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By: John J. Koresko, V, Attorney/CPA

Among the hottest issues in the life insurance industry is whether any of the welfare benefit plans being marketed in the U.S. today, also known as "419 Plans," qualify for favorable tax treatment under 419A(f)(6) of the Internal Revenue Code. These welfare benefit plans, which are often structured as either nondiscriminatory VEBAs [trusts qualified under 501(c)(9) and 505 as exempt organizations] or taxable trusts, generally offer life insurance and/or severance benefits to participants. The plans are intended for use by many unrelated employers, and are thus referred to as multiple employer plans. The plans purport to fit within an exception to severe deduction limitations contained in sections 419 and 419A of the Internal Revenue Code, enacted by Congress in the Tax Reform Act of 1984. If the exception applies, employers can apparently take large deductions, sometimes hundreds of thousands of dollars annually, in the manner available to taxpayers in years prior to the 1984 Act. Aside from pre-funding benefit costs and the inherent opportunities for tax minimization, the plans offer employers the ability to deduct the cost of permanent life insurance for employees with nominal current tax consequence to those employees, free of the restrictions of 79. If properly structured, these plans offer the ultimate in tax advantages: current deductions and a source of family wealth which is income tax free (101(a)) and estate tax free.

This hot issue has prompted concern at the Internal Revenue Service. Practitioners in the welfare benefit area have been inundated recently with inquiries by clients and colleagues about IRS Notice 95-34, 1995 - 23 IRB. Issued on May 19, 1995, the Notice has certainly attracted the attention of many in the insurance industry. The Notice is going to be problematic for many sponsors of welfare benefit programs which purport to fit within the 419A(f)(6) exception. However, a few plan sponsors can take pride that their assumptions in the design of multiple employer welfare plans apparently conform to the structure espoused by the Service.

Anyone's happiness about the clarifying effect of the Notice must, of course, be tempered by the realization that IRS is engaging in another propaganda campaign. The Notice will make uninformed people feel discomfort about welfare benefit trusts and VEBAs. I compare this to revelations disclosed in General Counsel Memorandum 39440, issued in 1985, in which the Service confessed that it had to contrive limitations on the use of life insurance in VEBAs because "there were no effective deduction limitations in the law." Prior to the Tax Reform Act of 1984, the IRS created its own legal standards without any support in the Internal Revenue Code when it implemented a policy of refusing to recognize VEBAs funded with non-79 permanent insurance. Suddenly, after Congress apparently put the straightjacket around VEBAs in the 1984 legislation, IRS coincidentally begged the public's pardon and withdrew its objection to permanent insurance.

The ban on permanent insurance improperly invented by the IRS was not the only example of a super-legislative policy gone wrong. In 1980, the Service issued a series of Regulations under 501(c)(9) dealing with VEBAs. In these regulations, IRS created a number of concepts found nowhere in the statute. One of these, the so-called geographic locale requirement was voided by the Seventh Circuit Court of Appeals in Water Quality Association v.United States, 795 F. 2nd 1303 (7th Cir. 1986). The IRS had required VEBAs to operate in limited geographic areas. The Circuit Court, however, said Congress expressed no such intention. The remainder of the VEBA regulations contain a number of similarly questionable requirements.

The current display of propaganda continues the pattern of inaccurate public statements in the welfare benefit arena, highlighted by a statement issued last year by the Dallas Key District about so-called illegal VEBAs. Professionals in the field know there is no such thing. The illegality discussed by IRS in its newsletter was merely noncompliance with 501(c)(9), but 419 contemplates non-VEBA welfare benefit plans which do not comply with 501(c)(9). Is this illegal? In another newsletter issued by the Baltimore Key District last summer, the IRS said that VEBAs may be either exempt arrangements [501(c)(9)] or taxable plans. The Prime Financial Benefit Multiple Employer Welfare Plan and Trust (Prime), a 419 Plan which has received much audit attention, would have apparently qualified as an "illegal VEBA," yet IRS offered taxpayers deductions of 40% in the year of contribution and 60% upon distribution. Does IRS make settlements with illegal operators? I doubt it. And even if a welfare benefit plan is recharacterized as a plan of deferred compensation, is this illegal? Has anyone heard of Code 404 or Treas. Reg. 1.162-10(a), the sections which would otherwise apply to allow the deductions?

