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419 Guidance

On October 17, 2007, the Internal Revenue Service and Treasury released guidance on single employer welfare benefit plans. Below is Niche's preliminary announcement and discussion of the two Notices and one Revenue Ruling.

We will follow up this initial press release with mailings to our employers and their advisors.

IRS and Treasury Release Long-Promised Guidance for Single Employer Welfare Plans

The IRS and Treasury issued two Notices and one Revenue Ruling related to single employer welfare benefit plans. Donald Korb, Chief Counsel for IRS said, "The guidance targets specific abuses involving a limited group of arrangements that claim to be welfare benefit funds".

Niche has been in consultation with our tax advisors to help us understand and communicate to you the impact on existing plans, and on the ability to design plans in the future that will not cause an IRS challenge.

Notice 2007-83 identifies certain trust arrangements that use cash value life insurance policies as "listed transactions" that would require taxpayers to disclose to the Office of Tax Shelter Analysis; Notice 2007-84 cautions against plans providing post retirement benefits that in form, offer non-discriminatory benefits, but in operation, primarily benefit the owner or key employees; and Revenue Ruling 2007-65, incredibly, reverses the IRS position of three years ago, incorrectly in most tax experts' opinions, and denies deductions for certain benefit costs if the funds to pay those benefits are invested in cash value life insurance policies. Of the three pieces of guidance, the Revenue Ruling is the most egregious act of the IRS to exert their bias against life insurance, generally, and any tax planning opportunities for small businesses.

The guidance makes it clear that welfare benefit plans that comport with the intent of §§419 and 419A, and do, in fact, provide meaningful medical and life insurance benefits to retirees on a non-discriminatory basis, with substantial deductible contributions to fund those welfare benefits, are outside the scope of Notice 2007-84.

The Bottom Line

1. Plans where the employer does not deduct any amount for the cost of the death benefits provided; and where the plan has a post retirement medical and/or death benefit, can use cash value life insurance as the funding vehicle; and, can deduct the amounts actuarially determined on reasonable basis to fund a limited reserve for post retirement medical benefits. These plans would not be considered listed transactions. The plans Niche has designed in 2007 would satisfy these parameters for a valid single employer welfare plan.
2. Plans must provide meaningful benefits to both key and non-key employees. If plan provisions or the intent of the business owner indicate that it would be unlikely for non-key employees to receive benefits, the employer is cautioned that the deductions will be challenged by the IRS as deferred compensation arrangements under §§404 or 409A. The Niche plans are marketed as a valuable and necessary component of overall benefit and retirement planning for small business owners and their employees, all entitled to the same benefits afforded government employees or employees of large, public companies.
3. Plans with insured death benefits, and where the employer has deducted, for years ending before November 5, 2007, more than the amount the employees reported as income for the benefits provided or the aggregate cost of insurance (but limited to a rate table formula, if higher) are now considered "listed transactions" and subject to disclosure requirements, discussed below. Most of the plans sponsored by "Niche employers" are likely to be subject to disclosure requirements, because most employers will have deducted the current year cost of providing death benefits (the "qualified direct cost") of those benefits, otherwise allowable until the release of this guidance.
4. Plans that invest contributed assets into cash value life insurance policies can only deduct the amounts attributable to the future benefit costs, i.e., post retirement reserves, or incurred but unpaid claims for current benefits. The IRS new position is that §264(a) would preclude a deduction for benefits because the funding of "qualified direct costs" does NOT include any amounts payable to a cash value insurance policy.
5. Following is an attempt to describe each of the three pieces of guidance in layman's terms and with discussion of the practical implications of the three pronouncements by IRS.

Revenue Ruling 2007-65

This ruling addresses the deduction limits when a plan invests in cash value life insurance polices.

Summary: The IRS position is that an employer cannot deduct the cost of current benefit expenses (called the qualified direct costs), even if otherwise deductible, if the fund purchases cash value life insurance to accumulate assets. However, the IRS acknowledges that an employer would be permitted a deduction for amounts attributable as an addition to a future benefit cost (called the qualified asset account), even if invested in cash value life insurance policies. A "qualified asset account" is the portion of the fund used to reserve for post retiree benefits or to pay incurred but unpaid claims as of the end of the plan year. In other words, cash value life insurance is acceptable and does not preclude a deduction, as the investment vehicle for certain plan liabilities, but not for others.

