Magazine article The CPA Journal

Tax Court Guidance regarding Welfare Benefit Plans

Magazine article The CPA Journal

Tax Court Guidance regarding Welfare Benefit Plans

Article excerpt

A key tool in estate planning, both to provide liquidity and to offset state taxes, is life insurance. Even though life insurance proceeds upon the insured's death are generally income tax free under IRC section 101(a), it is possible to have life insurance premiums paid for with pretax dollars.

One way to make pretax dollars available is by using money inside a pension plan. However, the life insurance proceeds will be included in the taxable estate of the insured/plan participant. Furthermore, concepts to create a subtrust within a pension plan to hold life insurance that would be outside the insured/plan participant's taxable estate are generally considered to violate the anti-alienation pension rules. These rules could cause the entire pension, not just the account of the participant creating the sub-trust, to be in violation. The specific consequences would be disallowance of pension contribution deductions, current taxability of income earned inside the pension plan, liability for penalties because the plan is invalid, and charges for interest on the taxes and penalties that become due.

A more attractive alternative, and a very hot topic at the moment, is the use of a welfare benefit plan under IRC section 419 to provide death benefits. Without going into all the detailed technical requirements, some broad concepts and strategies are becoming clear. To work, a plan cannot be a tax-deferral device like a pension plan. Instead, the plan purchases life insurance policies on all employees to fund the welfare benefits that the plan provides. Since contributions to such a plan would qualify, as corporate ordinary and necessary business expenses under Regulations section 1.16210(a) [Moser v. Commissioner, T.C. Memo. 1989-142, affd. on other grounds 914 F.2d 1040 (8th Cir. 1990)], the life insurance would be paid for with pretax dollars. Furthermore, since participants do not own, nor have access to, policy cash values, each employee should be able to designate his welfare benefit to an irrevocable life insurance trust. This would keep the life insurance proceeds out of the employee's taxable estate. However, a participant would be required to report as taxable income the lesser of the government's P.S. 58 rate or the insuring company's published annual renewable term insurance rate.

A welfare benefit trust is a taxable entity. If the trust qualifies as a 10 or more employer plan under IRC section 419A(f)(6), then it would be tax exempt under IRC section 501(cX9). Another benefit of a section 419A(f)(6) plan is that, should there be an unintentional plan defect, it will usually be possible to make corrections without penalty. However, clear guidance regarding how to meet the IRC section 419A(f)(6) requirements is lacking.

The Tax Court decision in Robert D. Booth and Janice Booth, et. al. v. Commissioner provides answers to some of the questions regarding welfare benefit plans in general and the specific requirements for ten or more employer plans. The fact pattern in this case contains amendments to the welfare benefit trust during its existence; a full discussion is beyond the scope of this article. Nonetheless, the Tax Court's decisions provide considerable guidance for those involved with similar plans.

A general problem that the IRS has had with welfare benefit plans is that they have some of the characteristics of deferred compensation plans. If the plans are deferred compensation plans, then IRC section 404(a)(5) and Regulations section 1.404(a)-12(b)(3) would only permit an employer (that maintains a separate account for each employee) a tax deduction equivalent to a corresponding taxable income item for employees. Should this be the case, there would not be any tax benefit for the establishment of a death benefit-only section 419 plan.

The Tax Court held that, even if a plan had deferred compensation features, if the major features are those of a welfare benefit plan, then the deferred compensation features will be "swallowed up . …

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