Small Business Retirement Plans Fuel Litigation

Maryland Trial Lawyer



Small businesses facing audits and potentially huge tax penalties over certain types of retirement plans are filing lawsuits against those who marketed, designed and sold the plans. The 412(i) and 419(e) plans were marketed in the past several years as a way for small business owners to set up retirement or welfare benefits plans while leveraging huge tax savings, but the IRS put them on a list of abusive tax shelters and has more recently focused audits on them.

The penalties for such transactions are extremely high and can pile up quickly.

 There are business owners who owe taxes but have been assessed 2 million in penalties. The existing cases involve many types of businesses, including doctors’ offices, dental practices, grocery store owners, mortgage companies and restaurant owners. Some are trying to negotiate with the IRS. Others are not waiting. A class action has been filed and cases in several states are ongoing. The business owners claim that they were targeted by insurance companies; and their agents to purchase the plans without any disclosure that the IRS viewed the plans as abusive tax shelters. Other defendants include financial advisors who recommended the plans, accountants who failed to fill out required tax forms and law firms that drafted opinion letters legitimizing the plans, which were used as marketing tools.

A 412(i) plan is a form of defined benefit pension plan. A 419(e) plan is a similar type of health and benefits plan. Typically, these were sold to small, privately held businesses with fewer than 20 employees and several million dollars in gross revenues. What distinguished a legitimate plan from the plans at issue were the life insurance policies used to fund them. The employer would make large cash contributions in the form of insurance premiums, deducting the entire amounts. The insurance policy was designed to have a “springing cash value,” meaning that for the first 5-7 years it would have a near-zero cash value, and then spring up in value.

Just before it sprung, the owner would purchase the policy from the trust at the low cash value, thus making a tax-free transaction. After the cash value shot up, the owner could take tax-free loans against it. Meanwhile, the insurance agents collected exorbitant commissions on the premiums – 80 to 110 percent of the first year’s premium, which could exceed million.

Technically, the IRS’s problems with the plans were that the “springing cash” structure disqualified them from being 412(i) plans and that the premiums, which dwarfed any payout to a beneficiary, violated incidental death benefit rules.

Under §6707A of the Internal Revenue Code, once the IRS flags something as an abusive tax shelter, or “listed transaction,” penalties are imposed per year for each failure to disclose it. Another allegation is that businesses weren’t told that they had to file Form 8886, which discloses a listed transaction.

According to Lance Wallach of Plainview, N.Y. (516-938-5007), who testifies as an expert in cases involving the plans, the vast majority of accountants either did not file the forms for their clients or did not fill them out correctly.

Because the IRS did not begin to focus audits on these types of plans until some years after they became listed transactions, the penalties have already stacked up by the time of the audits.

Another reason plaintiffs are going to court is that there are few alternatives – the penalties are not appeasable and must be paid before filing an administrative claim for a refund.

The suits allege misrepresentation, fraud and other consumer claims. “In street language, they lied,” said Peter Losavio, a plaintiffs’ attorney in Baton Rouge, La., who is investigating several cases. So far they have had mixed results. Losavio said that the strength of an individual case would depend on the disclosures made and what the sellers knew or should have known about the risks.

In 2004, the IRS issued notices and revenue rulings indicating that the plans were listed transactions. But plaintiffs’ lawyers allege that there were earlier signs that the plans ran afoul of the tax laws, evidenced by the fact that the IRS is auditing plans that existed before 2004.

“Insurance companies were aware this was dancing a tightrope,” said William Noll, a tax attorney in Malvern, Pa. “These plans were being scrutinized by the IRS at the same time they were being promoted, but there wasn’t any disclosure of the scrutiny to unwitting customers.”

A defense attorney, who represents benefits professionals in pending lawsuits, said the main defense is that the plans complied with the regulations at the time and that “nobody can predict the future.”

An employee benefits attorney who has settled several cases against insurance companies, said that although the lost tax benefit is not recoverable, other damages include the hefty commissions – which in one of his cases amounted to 400,000 the first year – as well as the costs of handling the audit and filing amended tax returns.

