When the IRS first started its 412(i) audit program, the assumption was that all of the plans were “abusive.” During the course of the audits, the IRS discovered – apparently to its surprise – that many, and perhaps most, of the plans were not abusive but might nonetheless contain technical violations of the 412(i) requirements. Some technical violations involve the terms of the insurance contracts used to fund the plan; other violations involve the terms of the plan itself. Whatever the basis for the technical violations, the IRS is referring to these as “merely noncompliant” plans.
The distinction between abusive and merely noncompliant cases is critical because the IRS requires that abusive plans be disqualified and all contributions taken into income, resulting in taxes, interest, and significant penalties for the plan sponsor. For merely noncompliant plans, the IRS will permit a form of retroactive correction, discussed later in this article.
Unfortunately, neither abusive nor merely noncompliant is well defined. This makes it difficult to resolve cases because the IRS generally seems to be unwilling to negotiate an arrangement that would preserve the existence of an abusive plan; thus, the plan sponsor that wishes to preserve the plan (and at least some of its tax deductions for earlier years) must consult with knowledgeable and experienced actuaries and counsel. In a presentation given at a conference last fall, the IRS identified the following as factors reflecting an abusive plan (any one of which would be sufficient, though in our experience, they are often found in combination):
- Policies with “springing cash values,” high surrender charges, and exchange rights for policies with higher values;
- Manipulation of coverage by “firing” employees or using multiple entities;
- Discrimination in favor of highly compensated employees;
Purchasing insurance with a death benefit exceeding the “incidental limit” by $100,000 or more (the simplest way to determine the incidental limit for a death benefit is for the benefit to be not more than 100 times the projected monthly benefit, though other more complicated calculations can be used).
As to the last point, in Revenue Ruling 2004-20, the IRS ruled that a policy with “excess” death benefits of $100,000 or more was a “listed transaction” if the plan sponsor took a tax deduction for the policy premium. [IRB 2004-10] A listed transaction is one the IRS believes may not comply with requirements of the Internal Revenue Code and should be given special scrutiny. A taxpayer that engages in such a transaction is required to file Form 8886 with its tax return, alerting the IRS. In most cases, this will trigger an audit of the return. The failure to self-report such a transaction results in a $100,000 penalty in the case of an individual taxpayer and a $200,000 penalty in the case of a corporate taxpayer; thus, plan sponsors whose 412(i) plans purchased excess death benefit policies and failed to file the required notice will face an additional, serious problem. A possible solution for this problem is discussed later in this article.
Resolution for Merely Noncompliant Plans
The IRS is offering two alternatives to plan sponsors with merely noncompliant plans. The first is for the plan sponsor to unwind the plan: Essentially, treat the plan as though it never existed, take into income all contributions to the plan, and pay taxes, interest, and penalties on the full amount of the contributions. At the end of the day, the plan sponsor will have no pension plan. This is generally the same treatment accorded abusive plans.
The other alternative – probably the more attractive alternative in most cases – would be to convert the plan to a traditional, non-412(i) defined benefit pension plan. In the traditional pension plan, the annual funding is calculated by an actuary using various assumptions about age at retirement, life expectancy, projected earnings on plan assets, and the like. The amount is certified on Schedule B of Form 5500. A 412(i) plan is, in contrast, funded by paying the premiums on insurance contracts (life, annuity, or a combination of both).
The parameters of a conversion from a 412(i) plan to a traditional defined benefit pension plan are:
The plan sponsor will need to have an actuary prepare a spreadsheet showing what the funding would have been under the general rules for funding pension plans. For 412(i) plans that convert, the IRS will not require the plan sponsor to go back and file Schedule Bs for all prior years. Instead, it will require a Schedule B only for the current year and any future years that the plan remains in existence. This is a significant benefit, because it will save the cost of going back and preparing the Schedule Bs and late filing penalties for failing to have filed them in earlier years.