Background: It may be useful to use non-technical language to define three terms that are relevant to determining the amount of deduction allowable for welfare benefits. The amount an employer can deduct for any welfare benefits provided to its employees is the "qualified cost" of the benefits, which is the sum of the qualified direct costs and the additions to the qualified asset account. The amount actually paid for benefits in a current year is called the "qualified direct cost". The amounts paid to fund incurred but unpaid claims, or to fund a limited reserve for post retiree medical benefits, are called the "additions to a qualified asset account".

Situations: This Revenue Ruling describes two situations. The first Situation is a plan that only provides a death benefit, but no other welfare benefits (commonly known as "death benefit only" plans). The plan purchases cash value life insurance policies to provide the stated death benefits, and each employee designates the beneficiary of the policy.

The second Situation is the same, except that it only provides an uninsured disability benefit. The cash values are intended to be used to pay the disability benefit claims. The plan paid $X in benefits during the year, which the participants included in their personal incomes, so the qualified direct cost of the benefits in Situation 2 is $X. It appears there was also an amount paid to the plan as an additional to the qualified asset account (for benefits incurred but unpaid as of the end of the year).

In both Situations, the plan is providing allowable welfare benefits. However, in Situation 1, all of the funding is for the year's qualified direct cost of the death benefits. (Because the benefits are fully insured, there would be no need to set aside an amount in its qualified asset account for incurred but unpaid claims.) In Situation 2, the funding includes both the portion attributable as the qualified direct cost and an amount as an addition to the qualified asset account for a benefit other than life insurance coverage (in this instance, the uninsured disability benefit).

Analysis: The analysis provided in this Revenue Ruling completely contradicts the IRS position in a Tax Advice Memorandum it wrote in December of 2004 (and while not precedent setting, it certainly is disturbing that the IRS is inconsistent in its application of the law). The TAM reviewed a VEBA welfare benefit plan, using life insurance to invest assets to pay post retiree medical benefits, and concluded that §264(a) did not prevent the taxpayer from deducting contributions to the plan.

Here, the IRS has reached the opposite conclusion, and has stated that because §264(a) would prohibit an employer from deducting premiums paid to a life insurance policy in which it was directly or indirectly a beneficiary, it also precludes an employer from making contributions to an independent plan (of which the employer could ever be a beneficiary, directly or indirectly) to fund its welfare benefits.

Holding: The holding in Situation 1 is that, although $X is the qualified direct cost for the benefits that year, and would be deductible to the employer had the plan invested in something other than life insurance, the contributions are not deductible as the plan's qualified direct costs because insurance premiums don't "count" toward qualified direct costs, under this new Ruling.

The holding in Situation 2 is similar, although it allows that some of the contribution may be deductible as additions to the plan's qualified asset account, for incurred but unpaid claims, subject to the account limit.

Niche's conclusion is that if a plan is using cash value life insurance to accumulate funds for post retirement medical benefits, or for other permissible welfare benefits, the employer can deduct the amounts funding the qualified asset account, but not deduct any amounts considered as the plan's qualified direct costs.

Notice 2007-83

This Notice describes promoted welfare benefit plans that the IRS considers as abusive, tax avoidance transactions, defines which type of plans are now deemed to be "listed transactions" and cautions that the IRS intends to challenge the deductions to plans as dividend arrangements, plans to defer compensation, or split dollar arrangements.

Plans that the IRS intends to challenge include plans that require large contributions relative to the actual cost of the benefit; plans where it is anticipated that the plan will terminate and distribute assets in a manner where a substantial portion of the distribution is paid to the business owners; and plans structured so that the business owner and/or key employees are the owners of the insurance policies and assign the death benefit proceeds to the trust.

Certain plans are now deemed listed transactions, and employers contributing to them are required to file a Reportable Transaction Disclosure Statement, Form 8886, with the Office of Tax Shelter Analysis by January 15, 2008 and with their tax returns.

If a plan has all of the following, or is substantially similar, it is a listed transaction:

1. Involves a trust or other fund;
2. Does not rely on §419A(f)(5)(A) (regarding collectively bargained arrangements);
3. Pays premiums to one or more life insurance policies where value is accumulated either inside the policy or outside the policy but where the policy will later be converted or exchanged with an accumulation value based on the premiums to the original policy; and
4. The employer has taken a deduction than for its contributions to the fund with respect to benefits provided under the plan (other than post-retirement medical benefits, post-retirement life insurance benefits, and child care facilities) that is greater than the sum of the following amounts:

   (a) With respect to any uninsured benefits provided under the plan:

   - An amount paid during the current tax year for claims incurred during the current or a prior taxable year plus the limited reserves allowed under 419A(c)(1) or (c)(3) plus administrative expenses.

