Originally published on Forbes.com.
For the last two decades Lance Wallach has been a voice crying out in the wilderness on the perils of 419(e) employee welfare plans. Lance is not an attorney, CPA or actuary. A graduate of Baruch College he trained as a financial planner with Mutual Benefit Life and then moved on to New England Life where he was a top producer selling life insurance as part of sophisticated plans. Now he speaks and serves as an expert witness helping to repair the damage done by insurance companies who promoted abusive tax plans.
The Plan That Should Have Stood Up?
Somehow or other Lance and I became facebook buds and when I saw the decision in Our Country Home Enterpise Inc, I immediately contacted him. I thought he would view the decision as vindication of his view on these plans. I was surprised when he told me that he thought the decision was wrong. His assessment of the situation was that Ron Snyder, whose Sterling Plan was about the only 419 plan which should have worked, was too frugal when it came to hiring lawyers to defend the plan. This might be understandable, because being much less aggressive, the plan was not as lucrative for the sponsor and Ron, according to this letter was having trouble getting people to chip in for the defense.
Lance told me that he had met with the IRS in 2002 and explained the abuse to them and pointed out the most abusive promoters. Ron Snyder had come along and had tweaked his plan based on informal IRS feedback making him optimistic that he would be successful in Tax Court.
What Can Be Abusive About These Plans?
In the extreme version a closely held corporation makes contributions to the plan. Rank and file employees do not get any benefits. The contributions are deducted by the corporation. The contributions go to fund whole dollar life insurance whose beneficiaries are designated by the principals. The principals are able to access the cash surrender value of the insurance contracts. The beneficiaries do not recognize any income.
What really drove these plans was that they allowed insurance companies to sell much larger policies than people, not motivated by tax savings, would have been willing to buy. Lance indicated that all the major life insurance companies, with the notable exception of Northwestern Mutual promoted the plans. The companies tried to avoid responsibility when the IRS cracked down on them.
The Country Home Decision
Whatever the merits of the Sterling Plan might have been relative to other 419 plans, the Tax Court came down hard on it. In Our Country Home Enterprise Inc several taxpayers involved in the Sterling Plan ended up with business entities being denied deductions, individual beneficiaries being required to recognize income and an enhanced 30% accuracy penalty for failing to adequately disclose a listed transaction. Total tax and penalty was over $3 million. The decisions on the small number of taxpayers will be applied to over 40 others. The decision covered plans that were run by C corporations and S corporations with and without life insurance involved.
I was pretty sure as to how the decision was going to go after reading the first sentence.
The deficiencies stem from petitioners’ participation in the Sterling Benefit Plan (Sterling Plan), a purported welfare benefit plan. The parties have selected these seven cases to serve as test cases for issues related to the Sterling Plan. The parties in approximately 40 other cases pending before the Court have agreed to be bound by one or more of the final decisions in these cases. (Emphasis added)
When a Tax Court judge writes “purported” it generally means something like “Liar, liar pants on fire” or bovine excrement. The word “purported” in the first sentence is a sign that things are not going to go well for the taxpayers.
We conclude and hold that petitioners significantly underreported income on their Federal income tax returns for each subject year. In addition, the evidence shows (and we find) that petitioners consciously participated in a plan that, as advertised to them, they should have known (and probably knew) was too good to true. A reasonable person in the position of petitioners also would not have been oblivious to the fact that the judiciary had rejected the use of cash value life insurance to fund welfare benefits in similar settings.
There Is More
I spoke with Sam Susser, a retired IRS manager. Sam represented several of the taxpayers on audit. One thing he realized was that many of them were probably required to file From 8886 – Reportable Transaction Disclosure Statement. The IRS has been going to town with that one because there is a stiff penalty for not filing it or filing it wrong. That penalty cannot be litigated in Tax Court. He thinks it likely that that will now be assessed against some of the participants or confirmed if it has already been assessed.
And There Is Even More
I knew this was an important decision when I saw it if only from being the first regular Tax Court decision of this half of the year. It has not received a lot of coverage yet. Lance has sent me a lot of material to absorb, so there will probably be a few more posts. Lance indicated that the same promoters have variations of the scheme going under other guises.
About Northwestern Mutual Life
I realize I have been a little hard on Northwestern Mutual Life, because of a number of cases in which taxpayers have been hit with sometimes large out of the blue amounts of phantom income. Ironically, those cases prove that Northwestern policies actually perform very well. The failure was on the part of agents poorly servicing or not servicing at all, which caused their clients to be blindsided. A really lousy policy would burn out before it could produce much in the way of phantom income, but one that performs well will last a really long time without new cash going in. Northwestern’s conservatism in not getting caught up in the 419 mania is another mark in its favor.