Defined benefit pension plans funded with annuities and life insurance have been around for a long time. Given an exemption from the normal pension funding rules by Internal Revenue Code section 412(i) (now section 412(e) after the Pension Protection Act), nobody paid them much attention until the late 1990s and early 2000s. Then insurance agents started to market them heavily, and the IRS began to pay attention. In early 2004, it issued several Revenue Rulings and proposed regulations intended to curb what the IRS viewed as “abuses” – that is, plans that did not, in the IRS view, meet the 5 or 6 key requirements for 412(i) plans under the Code – and not long thereafter it started a sweeping audit initiative to eliminate abusive 412(i) plans.
The IRS is currently processing hundreds of these audits. The vast majority of the cases have not been resolved.
It will come as no shock to the benefits community if we say that a number of the plans under audit fail to meet all of the rules under section 412(i). At the same time, it is also fair to say that many of the rules that the IRS is now seeking to enforce weren’t clear when the plans were set up. But what may come as a surprise is that there are many plans that do meet the requirements. Unfortunately, under the audit initiative, these plans are being lumped together with the non-compliant and abusive ones, and the taxpayers are being forced to spend significant sums defending their retirement funds.
We are currently handling the audits of a number of these plans. We discuss two examples below, but first let’s look at the background.
Background If a plan meets the requirements of section 412(i), the deductible contribution to the plan equals the premiums on the insurance contracts used to fund the benefits. You don’t need an actuary to calculate the funding contributions. To be a valid 412(i) plan, the law requires, among other things, that the benefit promised at normal retirement age under the plan be equal to the benefit provided under the insurance contracts used to fund the plan and guaranteed by a domestic insurance carrier. It also requires, according to the IRS position developed during the audit process, that every form of benefit provided for in the insurance contracts (i.e., life annuities, joint and survivor annuities, period certain annuities, lump sum benefits) is equivalent to every form offered as an option in the plan. And finally, there is a requirement that the death benefit provided by the plan be no greater than an “incidental” limit as permitted under IRS guidance.
But how do you know that the plan meets these requirements? Though this may seem counter-intuitive, you have to get an actuary to do a series of calculations. When a 412(i) plan is funded with a combination of the cash surrender value of life insurance policies and the value of annuity contracts, it takes an actuary to certify that the amount promised under the terms of the plan and the amount guaranteed by the insurance contracts are equal. The issue is even more complicated if the plan offers insurance policies providing for lump sum payments calculated using actuarial equivalents.
All very interesting, but how do you apply this to a real 412(i) plan under audit?
Two Examples These two cases illustrate that there really are valid 412(i) plans despite the IRS assertion that they are all bad and that taxpayers who have the support to show that the plan was done properly will need to fight back to save their plans. They also illustrate the types of information needed to justify the expenditure of time, money and emotion it takes to challenge the government.
In the first case, the client’s plan was funded with a combination of flexible annuity contracts and life insurance policies with cash surrender values. When the contracts were issued, the insurance company provided a policy rider with respect to the flexible annuity contract conforming it to the requirement for level annual premiums, as permitted in the regulations under section 412(i). The insurance policies also have “qualified plan riders” that contain a right to a joint and survivor annuity as the normal form of benefit for married participants as required under the terms of the plan. The plan’s only form of benefit is a life annuity with an optional joint and survivor annuity. The plan has only two participants and both have life and annuity polices with identical features.
To support what was done, we worked with an actuary who verified that the amount of the life insurance was not greater than the incidental benefit limit and certified that, using reasonable actuarial assumptions, the promised plan benefit for all participants is the same as the guaranteed benefits under the annuity contracts and the cash surrender value of the life polices at normal retirement age. (Generally, courts give great weight to the certification of the taxpayer’s actuary and are reluctant to substitute the judgment of the IRS actuary after the fact. See, e.g., Citrus Valley Estates, Inc. v Commissioner, 99T.C. 379 (1992).)