Defying the individualized approach an attorney filed a class action in federal court against four insurance companies claiming that they were aware that since the 1980s the IRS had been calling the policies potentially abusive and that in 2002 the IRS gave lectures calling the plans not just abusive but “criminal.” A judge dismissed the case against one of the insurers that sold 412(i) plans.

The court said that the plaintiffs failed to show the statements made by the insurance companies were fraudulent at the time they were made, because IRS statements prior to the revenue rulings indicated that the agency may or may not take the position that the plans were abusive. The attorney, whose suit also names law firm for its opinion letters approving the plans, will appeal the dismissal to the 5th Circuit.

In a case that survived a similar motion to dismiss, a small business owner is suing Hartford Insurance to recover a “seven-figure” sum in penalties and fees paid to the IRS. A trial is expected in August.

But tax experts say the audits and penalties continue. “There’s a bit of a disconnect between what members of Congress thought they meant by suspending collection and what is happening in practice. Clients are still getting bills and threats of liens,” Wallach said. “Thousands of business owners are being hit with million-dollar-plus fines. … The audits are continuing and escalating. I just got four calls today,” he said. A bill has been introduced in Congress to make the penalties less draconian, but nobody is expecting a magic bullet.

“From what we know, Congress is looking to make the penalties more proportionate to the tax benefit received instead of a fixed amount.”


nationwide Offices of lance wallach

Expert Tax Resolution Services

(516) 938-5007
Abusive Insurance, Welfare Benefit, and Retirement Plans
Tuesday, January 11
Published in Tax Practice: Tax Notes 
By Lance Wallach

​The IRS has various task forces auditing all section 419, section 412(i), and other plans that tend to be abusive. These plans are sold by most insurance agents. The IRS is looking to raise money and is not looking to correct plans or help taxpayers. The fines for being in a listed, abusive, or similar transaction are up to $200,000 per year (section 6707A), unless you report on yourself. The IRS calls accountants, attorneys, and insurance agents “material advisors” and also fines them the same amount, again unless the client’s participation in the transaction is reported. An accountant is a material advisor if he signs the return or gives advice and gets paid. More details can be found on and

​Bruce Hink, who has given me written permission to use his name and circumstances, is a perfect example of what the IRS is doing to unsuspecting business owners. What follows is a story about how the IRS fines him $200,000 a year for being in what they called a listed transaction. Listed transactions can be found at involved are what the IRS calls abusive plans or what it refers to as substantially similar. Substantially similar to is very difficult to understand, but the IRS seems to be saying, “If it looks like some other listed transaction, the fines apply.” Also, I believe that the accountant who signed the tax return and the insurance agent who sold the retirement plan will each be fined $200,000 as material advisors. We have received many calls for help from accountants, attorneys, business owners, and insurance agents in similar situations. Don’t think this will happen to you? It is happening to a lot of accountants and business owners, because most of theses so-called listed, abusive, or substantially similar plans are being sold by insurance agents.

Recently I came across the case of Hink, a small business owner who is facing $400,000 in IRS penalties for 2004 and 2005 because of his participation in a section 412(i) plan. (The penalties were assessed under section 6707A.)In 2002 an insurance agent representing a 100-year-old, well established insurance company suggested the owner start a pension plan. The owner was given a portfolio of information from the insurance company, which was given to the company’s outside CPA to review and give an opinion on. The CPA gave the plan the green light and the plan was started.Contributions were made in 2003. The plan administrator came out with amendments to the plan, based on new IRS guidelines, in October 2004.The business owner’s insurance agent disappeared in May 2005, before implementing the new guidelines from the administrator with the insurance company. The business owner was left with a refund check from the insurance company, a deduction claim on his 2004 tax return that had not been applied, and no agent.It took six months of making calls to the insurance company to get a new insurance agent assigned. By then, the IRS had started an examination of the pension plan.