   (b) With respect to any insured benefits provided under the plan:

   - Insurance premiums paid during the current or a prior taxable year that are properly allocable to the taxable year (other than premiums paid with respect to a cash value life insurance policy) plus administrative expenses.

   (c) With respect to life insurance benefits provided through cash value life insurance policies:

   - For taxable years ending prior to November 5, 2007, the amount allowed is the greater of (a) the economic benefit cost for the life insurance coverage provided (i.e., the amount taxed to the employee without regard to the exclusion under Section 79) or (b) the aggregate cost of insurance charged under the policy or policies with respect to the life insurance coverage provided to the plan participant (limited, however, to the product of the current life insurance protection provided multiplied by the current year's mortality rate provided in the higher of the 1980 or 2001 CSO Table).

   - For taxable years ending on or after November 5, 2007, the amount allowed is zero.

Conclusion: For years ending prior to November 5, 2007, any plans providing death benefits with cash value insurance policies, where the employer has deducted more than the table rate formula or the amounts reported by their employees, are now considered a listed transaction; and for years ending on or after November 5, 2007, if the employer deducts any amount for the death benefits provided, the employer is deemed to have participated in a listed transaction.

Most Niche employers will have taken deductions for the mortality and expense charges of the insurance policies providing the coverage, an amount we consider to be the qualified direct cost of the benefits, as it represents the amount the plan actually paid for the benefits during the year. This amount is likely to be greater than the table formula or amounts included in employee income. Disclosure is required for any prior year where such has occurred and the year has not been closed by the statute of limitations.

We will be contacting employers and their representatives in the very near future, and will encourage all employers to consult with their own tax counsel, but it is our opinion that most employers will need to file the Form 8886 for any years in which they made contributions. Additionally, any advisors with respect to the plan's implementation will need to file a Form 8918 as Material Advisors. We will have more information on our website, www.NichePlanSponsors.com, very shortly.

Notice 2007-84

This Notice addresses certain trust arrangements being promoted to and used by small business to avoid federal taxes.

Many businesses maintain welfare benefit funds that comport with the intent of §§419 and 419A and do in fact provide meaningful medical and life insurance benefits to retirees on a non-discriminatory basis, and make substantial contributions to those welfare benefit funds that are fully deductible. Such welfare benefit funds are outside the scope of this Notice.

The Notice describes plans that purport to provide post retirement benefits on a non-discriminatory basis, when in fact few employees (primarily owner employees) will receive those benefits. It describes plans that provide "loans" to owners; plans that intend or permit amending the plan to add benefits other than retiree medical and life insurance benefits; and plans that will terminate prior to retirement and distribute its assets so that owner and key employees receive all or a substantial portion of the assets.

These types of plans will be challenged by the IRS and characterized as dividend income or deferred compensation arrangements. We note the IRS has a bias against small business owners being able to take advantage of the same tax laws and benefit programs as large, public companies, and question whether the "scary" language in this Notice would be upheld in court. However, they are attempting to put employers on notice of their intentions.

Editorial:

While we have been eagerly awaiting "guidance", last week's pronouncements are woefully short of any actual, useful instruction with respect to benefit funding levels, plan provisions, definitions of terms, transferability of welfare benefits. We understand there may have been some abuses in the marketplace, which would all be preventable if the IRS would issue real rules for us to follow, as opposed to Notices that express the IRS bias against cash value life insurance, tax favored benefit programs for small business and small business owners wanting the same benefit packages they would receive if they were employed by the government or a large company. We believe the IRS has a duty to provide clear guidance, and we believe these pronouncements are far short of providing constructive guidance for those of us who wish to follow the rules enumerated under the Internal Revenue Code.

Niche Plan Sponsors, Inc.
949/655-1401

Neither Niche nor its agents or employees provide tax or legal advice. Any comments included in this written communication are not intended or written to be used, and cannot be used by the taxpayer, for the purpose of avoiding any penalties that may be imposed on the taxpayer by any governmental taxing authority or agency.