements in Single Employer Plans

The IRS cautions taxpayers about participating in certain trust arrangements being sold to professional corporations and other small businesses as welfare benefit funds.² Some of the arrangements have been identified as listed transactions (see Notice 2007-83, IR 2007-170, below).

Revenue Ruling 2007-65 addresses situations where an arrangement is considered a welfare benefit fund, but the employer’s deduction for its contributions to the fund is denied in whole or part for premiums paid by the trust on cash value life insurance policies.³ For purposes of determining the limitations on an employer’s deduction for contributions to a welfare benefit fund under Section 419 and Section 419A, the IRS concluded that regardless of whether the benefit provided through the fund is life insurance coverage, premiums paid on cash value life insurance policies by the fund are not included in the fund’s qualified direct cost whenever the fund is directly or indirectly a beneficiary under the policy within the meaning of Section 264(a). The fund’s qualified direct cost includes amounts paid as welfare benefits by the fund during the taxable year for claims incurred during the year.⁴

Some of the arrangements described above and substantially similar arrangements, as well as certain other arrangements using cash value life insurance policies for which an employer has deducted amounts as contributions to a welfare benefit fund, may be transactions that have been designated as listed transactions. If a transaction is designated as a listed transaction, affected persons may be subject to additional penalties and disclosure responsibilities ( Q 4107).

The IRS has identified certain trust arrangements involving cash value life insurance policies and substantially similar arrangements as listed transactions.⁵ If a transaction is designated as a listed transaction, affected persons have disclosure obligations and may be subject to applicable penalties.

The IRS cautions taxpayers that the tax treatment of trusts that, in form, provide post-retirement medical and life insurance benefits to owners and other key employees may vary from the treatment claimed.⁶ The IRS may issue further guidance to address these arrangements, and taxpayers should not assume that the guidance will be applied prospectively only.

The IRS and Treasury released a warning on certain trust arrangements being sold as welfare benefit plans to professional employers and small employers. The announcement discussed certain welfare plan arrangements using life insurance contracts that constitute listed transactions.

In 2009, the IRS released a lengthy background document that outlines the issues and patterns its agents will look for during audits of welfare benefit plans with respect to uncovering disguised dividend arrangements, for example, as in the Neonatology and DeAngelis cases ( Q 4107), as well as disguised deferred compensation arrangements.⁷ In the audit guidance, the IRS advises its agents to place a particularly sharp focus on arrangements using cash value life insurance policies and includes several questions that agents will use to identify abusive arrangements.