Notwithstanding all the evidence we provided to the IRS agent and the agent’s manager, the IRS said the plan was non-compliant and disallowed the taxpayer’s deductions for contributions to the plan. Our request for a conference with the IRS actuary and the client’s actuary was denied. The taxpayer had no choice but to challenge the IRS determination, and the case is now pending in the IRS Appeals Office.
In the second case, the plan was funded exclusively with flexible premium annuity contracts – no life insurance of the type the IRS considers “abusive” (i.e., policies with high initial surrender charges). As in the first case, the carrier provided a rider to the contracts conforming them to the requirements of section 412(i). The annuity contracts were applied for in 2003, the first plan year, but were not signed and the first premiums were not paid until March of 2004. The insurance carrier has confirmed that the contract was in effect in 2003, per an oral binder given by the agent to the plan.
After more than 18 months of protracted discussion, provision of voluminous documentation and detailed analyses of the legal authorities and the facts of the case, the IRS has conceded all issues except for one: was the annuity contract in effect for the first year of the plan? We have pointed out that there is nothing in the Code or the regulations that requires that the annuity contract be signed or the premium paid before the end of the first plan year. The Code simply states that the contract must commence with the date the participant enters the plan, and the carrier is prepared to certify that this was the case. The contract commences when the carrier certifies that there is coverage, not upon the signing of the contract or the payment of the premium. Indeed, the 412(i) regulation specifically provides that premiums may be paid any time before lapse of the contract and that a payment made on the first payment date under the contract still meets the requirement even if that date is after the participant enters the plan. Thus, in our view, there is no legal support for the IRS position that the policy must be signed and the premium paid before the last day of the first plan year. Nevertheless, the IRS is proposing to disallow the deduction for the first plan year, and the case is headed to Appeals.
Conclusion Our purpose in presenting these two examples is not to suggest that the IRS is entirely wrong or that it is acting unreasonably in handling this audit initiative. As we noted at the outset, there certainly are plans that fail to comply with the 412(i) requirements and there are others that were abusive. And to its credit, the IRS has developed an approach that will permit most of the audits to be settled in a way that will preserve much of the original tax deductions and plan benefits.
That said, not every case is bad, and it is unfortunate that the IRS has failed to give its agents the discretion to close cases that clearly do not fall within either category.
The IRS is currently processing hundreds of these audits. The vast majority of the cases have not been resolved.
It will come as no shock to the benefits community if we say that a number of the plans under audit fail to meet all of the rules under section 412(i). At the same time, it is also fair to say that many of the rules that the IRS is now seeking to enforce weren’t clear when the plans were set up. But what may come as a surprise is that there are many plans that do meet the requirements. Unfortunately, under the audit initiative, these plans are being lumped together with the non-compliant and abusive ones, and the taxpayers are being forced to spend significant sums defending their retirement funds.
We are currently handling the audits of a number of these plans. We discuss two examples below, but first let’s look at the background.
Background If a plan meets the requirements of section 412(i), the deductible contribution to the plan equals the premiums on the insurance contracts used to fund the benefits. You don’t need an actuary to calculate the funding contributions. To be a valid 412(i) plan, the law requires, among other things, that the benefit promised at normal retirement age under the plan be equal to the benefit provided under the insurance contracts used to fund the plan and guaranteed by a domestic insurance carrier. It also requires, according to the IRS position developed during the audit process, that every form of benefit provided for in the insurance contracts (i.e., life annuities, joint and survivor annuities, period certain annuities, lump sum benefits) is equivalent to every form offered as an option in the plan. And finally, there is a requirement that the death benefit provided by the plan be no greater than an “incidental” limit as permitted under IRS guidance.
But how do you know that the plan meets these requirements? Though this may seem counter-intuitive, you have to get an actuary to do a series of calculations. When a 412(i) plan is funded with a combination of the cash surrender value of life insurance policies and the value of annuity contracts, it takes an actuary to certify that the amount promised under the terms of the plan and the amount guaranteed by the insurance contracts are equal. The issue is even more complicated if the plan offers insurance policies providing for lump sum payments calculated using actuarial equivalents.