Propaganda is only effective if the intended recipients are vulnerable and uninformed. Clearly, the insurance industry feels vulnerable. Many persons suffer from memories of 1980s-style tax shelters and the angry clients many deals produced. Recent adverse decisions against insurance companies, agents and public accounting firms contribute to more sensitivity. Misinformation is also rampant. There are far too many marketers purporting to be "419 Plan" experts who know enough about the welfare plan area to be dangerous and nothing more. The author's own concern about litigation prevents a recitation of names. The IRS has refused to issue regulations or even a private letter ruling concerning 419A(f)(6). Of course, with close inspection one will see that even the Service is changing its views regarding the proper analysis under 419A(f)(6).

Notice 95-34 contains nothing new. It says that the IRS believes there are at least four issues involved in the analysis of multiple employer welfare benefit programs, whether they are VEBAs or taxable arrangements. The issues are: deferred compensation, experience rating, single plan, and prepaid expense. The first three of these issues were raised in the Revenue Agent's Report, Form 886-A, written in connection with the 10 pending Tax Court cases involving the Prime Financial Benefit Multiple Employer Welfare Plan and Trust (see U.S. Tax Court Docket No. 94-7109). The prepaid expense argument is something which has been tried before and discredited. Surprisingly, the Notice said nothing about welfare benefits lacking substantial risk of forfeiture, as this was raised early in the Prime cases. Competent draftsmen have known or anticipated these issues for over three years. A short discussion of each issue follows.

I. Deferred Compensation. It is not surprising that IRS says that the welfare plans may have elements of deferred compensation. This is the argument raised in Wellons v. Commissioner, 31 F. 3rd.569 (7th Cir. 1994) which was decided last summer. The Service's reliance on Wellons is misplaced outside of a relatively narrow area. Wellons involved a severance pay plan which was self-funded. It did not contain a death benefit. The Wellons plan did not exclude retirement from the definition of severance and permitted highly compensated employees to effectuate severance for themselves at their discretion. Relying on the Federal Circuit Court decision of Lima Surgical Associates v. U.S. 994 F. 2d. 885 (Fed. Cir. 1991), the Seventh Circuit agreed with the IRS that the plan displayed sufficient elements of deferred compensation to cause the deductions to be governed by 404. It should be clear that the elements in the Wellons plan are not present in a death benefit plan, or a plan which limits severance to non-key employees and excludes retirement from the definition of severance. Although Wellons was decided correctly, the case is of questionable authority beyond its facts. It appears that the narrow holding of Wellons does not impact VEBAs and other welfare plans which appropriately limit benefits.

There is something else which is often overlooked when one attempts to analyze a purported welfare benefit plan for the existence of a scheme of deferred compensation. The broad holding of Wellons is that a plan sponsor's nomenclature for a benefit does not control. That is, a court is free to find a plan of deferred compensation regardless of whether it is called welfare benefit by a particular plan. Such potential for recharacterization mandates attention to procedures which minimize such risks. Among the procedures is compliance with the VEBA regulations in the design of a plan. Another is use of common sense.

When a VEBA receives a determination letter from IRS, the letter is evidence that the Service has looked at the benefits and that they comply with the regulations. Treas. Reg. 1.501(c)(9)-3(e) says that a VEBA cannot contain a benefit similar to a pension, profit-sharing, annuity or stock bonus plan. In essence, once IRS issues a letter, they will be hard pressed to make the deferred compensation argument if the plan is operated in accordance with its terms. We submitted our VEBA trusts with variable life contracts and the Service still issued favorable determination letters, so we know that using permanent insurance is not sufficient, in and of itself, to cause recharacterization. In Wellons, the taxpayer did not obtain a VEBA determination from the Service. Accordingly, IRS was not estopped from raising the deferred compensation argument.

