by Lance Wallach
The older 412i plans were abusive tax shelter. Below is one of the abusive. There were many others but this is one example. If a physician- investor puts $250,000 into a 412(i) plan every year for 5 years as a tax-deductible expense, they'll eventually fund $1.25 million over that period. The cash surrender value (CSV) of the policy at the end of the 5th year will be $250,000. The physician-investor will then purchase the life policy from the 412(i) plan for that $250,000 CSV and think they got a great deal since the cash account value (CAV) of the policy is really $1.1 million. After waiting for surrender charges in the life policy to evaporate, they will take income tax–free loans from the policy.
Buying a policy with a low CSV and a high CAV seems like a steal of a deal since the investor only pays 20% of the value of the asset when they purchase it out of the 412(i)plan. This was supposed to save the investor 80% of the tax on that money. If this sounds too good to be true, it didn't to many physician-investors who allowed insurance agents to sell them 412(i) plans. After looking at the plan, the IRS eventually shut it down. Ironically, the beginning of the end of 412(i) plans started on Friday, Feb. 13, 2004.
IRS Revenue Procedure 2004-16 basically states that the fair market value of a life insurance policy that comes out of a 412(i) defined-benefit plan should be based on the premiums paid and not on the CSV or internal reserve value of the insurance company. How will this affect a recently implemented 412(i) plan? The investor will not be able to purchase the life policy from the 412(i) plan for the CSV, which is 80% lower than the premiums paid. Instead, they will have to use the premiums paid as the value (minus minor term costs), which basically destroys the tax-favorable nature of a 412(i) plan.
In addition, Revenue Procedure 2004-20 states that the IRS doesn't want excess life insurance purchased inside a 412(i) plan. In this case, the IRS is referring to insurance contracts where the death benefits exceed the death benefits provided to the employee's beneficiaries under the terms of the plan, whereby the balance of the proceeds revert to the plan as a return on investment. IRS Revenue Procedure 2004-20 also states that if excess death benefits are purchased, those deductions will be disallowed in the current tax year and will be spread out, if allowable, over future years. Furthermore, any nondeductible premiums will be subject to a 10% excise tax.
Finally, Revenue Ruling 2004-21 says that a qualified plan cannot discriminate in favor of highly compensated employees by buying life policies for non-highly compensated employees that aren't inherently equal. Note: The word inherently seems to indicate that the IRS has no idea how to define certain standards or rules in their attempt to give final guidance to taxpayers. As is the case with a lot of revenue rulings and regulations on advanced tax topics, the IRS doesn't always know how to give guidance on what should be done. Instead, it tries to muddy the waters and scare investors so that certain tax plans aren't used due to uncertainty about the law.
In Oct. 2002 I spoke at the annual National Society of Pension Actuaries convention about plans. The IRS chief actuary also warned about 412i plans. This was not the first warning about these plans. Most in the industry knew that IRS would be coming after the participants in these plans long before that convention. In spite of that insurance company's promoters and agents continued to sell the scams to unsuspecting business owners. The insurance company's had the purchasers sign fraudulent disclaimers saying that they would get their own tax advice. The insurance companies had a duty to disclose the fact that there were potential IRS problems with these 412i scams, but they did not, thereby making the disclaimers fraudulent. The reason for the disclaims was to try to protect the insurance company's from potential lawsuits when the buyers were audited by the IRS.
We have helped may fight the IRS audits. As an expert witness my side has never lost a case. Most lawsuits however against insurance company's and agents are lost. The inexperienced attorneys lose based on the disclaimers that the clients signed. The attorneys fail to prove that those disclaimers were fraudulent.
Another issue was the failure of the participants in the 412i scams failure to properly file under 6707a to avoid horrendous fines for being in listed transactions and not telling the IRS. You can still avoid the fine by filing properly.