Dolan Media Newswires
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 used 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,
N.Y. (516-938-5007), 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 an administrative claim for a refund.
The suits allege misrepresentation, fraud
and other consumer claims. "In street language, they lied," said
Peter Losavio, a plaintiffs' attorney in Baton Rouge, La., who is investigating
several cases. So far they have had mixed results. Losavio said that the
strength of an individual case would depend on the disclosures made and what
the sellers knew or should have known about the risks.
In 2004, the IRS issued notices and
revenue rulings indicating that the plans were listed transactions. But
plaintiffs' lawyers allege that there were earlier signs that the plans ran
afoul of the tax laws, evidenced by the fact that the IRS is auditing plans
that existed before 2004.
"Insurance companies were aware this
was dancing a tightrope," said William Noll, a tax attorney in Malvern,
Pa. "These plans were being scrutinized by the IRS at the same time they
were being promoted, but there wasn't any disclosure of the scrutiny to unwitting
customers."
A defense attorney, who represents
benefits professionals in pending lawsuits, said the main defense is that the
plans complied with the regulations at the time and that "nobody can
predict the future."
An employee benefits attorney who has
settled several cases against insurance companies, said that although the lost
tax benefit is not recoverable, other damages include the hefty commissions -
which in one of his cases amounted to $860,000 the first year - as well as the
costs of handling the audit and filing amended tax returns.
Defying the individualized approach an
attorney filed a class action in federal court against four insurance companies
claiming that they were aware that since the 1980s the IRS had been calling the
policies potentially abusive and that in 2002 the IRS gave lectures calling the
plans not just abusive but "criminal." A judge dismissed the case
against one of the insurers that sold 412(i) plans.
The court said that the plaintiffs failed
to show the statements made by the insurance companies were fraudulent at the
time they were made, because IRS statements prior to the revenue rulings
indicated that the agency may or may not take the position that the plans were
abusive. The attorney, whose suit also names law firm for its opinion letters
approving the plans, will appeal the dismissal to the 5th Circuit.
In a case that survived a similar motion
to dismiss, a small business owner is suing Hartford Insurance to recover a
"seven-figure" sum in penalties and fees paid to the IRS. A trial is
expected in August.
Last July, in response to a letter from members of Congress, the
IRS put a moratorium on collection of §6707A penalties, but only in cases where
the tax benefits were less than $100,000 per year for individuals and $200,000
for entities. That moratorium was recently extended until March 1, 2010.
But tax experts say the audits and penalties continue.
"There's a bit of a disconnect between what members of Congress thought
they meant by suspending collection and what is happening in practice. Clients
are still getting bills and threats of liens," Wallach said.
"Thousands of business owners are being hit with
million-dollar-plus fines. ... The audits are continuing and escalating. I just
got four calls today," he said. A bill has been introduced in Congress to
make the penalties less draconian, but nobody is expecting a magic bullet.
"From what we know, Congress is looking to make the penalties
more proportionate to the tax benefit received instead of a fixed amount."
Lance Wallach can be reached at: LaWallach@aol.com- 516-938-5007- or www.vebaplan.com