The Wellons and Lima Surgical cases teach us that a voluntary severance plan is tantamount to deferred compensation. The event causing payment of the benefit is controllable by an individual, and the courts say that the hallmark of welfare benefits is lack of control. For example, no one argues that death and disability are beyond one's control. In response, some 419 Plan operators have devised schemes to try and fit highly-compensated persons into involuntary severance plans in the hope that Wellons and Lima will not apply. They claim that restrictive employment contracts do the trick. For example, let's say that a doctor has a contract with his professional corporation to work full time. Then, at a convenient time, the professional corporation unilaterally reduces the doctor's hours. The employment contract would be "breached" or working rules "changed" resulting in an alleged involuntary severance. The practical question is this: who makes it happen? If the doctor has a hand in the decision, directly or indirectly, is not the "involuntary" event really "voluntary?" Anytime one must try to jam a square peg into a round hole to accomplish a result, an objective re-examination is in order.

In Notice 95-34, the Service failed to expound upon a better strategy in support of the deferred compensation attack, although it appeared in GCM 39300 (10/30/84) and 39818 (5/10/90). It was also mentioned in the Prime Form 886-A. Basically, if there is a substantial likelihood of plan termination, the plan can be recharacterized as deferred compensation. With virtually every non-VEBA in the United States, there is a substantial likelihood of termination. Section 4976 provides a 100% excise tax on any welfare benefit plan which does not comply with 505 nondiscrimination rules, to the extent of assets attributable to post-retirement life benefits for highly compensated employees. A plan like a VEBA, which complies with 505, need not be concerned about the excise tax. It can provide post-retirement benefits, and it can theoretically last forever. There is a justification for long-term accumulation of cash values in permanent life insurance policies. A non-VEBA 419 plan must terminate pre-retirement or face the excise tax. If all insurance obligations have been funded years before, as in a situation where premiums are set to vanish after ten years, what arguments conceivably exist for the accumulation of cash values?

Recognition of this risk has led certain 419 Plan operators to require key employees to work right up to the date of death. Consider this scene: a 99 year old doctor being pushed around his office in a wheelchair, where he is incapable of practicing, to sustain the charade that he has not retired so as to avoid the 4976 excise tax. What has this person been living on? Probably, retirement plan money distributed because he has met the definition of retirement under that plan. Can anyone seriously believe that IRS will not overlook the form of this arrangement in favor of substance?

The statute is not clear with respect to calculation of the 4976 excise tax. It appears that the tax will be assessed on the basis of total contributions, less PS 58 costs attributable to pre-retirement years; approximately 100% of the cash value at age 65. The excise tax is assessed on the employer, not the plan. Because most welfare plans do not permit a reversion of assets to the employer, there would appear to be no source for payment of the excise tax. The potential horror story does not end there, however. The business owner will probably terminate the plan once IRS attacks it. This termination will result in income taxation upon the recipients under 83. Double taxation is, therefore, quite probable. Sponsors of non-VEBA 419 plans conveniently omit a discussion of this risk, and the Service will, at some point, awaken to its utility.

II. Experience Rating. The Form 886-A issued in the Prime cases showed that the Service was relying on Black's Law Dictionary for support of its definition of experience rating. Unfortunately, this disregards the Supreme Court's decision in American Bar Endowment, 477 U.S. 105 (1986), as well as the definition of experience rating supplied by Congress in the legislative history to 419.

Section 419A(f)(6) proscribes employer experience rating. The Service has taken a position that employee-by-employee experience rating is the same as employer experience rating. This argument fails because it ignores the statute. Also, it does not apply to a VEBA because the regulations proscribe any reversion to an employer once a contribution is made.

Absent other flaws described herein, many welfare plans are not experience-rated because the contributions are not determined on the basis of employer experience. Contributions are determined by reference to the cost of life insurance policies, and these are based on general actuarial tables. See American Bar Endowment.

Congress said that pure experience rating means (1) a rebate is automatically payable to an employer if the trust's claims experience is favorable, and (2) the employer has an automatic liability if the claims experience is unfavorable. Congress said it is an "AND" test, not an "OR" test. A properly designed VEBA program does not maintain experience rating because there is no possibility of reversion to an employer, regardless of claims experience. Secondly, the trust should have no legal ability to compel a contribution in the event of unfavorable experience. Finally, the trustee should have no ability to unilaterally decrease the amount of a promised benefit. In the opinion of the Service, this latter attribute was a damning characteristic of the Prime trust.

