419 - Welfare Benefits Plans

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419 Welfare Benefits Plans Reborn - New Regs Clarify Existing Law
By:  Paul M. League, QFP, CFP^® - October 2003

(Click here to review a critical update since this article was written: 1/2004 to present - the move to Single Employer Welfare Benefits Plans - Section 419 / 419A)

 

(Click here for a discussion / comparison between VEBAs and Section 419/419A plans)

 

Article:

 

419 Plans, "arrangements" in government speak, are best known by employers for both the tax deductions and the benefits they provide. The key benefits of 419 Plans are most often the death and severance benefits to business owners and their valued employees. 

 

The central advantage to business owners is the ability to use business entity resources (on a tax deductible basis) to provide post-retirement resources back to the individual (owner) at more favorable, reduced tax bracket levels.

 

Over the years, 419 Plan design abuses that resulted in benefits based solely upon death benefits, caused the government to recently issue these new regulations that, in reality, now merely provide clarifications to already existing law.

 

At long last, the new regulations define a "welfare benefit" as a benefit resulting from illness, personal injury, death of the employee, and involuntary termination of employment (severance). As was the case prior to these new regulations, there remains no regulation over the investments of a welfare-benefit fund. The new regulations do not rule on any kind of non-discrimination or participation requirements, though input is expected in the near future.

 

Historically, 419 Plans have used a number of funding vehicles to provide the benefits for which they are designed. But, for the most part, we typically find a combination of term or cash value life insurance (whole life, interest sensitive UL, or even variable or equity investment based VUL) as the central, if not the only, funding vehicle within such plans.

 

New regulations, issued by the Treasury and IRS, clarify the government’s concerns over how such arrangements use various forms of experience rating, especially, though not only, as it relates to death benefit only insurance funded plans (i.e. experience ratings such as employer reductions in policy premiums by reallocations of plan assets on terminating employees; reductions to benefits based on investment results; etc.).

 

The government now clarifies the requirement that an employer's interest be more like that of an individual to an indistinct group, rather than that of an individual employer to its' own asset. The reason is to best ensure that the employer and the plan are exempt from the deduction limits of Sections 419 and 419A, and by being so they meet the self-regulating 419A(f)(6) Safe-Harbor rules. In the words of the IRS and Treasury, "these regulations generally clarify existing law", and are applicable to Plans to which contributions have been paid or are "incurred" beginning July 17, 2003 [the Final Regulations actual effective date: §1.419A(f)(6)-1(g)], making it also clear that Plans in place prior to this final effective date need immediate re-examination. The new Regs do not prevent transferring from a non-compliant Plan to a compliant one.

 

The prohibition against individual employer experience rating forces the question, “Would you, Mr. Employer, pay your hard-earned dollars into a program in which the contributions and benefits are not solely for your benefit, but are based on the experience of all other plan employers (i.e. a specific employers asset Vs an indistinct group)?”  Experience rating can co-exist within 419A(f)(6) plans as long as it is global, meaning that it is applied to the whole plan (all employers), and not to any one plan employer.

 

The new regs require that 419A(f)(6) arrangements, which are designed to overcome the deduction limits, prove adherence to the new "experience rating regs," not only through objective mathematical calculations and plan documents, but also right down to marketing materials! Of course, the plan must be maintained with a written document, which also requires the plan administrator to maintain records for the IRS and any plan employer, and that these be made readily available for inspection and/or copying by these parties.

 

Given all that we have discussed above, it appears that one would be on more solid footing as long as a 419A(f)(6) arrangement also consists of the following:

 

• A 419A(f)(6) "arrangement" must consist of 10 or more separately distinct employers, with no employer contributing more than 10% of the total contributions, and must be non-experience rated.
• Benefits are based upon non-discriminatory multiples of compensation.
• The plan must provide for fixed benefits, a fixed-coverage period, and at a non-excessive fixed price charged by the plan.
• No separate accounting by the participating employer.
• The experience rating must be plan-wide, not specific to any one employer (this includes such experience items as claims, investment returns, funding expenses, etc.).
• Plan-wide separate accounting at plan termination and/or employer withdrawal.
• When using life insurance as a funding vehicle, it must be subject to plan rules regarding cost of benefits, no separate accounting, and where costs must be based on current age and not age at date of policy issue.
• Death benefits are not determined by the amount of cash values in an employer's group (i.e. the prohibition against segregating of assets by employer).
• Employee death benefits are paid to a named beneficiary, never the employer.
• Severance benefits are based on a uniform formula for all employees, with an independent actuarial certification that the formula is reasonable, and that they are only available for involuntary termination of employment, not death, illness, or retirement (i.e. a welfare benefit based upon uncertainty, not the certainty of deferred compensation.)
• All assets of the plan are commingled indistinctly over the entire plan.
• Upon employer termination from the plan, vested benefits are distributed uniformly, and are not based upon the benefits or experience of any one employer. 

 

In conclusion, a 419A(f)(6) plan must not run afoul of the “suspect characteristics” contained in the “examples” found in the Proposed Regulations of 2002, that were only slightly modified in the New Regulations; namely: there is no allocation of assets to a specific employer; benefit costs can not vary by employer; fixed benefit, coverage and price; there are no excessive charges for covered risks; the only benefits are illness, injury, death or involuntary termination, and the special rules regarding life insurance which require that cash values must be treated as values of the plan, and not any single employer.  They must also meet the form and substance of these clarifying regulations, which is another way of saying that, in practice, the plan must be able to demonstrate that it is not simply a scheme for tax deferral without the purpose of providing actual employee welfare benefits. The government will not allow for plans that do not provide such benefits and that are really just disguised nonqualified deferred compensation or constructive dividend schemes.