In preparing the funding calculations, there were indications that it would be permissible to change the benefit formula and other terms of the plans, so long as this did not result in a reduction of benefits to any participant. This would have been beneficial because many 412(i) plans were not funded at the maximum benefit that could be provided by a pension plan. In many cases, a change in formula would likely have resulted in the preservation of a significant portion of the contributions to the plan. Recently however, the IRS clarified its position on this point. Ms. Karen Justesen, supervisor of field actuaries at the IRS, advises that if a plan sponsor wishes to convert an existing 412(i) plan retroactively to a standard defined benefit pension plan (a non-412(i) plan). the sponsor may not amend the document to change the benefit formula or other plan provisions that affect the funding.
Example. The plan provides for a retirement benefit equal to 35% of final average pay and a normal retirement age of 65. In converting to a non-412(i) plan, the plan could not be amended retroactively to provide for a benefit equal to 100% of final average pay or a lower retirement age, such as 62. On the other hand, because the plan was not funded using actuarial assumptions, the plan actuary is free to adopt reasonable assumptions in determining the contributions for prior years (based on the plan terms in effect for those years), including potentially a retirement age younger than the normal retirement age.
Calculation of the contributions in connection with a conversion may be the most critical issue to be resolved in an audit and will require a combination of actuarial skill and creativity together with legal input to maximize this opportunity while avoiding a variety of pitfalls that might arise.
To the extent the funding amounts, as calculated by the actuary and accepted by the IRS, result in lower funding for any of the open tax years, the plan sponsor will be required to take the difference into income and pay the income tax, interest, and penalties. The penalty will equal 25% of the tax amount. In addition, because those amounts are nondeductible contributions to a pension plan, the plan sponsor will also be required to pay the 10% excise tax on those nondeductible amounts.
The IRS will not require the plan sponsor to take a distribution or purchase large life insurance policies out of the plan as part of the conversion; however, the insurance policies used to fund the 412(i) plan may create problems in the future because of the high premium charges on some of those contracts which may require partially nondeductible contributions in the future (requiring the plan sponsor to pay an annual 10% excise tax on the nondeductible amounts). In addition, to the extent a large death benefit is payable to the plan, and the participant dies, the plan may wind up with a significant overfunding, possibly resulting in a reversion subject to confiscatory income and excise taxes. For these reasons and others, many plan sponsors may wish to negotiate with the insurance carrier to convert the policies into lower death benefit, lower cost policies.
IRS acceptance of this arrangement will be documented in a closing agreement between the IRS and the plan sponsor. As a part of the closing agreement, the plan sponsor will be required to correct any other qualification failures in the plan and will also be required to pay a sanction in an amount to be determined, based on the facts and circumstances of the case. Unfortunately, a range of sanction amounts cannot be provided; this will be a matter of negotiation with the IRS. The IRS is not intending to impose draconian sanctions on merely noncompliant plans; however, negotiation of the sanction should be handled by experienced practitioners.
A conversion might be possible on a case the IRS would otherwise view as abusive (and not merely noncompliant) if the plan as restructured would be beneficial to rank and file employees. This would doubtless involve extensive negotiations with the IRS to achieve; however, Ms. Justesen also indicated that an abusive (versus a merely noncompliant) 412(i) plan might not be retroactively converted if it contains any other qualification failures. Even though a merely noncompliant plan may retroactively correct such failures, the only option available for an abusive plan is to unwind it and pay applicable taxes, interest, and penalties.
For those 412(i) plans that are treated as listed transactions under Revenue Ruling 2004-20, if the plan sponsor failed to file the Form 8886, reporting that the plan sponsor had engaged in a listed transaction, the IRS will not waive the failure to file penalty at the audit level. A resolution of all but this issue could be worked out (under the parameters outlined above), then an appeal filed with the IRS Appeals Office with respect to the penalty issue. Although the Appeals Office also cannot waive the penalty, a significant abatement of the amount of the penalty could be achieved through negotiation.
The conversion option may not seem especially attractive at first glance, but in most cases may prove to be beneficial for merely noncompliant plans under audit.