IRS Notice 95-34 injects a new element into the experience rating argument. This new argument reflects an apparent change from the weak position originally articulated in the Prime cases. It implies that compliance with the "single plan" requirement will also satisfy the inquiry regarding experience rating. If the contributions of another employer are available for the payment of benefits to an employer's employees, the employer's liability cannot be deemed experience rated because the liability is not limited to the experience of that employer group. This new articulation of the test for experience rating seems much more logical and closer to the ideas expressed by Congress in the Committee Reports accompanying the Tax Reform Act of 1984. This author and others have been saying this for years, and a properly drafted VEBA trust would satisfy this test. All assets of the trust must be at least theoretically available for all claims of all employees of all participating employers.

III. Single Plan. Notice 95-34 says that advisors should be careful that the ten-or-more-employer plan ("TOME") is, in fact, a single plan, and not a collection of individual plans using a common document. Many persons ignored this in the drafting of their 419 plans, reasoning that the single plan rules in Treas. Reg. 1.414(l)-1(b)(1) applied only to pension plans. Practitioners should be happy that IRS has announced this position.

In GCM 39284 (Sept. 14, 1984), IRS stated that in the context of a multiple employer VEBA, rules similar to those in 413(c) should apply. Section 413 instructs us as to the requirements of a "more than one employer pension plan." The Section commands that such a plan be a "single plan" and directs us to 414 for guidance. Reg. 1.414(l)-1(b)(1) says that a plan may have many employers contributing, allocated insurance contracts, separate accounting, and differing benefit structures among participating employers, yet still qualify as a single plan. There is, however, one axiom: all assets must be available for all claims. If any part of the trust is not available for the payment of any claim, the plan is not a single plan. If it is not a single plan, it is not a TOME. And if the plan is not a TOME, the limits of 419 and 419A apply.

Many purveyors of so-called 419 Plans have taken the intellectually dishonest position that since there is no definition of single plan in the welfare benefit sections of the Code, and a welfare plan is not a pension plan, they need not comply with Reg. 1.414(l)-1(b)(1). They do not make all assets available for all claims. Those 419 Plan operators who have taken the time to read GCM 39284 (9/14/84) argue that taxable 419 Plans need not be concerned because the GCM was written about VEBAs. It appears from Notice 95-34 that they are going to be in trouble. Moreover, the IRS Baltimore Key District in its Summer 1994 newsletter said that it considered VEBAs and other 419 Plans essentially the same animal. In fact, the Service wrote:

"A VEBA may be funded through an exempt or nonexempt trust. It is not unusual to find a taxable VEBA trust when the income from the trust's investments is nontaxable by definition. Insurance contracts . . . were cited as examples [of nontaxable investments used to fund such trusts]."

This and other public statements indicate that VEBA law will be persuasive and probably controlling in analyzing all 419 Plans, whether or not they seek the safe harbor of a 501(c)(9) and 505 determination.

The single plan test comports with the vision of the 419A(f)(6) exemption which Congress articulated in the Committee Reports accompanying the Tax Reform Act of 1984. Congress said that the exemption would be available for plans which made the relationship between contributing employers and the plan similar to that between an insured and an insurance company. Although the statute does not mandate that the plan be identical to an insurance company, the arrangement must exhibit attributes of an insurance relationship. One of the principal attributes is sharing of risk. See, General Counsel Memorandum 39817 for a discussion of the attributes of an insurance arrangement.

The easiest way to visualize a welfare plan which qualifies under 419A(f)(6) is to think about the way an actual insurance company operates. Each policy holder gets a statement or ledger which details cash values and other attributes of the policy. Does this statement mean that there is a little vault at the insurance company in which this money sits, unavailable for any other purpose? Of course not. All the assets of the insurance company are theoretically available for any claim. In fact, this is precisely what occurs when insurance carriers become insolvent. The assets hypothetically earmarked for satisfaction of various policies have been used for the payment of other claims, and the carrier is no longer able to fulfill its promises on the remaining, unpaid policies.

