While many business owners adopt legitimate Voluntary Employee Beneficiary Associations (“VEBAs”), welfare benefit plans (“419(e) plans”), and fully insured defined benefit pensions (“412(i) plans”), all of the foregoing plans are also marketed as a way for owners to obtain huge tax deductions, with the ability to take money out of a corporation tax free, protect assets from creditors, deduct life, health, disability, and long-term care insurance premiums, as well as pass wealth tax free to the next generation. This article will explore those representations.

We have worked with each of these benefit plans for years without problems for ourselves or for our clients. Yet a review of recent Internal Revenue Service (“IRS”) rulings and court cases instituted both by the IRS as well as the Department of Labor (“DOL”) shows that some taxpayers adopting VEBAs, 419 plans, or 412(i) plans have had tax deductions disallowed, been sued, or even worse. Many plans have been determined by IRS to be “listed transactions” (or potentially abusive tax shelters), requiring notifying the Service and the possibility of substantial penalties.

When the various plans are sold and operated properly, they can be very advantageous. However, rather than brave the regulatory minefield, many accountants and advisors would rather simply just say “no”. How can a non-specialist differentiate between a legitimate plan and one that IRS or DOL may attack?

VEBAs and 419(e) Plans

VEBAs and 419(e) plans potentially provide a triple tax benefit: (i) actuarially determined contributions to a legitimate VEBA or other welfare benefit plan may be tax deductible (ii) investment income may accumulate tax-deferred, and (iii) benefits paid from the plan can be distributed income tax free, either as life insurance proceeds or for health care expense reimbursement benefits If properly designed and established, the benefits inside the plan are protected from creditors and the death benefits may be excluded from the participant’s estate for estate tax purposes. Look out for plans that offer benefits that appear too good to be true: tax deductible contributions and tax free retirement benefits, severance benefits for the business owner, etc.

419A(f)(5) and (6) Plans

Over the past few years, the Treasury and the IRS have acted forcefully to eliminate so-called “Section 419 plans”. The Section 419 Plans that are in disfavor with the IRS are those plans that claim to be in compliance with Internal Revenue Code Sections 419A(f)(5) or 419A(f)(6).

So-called Section 419A(f)(5) plans are marketed as “union” plans. Some of these use convincing language to persuade employers that they are able to include only key employees and owner-employees in their “union,” and to provide such “union members” with an inviting array of benefits.

Section 419A(f)(6) plans, also called “10-or-more employer plans”, are marketed as exempt from tax deduction limitations altogether. Some such plans even claim to be exempt from nondiscrimination requirements. It appears that IRS succeeded in eliminating most of these plans.

412(i) Fully Insured Defined Benefit Plans

412(i) plans continue to generate both interest and caution following recent Internal Revenue Service and Treasury Department actions to crack down on a number of abusive schemes that had cropped up in this marketplace.

Unlike 401(k) and other defined contribution plans, defined benefit plans, including 412(i) plans, are not subject to the $42,000 contribution limit ($46,000 with catch up salary deferrals).

Maximum contributions to a defined benefit plan may far exceed 100% of compensation. (We have seen cases where tax deductible contributions in excess of $200,000 per year for a single participant were available.) For example, a W-2 wage of $50,000 would permit a maximum SEP-IRA contribution of $12,000 for a person of fifty but will allow a 412(i) contribution of over $75,000!

Defined benefit plans (including 412(i) plans) have tremendous appeal for small, closely held businesses that are profitable and have few, if any, employees. The initial tax-deductible contributions and projected benefits are unparalleled for participants age 40 and older. But care must be exercised to assure that a 412(i) or other defined benefit plan is properly designed and funded. We have seen plans offering tax deductible contributions of $800,000 in a single year! If it looks to good to be true it probably is.

Properly structured 412(i) plans are viable when avoiding the pitfalls and can provide maximum tax deductions and retirement benefits.