Small Business Retirement Plans Fuel Litigation
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 - $100,000 per individual and $200,000 per entity per tax year for each failure to disclose the transaction - often exceeding the disallowed taxes.There are business owners who owe $6,000 in taxes but have been assessed $1.2 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 sed 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 $1 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, New York 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 appealable and must be paid before filing anadministrative claim for a refund.