If the Service is correct in its assertion of the single plan test, many persons who have participated in implementing 419 Plans will face an interesting dilemma. They will be forced to tell their clients that assets placed in the welfare plan cannot be restricted to benefit only the employees of the client. The client must be told that its contributions may be used to satisfy benefit claims of employees of other employers in the plan. This will be especially troublesome if the agent in the case previously represented otherwise to the client in order to procure the client's adoption of the plan and purchase of insurance.

There are, however, plans in the marketplace which meet the requirement that all assets be available for all claims. Approximately three years ago, this author invented a unique set of features for a VEBA designed to minimize, but not eliminate, the risk of cross-invasion of the assets related to different employers' contributions. The regulations contemplate a theoretical risk sharing, but do not prohibit mechanisms to minimize such risks, like those employed by insurance companies before they pay claims.

IV. Prepaid Expense. This issue has been raised by the Service in both the Schneider, 63 TCM 1787 (1992) and Moser, 56 TCM 1504 (1989). On both occasions, the Tax Court rejected the IRS arguments.

In Moser, the Court approved full funding of a severance benefit in the first year of the plan. In holding for the taxpayer, the Tax Court affirmed that there is no actuarial funding requirement in the context VEBAs outside of the specific provisions of sections 419 and 419A. If these sections do not apply, the Court had no power to write them into the law. The Court said that the appropriate inquiry was whether the employer could get back money paid into the plan. If there is no possibility of reversion, there is no prepaid expense because there is no asset of the employer created by the expenditure. The Tax Court also said that it is ordinary and necessary to prefund expenses because of the possibility of future economic reversals which could impair funding.

The Schneider case confirmed the holding in Moser. Dr. Schneider successfully deducted over $1.1 million of VEBA contributions over a three year period. In fact, the IRS was so outraged at the decision, they chased Dr. Schneider to Dr. Wellons' firm. The first page of the Wellons Tax Court decision shows that Schneider was an employee of the Wellons professional corporation.

It is quite surprising that the Service decided to raise this weak issue in Notice 95-34, in light of their unfavorable experience. It was not raised in the Prime litigation. Frankly, it appears to have been a "throw in" to enhance the propaganda value of Notice 95-34.

* * * * *

Sources in Washington indicate that 419A(f)(6) continues to be a no-ruling area for the Service. This is understandable, in light of pending Tax Court litigation in the Prime cases. It seems unfair, however, for the IRS to attempt to influence public behavior by using newsletters and Notices which have no real force of law and questionable legal underpinnings. In 1986, Congress disapproved of the first set of proposed regulations and enacted amendments to 419 to correct the error of the IRS views regarding experience rating. We have been waiting for final regulations under 419 and 419A since then. Did the government really think that people would not seek to use the 419A(f)(6) exception pending issuance of regulations?

The true meaning of IRS Notice 95-34 is that everyone is entitled to an opinion regarding the 419A(f)(6) exception, but the government is not quite sure all its opinions will pass muster. Even when its arguments are not good, the IRS still weilds a mighty sword -- threat of audit. In many cases this is more effective than a credible legal position in dissuading taxpayers from exercising their rights under the law. Experience teaches us, however, that taxpayers who can afford plan contributions of $50,000 or $100,000 per year tend to be entrepreneurial by nature and tolerant of certain types of identifiable and controllable risks.

We are not very upset that the Service has publicly stated the salient issues because some people will now understand the difference between hyperbole and reality in connection with analyzing welfare benefit plans. Agents and advisors in the field must remember a simple rule. Proper structure is critical, and there is no free lunch. Consult an expert if you are unsure of how to spot a problem in the plan documents. The author is a shareholder in the suburban Philadelphia law firm of Koresko & Associates, counsel to Penn-Mont Benefit Services, Inc., and draftsman of the REAL VEBA multiple employer welfare benefit program. He has been published in several professional periodicals, lectures extensively, and consults with life insurance companies and agents throughout the United States on multiple employer welfare benefit plans and other advanced taxation and estate planning issues.

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