Asking advice from the CPA and a local attorney (who had no previous experience in these cases) made matters worse, with a “big name” law firm being recommended and over $30,000 in additional legal fees being billed in three months.To make a long story short, the audit stretched on for over 2 ½ years to examine a 2-year-old pension with four participants and the $178,000 in contributions. During the audit, no funds went to the insurance company, which was awaiting formal IRS approval on restructuring the plan as a traditional defined benefit plan, which the administrator had suggested and the IRS had indicated would be acceptable. The $90,000 in 2005 contributions was put into the company’s retirement bank account along with the 2004 contributions.In March 2008 the business owner received a private e-mail apology from the IRS agent who headed the examination, saying that her hands were tied and that she used to believe she was correcting problems and helping taxpayers and not hurting people.

The IRS denied any appeal and ruled in October 2008 the $400,000 penalty would stand. The IRS fine for being in a listed, abusive, or similar transaction is $200,000 per year for corporations or $100,000 per year for unincorporated entities. The material advisor fine is $200,000 if you are incorporated or $100,000 if you are not.Could you or one of your clients be next?To this point, I have focused, generally, on the horrors of running afoul of the IRS by participating in a listed transaction, which includes various types of transactions and the various fines that can be imposed on business owners and their advisors who participate in, sell, or advice on these transactions. I happened to use, as an example, someone in a section 412(i) plan, which was deemed to be a listed transaction, pointing out the truly doleful consequences the person has suffered. Others who fall into this trap, even unwittingly, can suffer the same fate.Now let’s go into more detail about section 412(i) plans. This is important because these defined benefit plans are popular and because few people think of retirement plans as tax shelters or listed transactions. People therefore may get into serious trouble in this area unwittingly, out of ignorance of the law, and, for the same reason, many fail to take necessary and appropriate precautions.

The IRS has warned against the section 412(i) defined benefit pension plans, named for the former code section governing them. It warned against trust arrangements it deems abusive, some of which may be regarded as listed transactions. Falling into that category can result in taxpayers having to disclose the participation under pain of penalties, potentially reaching $100,000 for individuals and $200,000 for other taxpayers. Targets also include some retirement plans.One reason for the harsh treatment of some 412(i) plans is their discrimination in favor of owners and key, highly compensated employees. Also, the IRS does not consider the promised tax relief proportionate to the economic realities of the transactions. In general, IRS auditors divide audited plan into those they consider noncompliant and other they consider abusive. While the alternatives available to the sponsor of noncompliant plan are problematic, it is frequently an option to keep the plan alive in some form while simultaneously hoping to minimize the financial fallout from penalties.The sponsor of an abusive plan can expect to be treated more harshly than participants. Although in some situation something can be salvaged, the possibility is definitely on the table of having to treat the plan as if it never existed, which of course triggers the full extent of back taxes, penalties, and interest on all contributions that were made – not to mention leaving behind no retirement plan whatsoever.

Another plan the IRS is auditing is the section 419 plan. A few listed transactions concern relatively common employee benefit plans the IRS has deemed tax avoidance schemes or otherwise abusive. Perhaps some of the most likely to crop up, especially in small-business returns, are the arrangements purporting to allow the deductibility of premiums paid for life insurance under a welfare benefit plan or section 419 plan. These plans have been sold by most insurance agents and insurance companies.Some of theses abusive employee benefit plans are represented as satisfying section 419, which sets limits on purposed and balances of “qualified asset accounts” for the benefits, although the plans purport to offer the deductibility of contributions without any corresponding income. Others attempt to take advantage of the exceptions to qualified asset account limits, such as sham union plans that try to exploit the exception for the separate welfare benefit funds under collective bargaining agreements provided by section 419A(f)(5). Others try to take advantage of exceptions for plans serving 10 or more employers, once popular under section 419A(f)(6). More recently, one may encounter plans relying on section 419(e) and, perhaps, defines benefit sections 412(i) pension plans.Sections 419 and 419A were added to the code by the Deficit Reduction Act of 1984 in an attempt to end employers’ acceleration of deductions for plan contributions. But it wasn’t long before plan promoters found an end run around the new code sections. An industry developed in what came to be known as 10-or-more-employer plans.The IRS steadily added these abusive plans to its designations of listed transactions.