All very interesting, but how do you apply this to a real 412(i) plan under audit?
Two Examples These two cases illustrate that there really are valid 412(i) plans despite the IRS assertion that they are all bad and that taxpayers who have the support to show that the plan was done properly will need to fight back to save their plans. They also illustrate the types of information needed to justify the expenditure of time, money and emotion it takes to challenge the government.
In the first case, the client’s plan was funded with a combination of flexible annuity contracts and life insurance policies with cash surrender values. When the contracts were issued, the insurance company provided a policy rider with respect to the flexible annuity contract conforming it to the requirement for level annual premiums, as permitted in the regulations under section 412(i). The insurance policies also have “qualified plan riders” that contain a right to a joint and survivor annuity as the normal form of benefit for married participants as required under the terms of the plan. The plan’s only form of benefit is a life annuity with an optional joint and survivor annuity. The plan has only two participants and both have life and annuity polices with identical features.
To support what was done, we worked with an actuary who verified that the amount of the life insurance was not greater than the incidental benefit limit and certified that, using reasonable actuarial assumptions, the promised plan benefit for all participants is the same as the guaranteed benefits under the annuity contracts and the cash surrender value of the life polices at normal retirement age. (Generally, courts give great weight to the certification of the taxpayer’s actuary and are reluctant to substitute the judgment of the IRS actuary after the fact. See, e.g., Citrus Valley Estates, Inc. v Commissioner, 99T.C. 379 (1992).)
Notwithstanding all the evidence we provided to the IRS agent and the agent’s manager, the IRS said the plan was non-compliant and disallowed the taxpayer’s deductions for contributions to the plan. Our request for a conference with the IRS actuary and the client’s actuary was denied. The taxpayer had no choice but to challenge the IRS determination, and the case is now pending in the IRS Appeals Office.
In the second case, the plan was funded exclusively with flexible premium annuity contracts – no life insurance of the type the IRS considers “abusive” (i.e., policies with high initial surrender charges). As in the first case, the carrier provided a rider to the contracts conforming them to the requirements of section 412(i). The annuity contracts were applied for in 2003, the first plan year, but were not signed and the first premiums were not paid until March of 2004. The insurance carrier has confirmed that the contract was in effect in 2003, per an oral binder given by the agent to the plan.
After more than 18 months of protracted discussion, provision of voluminous documentation and detailed analyses of the legal authorities and the facts of the case, the IRS has conceded all issues except for one: was the annuity contract in effect for the first year of the plan? We have pointed out that there is nothing in the Code or the regulations that requires that the annuity contract be signed or the premium paid before the end of the first plan year. The Code simply states that the contract must commence with the date the participant enters the plan, and the carrier is prepared to certify that this was the case. The contract commences when the carrier certifies that there is coverage, not upon the signing of the contract or the payment of the premium. Indeed, the 412(i) regulation specifically provides that premiums may be paid any time before lapse of the contract and that a payment made on the first payment date under the contract still meets the requirement even if that date is after the participant enters the plan. Thus, in our view, there is no legal support for the IRS position that the policy must be signed and the premium paid before the last day of the first plan year. Nevertheless, the IRS is proposing to disallow the deduction for the first plan year, and the case is headed to Appeals.
Conclusion Our purpose in presenting these two examples is not to suggest that the IRS is entirely wrong or that it is acting unreasonably in handling this audit initiative. As we noted at the outset, there certainly are plans that fail to comply with the 412(i) requirements and there are others that were abusive. And to its credit, the IRS has developed an approach that will permit most of the audits to be settled in a way that will preserve much of the original tax deductions and plan benefits.
That said, not every case is bad, and it is unfortunate that the IRS has failed to give its agents the discretion to close cases that clearly do not fall within either category.
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