 

We trust that the above clarifies many of the questions and concerns surrounding 419 Plans. Clearly, compliantly designed and properly administered 419 plans, can still deliver significant advantages to business owners and their employees. Large tax deductions, tax deferral, and meaningful pre & post-plan benefits continue to compel employers to consider establishing such plans as terrific ways to augment other benefit plans, such as traditional pension plans (defined benefit, 412(i), 401(k), new comparability profit sharing plans, etc.), as well as many other employee benefit plans.

 

We provide solutions, that comply in both form & substance, to help you, and your professional advisors, meet the challenges posed in these & other government Regulations.

 

Disclaimer Notes: The material discussed is meant for general illustration or informational purposes only and is not to be construed as investment or tax advice. Although the information has been gathered from sources believed to be reliable (relevant and referenced IRC Code Sections, IRS publications and materials), it is not guaranteed. Please note that individual situations can vary. Therefore, the information should be relied upon only when coordinated with individual professional advice. We do not provide tax or legal advice (10/03)]. ©Paul M. League/LFIS. All Rights Reserved (0011050400).

 

Author: Paul M. League, QFP, CFP® is the principal of League Financial & Insurance Services / LeagueFinancial.com, and Co-Founder of the INTERNATIONAL ASSOCIATION of QUALIFIED FINANCIAL PLANNERS (www.IAQFP.org). Paul has specialized in assisting clients to create, preserve and expand assets through individual and group benefit programs for over 25 years. He can be reached at 332 S. Beverly Drive, Suite #101, Beverly Hills, CA 90212, phone (310) 277-3141; www.LeagueFinancial.com; E-mail: Paul@LeagueFinancial.com.                                                   

 

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CRITICAL UPDATE (1/1/2005 Retro to 1/1/2004):

 

In brief...due to recent positions of the Treasury it now can impose a $200,000 penalty for entities involved in certain "listed transactions" and other reportable transactions.  The IRS has currently identified 30 transactions that it considers "listed transactions".  Arrangements similar to any of the listed transactions are also subject to the "failure to disclose" penalty - and this is true even if, upon audit, the IRS deems the transaction to be valid and upholds the deduction!

Unfortunately, Congress has given the IRS the ability to accuse a taxpayer of failure to disclose a listed transaction, or one substantially similar, and to assess the new penalty - and makes it very difficult and costly for the taxpayer to argue against the IRS.

Why are we concerned if the plans we recommended prior to 2005 were not listed transactions or substantially similar? Such plans (before being amended post 2004), were multiple employer welfare benefit plans under code section 419A(f)(6), providing welfare benefits.  One of the "listed transactions" is a Notice issued by the IRS in 1995, and identified as a listed transaction in 2000.  The Notice 95-34 describes a multiple employer plan purporting to qualify under code section 419A(f)(6) but with features not allowable, such as separate accounting by employer, overcharging for the benefits, and plans of disguised deferred compensation. Our plans did not have any of the egregious features, and so were not substantially similar.  However, without judicial recourse for taxpayers, and with such stiff penalties available to the IRS, our worry is that the IRS can accuse a taxpayer of failing to disclose what we believe is not a transaction subject to disclosure, and therefore, even without merit, asses the $200,000 penalty; therefore, we now split the single plan into hundreds of individual employer plans (Single Employer Welfare Benefits Plans - Section 419 / 419A) not purporting to qualify for code section 419A(f)(6), and not part of a multiple employer welfare benefit arrangement, and in doing so while we lose some of the deductibility of the benefits, we protect participating employers from an accusation by the IRS that could result in unwarranted yet huge penalties.

The resources we recommend provide cost effective and proper trust administration, and a major Bank serves as the Trustee, so employers are in good hands. We anticipate we can add many new benefits to the plans, including post retirement medical benefits, disability benefits and health savings accounts over the coming months and years.

 

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VEBA Plans vs. Section 419/419A Single Employer Welfare Benefits Plans

 

The typical reason clients suggest they want a VEBA (Voluntary Employee Benefits Arrangements) is that they wrongly perceive that such plans are "IRS Approved", when they are not. Unless a VEBA plan has a PLR (Private Letter Ruling) it is subject to audit to "prove up" its status, and even with a PLR, if the facts on the ground don't match up with the specified parameters of the PLR itself and the basis on which it was formed, then even such an "approved plan" could be challenged and possibly also invalidated.
 
Business owners also mistakenly think that VEBA plans are "income tax free", which is also not the case. As soon as you generate UBTI (Unrelated Business Taxable Income) you are subject to income tax even if your are otherwise exempt. It is for this reason that both 419/419A AND VEBA BOTH USE CASH VALUE LIFE INSURANCE as the typical funding vehicle of choice for the benefits they provide, because properly funded life insurance accumulates its cash value assets income tax free. VEBAs, otherwise funded, would generate taxable income.

 

Further, VEBA plans add nothing that properly structured 419/419A Plans don't also offer. 

 

The problem with VEBAs are that they must comply not only with the provisions of 419/419A, but also with VEBA statutes, thus making their filing and annual admin fees, and ongoing administrative compliance typically much more complicated, because of all of the added compliance requirements they bring.
 
The beauty of properly structured and funded Single Employer Section 419/419A Welfare Benefits Plans is that they are not also required to "qualify" under the heavily burdensome, and unnecessary, VEBA statutes...but they give you everything a VEBA does in practical application.

 

(0507381A-31006)