Abusive and Noncompliant Plans


4.4.1                Abusive and Noncompliant Plans
.1         There are a few things that the practitioner should know about how the IRS conducts audits of IRC §412(i) defined benefit retirement plans.  These defined benefit plans are quite popular, despite extensive regulation by the Service.  They tend to be funded by life insurance, annuities, or a combination thereof, and they often allow participating employers to realize substantial tax deductions, which accounts in large part for their popularity among business owners.
These plans are now technically called “IRC §412(e)(3) plans,” but the majority of practitioners still refer to these plans as “IRC §412(i) plans;” thus, the author refers to them as IRC §412(i) plans here.
.2         In auditing these plans, Service personnel have often discovered discrimination in favor of owners and key, highly compensated employees.  There is also the general feeling that claimed tax relief is disproportionate to the economic realities of the transactions.
.3         Auditors have essentially divided the plans into two categories.
(A)       The first are the plans that are substantially in compliance to varying degrees.  Many auditors were initially surprised to discover that these plans were in compliance, believing initially that all of these plans were tax avoidance schemes of varying levels of sophistication.  That proved not to be the case, as many of these plans are at least in substantial com­pliance with the tax laws.  The Service refers to these plans as merely “noncompliant.”
(B)       The second category would be those plans that the Service regards as “abusive.”  The Service generally demands that these plans be revoked.  This, of course, would entail back taxes, interest, and penalties being assessed against the plan sponsor.  The treatment of noncompliant plans, often featur­ing only technical violations, is considerably less severe.
.4         Neither category is particularly well defined, which makes it unpre­dictable how the Service will proceed in a given situation.  Some factors, however, if present, greatly increase the chances of being regarded as abusive.  These include, but are not limited to, insurance policies/plans with the following:
(A)       Springing cash values
(B)       Manipulation of life insurance coverage by means of ques­tionable “firings” and/or the use of sham, bogus entities, often on a multiple basis
(C)       Discrimination in favor of owners and key, highly compen­sated employees
.5         The taxpayer is in for a special degree of difficulty should the plan in question be regarded as a listed transaction.  A taxpayer, corporate or otherwise, who has engaged in such a transaction must disclose such participation by means of a form attached to the tax return, which many feel is likely to trigger an audit.  If the taxpayer fails to disclose, s/he is almost automatically liable for severe penalties, simply for failing to disclose.  These penalties are not subject to appeal, and the Tax Court lacks the jurisdiction to overturn or even to reduce them.
.6         What alternatives are available to the sponsor of a plan that is merely noncompliant?  There are essentially two of them.
(A)       The first is quite unattractive.  It entails, basically, treating the plan as if it never existed. This, of course, triggers, to the fullest extent possible, back taxes, penalties, and interest on all contributions that were made, not to mention leaving behind no pension plan whatsoever.  This is exactly how abusive plans are treated.  There is a much better alternative, however.
(B)       The alternative is to convert to a traditional defined benefit pension plan.  This is possible because it is permissible to change the benefit formula and other terms, so long as no participant’s benefits are reduced.  However, to the extent that funding amounts are lower under the converted plan, back taxes, interest, and penalties will be triggered.  The penalty will be 25 percent of the tax amount, and a 10-percent excise tax will also be imposed.  Finally, there will be a separate monetary sanction, based on the underlying facts and circumstances.  This is to be negotiated directly with the Service.  An experienced, competent negotiator should be hired for this purpose.

.7         What, if anything, can be done to salvage something when a plan has been deemed abusive? The answer seems to be, not much.  The option of converting to a traditional defined benefit plan is available, and even then probably only after extensive negotiating only if the restructured plan is “beneficial” to rank-and-file employees.  The precise problem, at present, is that the term “beneficial,” in this context, lacks a precise definition.

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