If your clients who are business owners are thinking about setting up a 419(e) single-employer welfare benefit arrangement plan, beware: It must be airtight to escape the tentacles of the Internal Revenue Service.
A 419(e) plan is a funded, welfare benefit that allows for employer-provided benefits covering sickness, accidents, disability, death or unemployment. Some plans offer benefits both before and after retirement.
If structured properly, these arrangements may allow for tax-deductible employer contributions.
But, be careful: Welfare benefits are not pension or retirement benefits. Internal Revenue Code Section 419 allows employers to take deductions, within certain limits, for contributions generally made to a trust to fund welfare benefits for employees, such as benefits paid in the event of sickness, accident, disability, death or, in some cases, unemployment. The trust can own life insurance. Yet under no circumstances can plan assets revert to the employer.
To be considered a 419(e) plan, it must be funded and offer benefits to all employees. This means that the employer must set aside assets specifically dedicated to paying benefits, often in a trust, for employees or their beneficiaries.
The typical company that uses a 419(e) plan has one or more owners in their 50s, with long-time, key employees. The typical company also has 10 employees or less.
Kurt Fasen, senior vice president of ING, in Minneapolis, says professional groups and small business operations with strong cash flows are attractive candidates for this type of program. For a medical office with two doctors and four employees, for example, contributions to this type of plan may range from $50,000 to about $250,000 annually.
Fasen notes that 419(e) plans use lower-cost term insurance to fund death-benefit-only benefits. Universal life insurance, which offers flexible premium rates and payments, frequently is used for post-retirement medical, disability and unemployment benefits. Loans against the cash value or cash withdrawals are also used to pay for welfare benefits.
For 419(e) plans, ING provides only the insurance products, says Fasen. But often the company will review a plan provided by a vendor or third-party administrator to double check to see if the plan complies with the law. Fasen stresses that it's important for business owners to hire a third party to design a plan that strictly adheres to IRS regulations.
At first blush, 419(e) plans look like a good way for a small business to attract and keep key employees, while getting a tax deduction for the company's 419(e) contributions into the insurance policy. In addition, assets in the life insurance trust are sheltered from creditors.
But experts warn that 419(e) plans have complex rules that dictate the need for a third-party administrator. The amount of the deductions must be actuarially certified. And if the company offers post-retirement benefits, they must offer them to all the company's employees.
Previous tax abuses involving 419A(f)(6) plans designed for companies with 10 or more employees may have tainted the perception and increased IRS scrutiny of 419(e) plans, notes Lance Wallach, financial planner, Plainview, N.Y. Wallach is co-author of "A Rose by Any Other Name: What Ever Happened to All Those 419A(f)(6) Providers?" a study published in the March/April 2006 issue of the National Association of Enrolled Agents' EA Journal. During the past few years, says Wallach, a number of IRS rulings and court cases, as well as Department of Labor cases, have disallowed tax deductions for 419A(f)(6) plans.
The IRS has come to consider 419A(f)(6) plans as a potentially abusive tax shelter and has identified them as listed transactions. Yet the IRS has issued no notice on 419(e) plans, according to John Lipold, an IRS spokesperson based in Washington.
As a result, today, 419(e) plans often take the place of 419A plans. Even still, 419(3) can be problematic.
Wallach's study, done in conjunction with Ronald H. Snyder, an ERISA attorney and pension actuary with the Benefit Strategies Group, Inc., Salt Lake City, analyzed several 419(e) plans for potential tax problems.
Their bottom line: if you are going to recommend a 419(e) plan, it had better be well-defined in the IRC and rely on minimal interpretation. Otherwise, expect the IRS to disallow the tax deductions.
To keep in line, be sure to follow these guidelines:
- The plan must cover all employees. You may not discriminate in favor of key employees.
- Severance benefits can't be offered through a 419(e) plan.
- You can't offer 419(e) welfare benefits to self-employed individuals or partnerships that are subcontracted by the company for work.
- Universal or whole life insurance can't be used to fund benefits for key employees, while rank-and-file welfare benefits are covered by term insurance.
- A universal or whole life insurance policy can't be used if the company is only offering life insurance as a welfare benefit. Term insurance must be used. Cash value insurance is more costly than term life and may be considered an excessive tax deduction by the IRS. As a result, the IRS may treat the employer deduction as a taxable dividend.
- Aggressive actuarial assumptions can't be used to determine the proper death benefit and employer's premium. Aggressive assumptions can lead to excessive tax deductions. The actuary should use the conservative level annual cost method, which looks at the cost per individual in determining the total cost of the insurance that is used in the plan.
There are additional drawbacks to 419(e) plans. For example, a company's business could decline, and the employer may fail to make the required contributions. As a result, the insurance policy could lapse and the employees will lose their benefits.
The assumptions of the insurance illustration may be off the mark. The policy may not perform as expected. It's the employer who would have to kick in extra premiums to keep the policy in force.
In addition, employees are subject to income tax on the current cost of life insurance death benefit protection. The insurance benefit also is considered part of a taxable estate, unless it can be legally sheltered from the estate tax.
"When the various plans are sold and operated properly, they can provide excellent advantages," Wallach says. But "rather than brave the regulatory minefield, many accountants and advisors simply just say, 'No.'"
That can be a mistake. The 419(e) plan might be a good option -- if handled well.
Alan Lavine is co-author with his wife, Gail Liberman, of Quick Steps to Financial Stability (Que/Penquin Group, 2006).