With Revenue Ruling 90-105, it warned against deducting some plan contributions attributable to compensation earned by plan participants after the end of the tax year. Purported exceptions to limits of sections 419 and 419A claimed by 10-or-more-employer benefit funds were likewise prescribed in Notice 95-24 (Doc 95-5046, 95 TNT 98-11). Both positions were designated as listed transactions in 2000.At that point, where did all those promoters go? Evidence indicates many are now promoting plans purporting to comply with section 419(e). They are calling a life insurance plan a welfare benefit plan (or fund), somewhat as they once did, and promoting the plan as a vehicle to obtain large tax deductions. The only substantial difference is that theses are now single-employer plans. And again, the IRS has tried to rein them in, reminding taxpayers that listed transactions include those substantially similar to any that are specifically described and so designated.On October 17, 2007, the IRS issues Notices 2007-83 (Doc 2007-23225, 2007 TNT 202-6) and 2007-84 (Doc 2007-23220, 2007 TNT 202-5). In the former, the IRS identified some trust arrangements involving cash value life insurance policies, and substantially similar arrangements, as listed transactions.

The latter similarly warned against some postretirement medical and life insurance benefit arrangements, saying they might be subject to “alternative tax treatment.” The IRS at the same time issued related Rev. Rul. 2007-65 (Doc 2007-23226, 2007 TNT 202-7) to address situations in which an arrangement is considered a welfare benefit fund but the employer’s deduction for its contributions to the fund id denied in whole or in part for premiums paid by the trust on cash value life insurance policies. It states that a welfare benefit fund’s qualified direct cost under section 419 does not include premium amounts paid by the fund for cash value life insurance policies if the fund is directly or indirectly a beneficiary under the policy, as determined under sections264(a).Notice 2007-83 targets promoted arrangements under which the fund trustee purchases cash value insurance policies on the lives of a business’s employee/owners, and sometimes key employees, while purchasing term insurance policies on the lives of other employees covered under the plan. These plans anticipate being terminated and anticipate that the cash value policies will be distributed to the owners or key employees, with little distributed to other employees. The promoters claim that the insurance premiums are currently deductible by the business and that the distributed insurance policies are virtually tax free to the owners. The ruling makes it clear that, going forward, a business under most circumstances cannot deduct the cost of premiums paid through a welfare benefit plan for cash value life insurance on the lives of its employees.Should a client approach you with one of these plans, be especially cautious, for both of you.

​Advise your client to check out the promoter very carefully. Make it clear that the government has the names of all former section 419A(f)(6) promoters and, therefore, will be scrutinizing the promoter carefully if the promoter was once active in that area, as many current section 419(e) (welfare benefit fund or plan) promoters were. This makes an audit of your client more likely and far riskier.It is worth noting that listed transactions are subject to a regulatory scheme applicable only to them, entirely separate from Circular 230 requirements, regulations, and sanctions. Participation in such a transaction must be disclosed on a tax return, and the penalties for failure to disclose are severe – up to $100,000 for individuals and $200,000 for corporations. The penalties apply to both taxpayers and practitioners. And the problem with disclosure, of course, is that it is apt to trigger an audit, in which case even if the listed transaction was to pass muster, something else may not.Lance Wallach, National Society of Accountants Speaker of the Year and member of the AICPA faculty of teaching professionals, is a frequent speaker on retirement plans, financial and estate planning, and abusive tax shelters. He writes about 412(i), 419, and captive insurance plans. He speaks at more than ten conventions annually, writes for over fifty publications, is quoted regularly in the press and has been featured on television and radio financial talk shows including NBC, National Public Radio's All Things Considered, and others. Lance has written numerous books including Protecting Clients from Fraud, Incompetence and Scams published by John Wiley and Sons, Bisk Education's CPA's Guide to Life Insurance and Federal Estate and Gift Taxation, as well as AICPA best-selling books, including Avoiding Circular 230 Malpractice Traps and Common Abusive Small Business Hot Spots. He does expert witness testimony and has never lost a case.