Journal of Financial Planning - March 2004

Like a bad dream, tax schemes trying to use 100 percent funding with permanent life insurance just won't go away. Worse, some "reputable" journals and newsletters are promoting them, and planners and their clients need to be wary.

Tax-Avoidance Life Insurance Schemes Redux

by Peter Katt, CFP, LIC

"Every time I try to get out, they keep bringing me back in," paraphrases a Sopranos character's joking mimic of a mobster's lament about his attempts to go straight. I feel the same way about my frequent comment about the use of life insurance within tax-avoidance schemes. Just when I think the Internal Revenue Service has put slick developers of such things as 419 and 412(i) plans in their boxes and I can move on to positive aspects of life insurance issues, they keep coming back.

Unfortunately, these tax-avoidance schemes will continue because unsavory financial product developers will always turn to permanent life insurance: it is incredibly complicated and has grossly high commissions that are easily hidden from non-expert advisors and clients. I long ago gave up believing that the developers of such schemes have any conscience about the financial carnage they wrought, and I have no illusions about the greedy ignorance of the frontline sellers of these plans. But I am mystified by some supposedly professional and ethical journals and newsletters abetting these shady characters.

The problem is that while most of you don't become involved in selling these tax-avoidance schemes and have little expert knowledge about them, you are asked by clients to comment when they are being pursued to buy one. Your reliance on opinions expressed by some journals and newsletters may be adverse to your clients' interests because they may be either camouflaged endorsements, or they acquiesce in order to get along with colleagues without a complete awareness of the costs of such comity. My concern about this has been heightened because of two occurrences last year.

412(i) Plans Defended

412(i) is a defined benefit plan that uses deferred annuities and life insurance as funding assets. Some promoters claim that 412(i) plans can use life insurance for 100 percent of the funding, though prudence suggests this isn't possible because the excessive amount of life insurance relative to the amount of contribution (premium) gets tangled with the requirement that life insurance must be incidental to the pension plan. The IRS has signaled that some plans using life insurance are abusive tax avoidance schemes, mostly because they use life insurance policy springing-cash-values. I examined a 412(i) plan with springing-cash-values for a client in February 2003.(1) The IRS went so far as to indicate that there may be a criminal element beyond penalties and fines associated with the development and promotion of abusive 412(i) plans.

In the face of this comes an article near the end of 2003 defending 412(i) plans in a professional journal written by two attorneys identified for their academic and professional achievements by the journal. The journal didn't mention that these attorneys are with a law firm listed as legal counsel for the developer of the 412(i) plan I reviewed in the redacted report noted above. This firm also wrote a legal opinion for this plan. The features of this 412(i) plan:

1. One hundred percent life insurance funding
2. It recommends that the policy be purchased from the plan after five years, with the 412(i) plan terminated and cash from the purchase of the life insurance policy rolled into an IRA
3. After the policy has been purchased, illustrated cash-surrender values grow at a compounding annual rate from the sixth through tenth policy years of 39 percent

Springing-cash-values refers to a policy that has artificially low cash-surrender values when measured for tax purposes, such as when purchased from a pension plan, then is illustrated to dramatically increase in value. For example, in the 412(i) plan I reviewed, the insurance company would receive $1,549,845 in premiums over five years (but only cost the participant $929,907 because of the deduction), but the policy's surrender value and advertised purchase price from the pension plan after five years is only $309,787 but then increases to $1,585,014 in the next five years.

The journal article defends 100 percent life insurance funding and what some may consider to be springing-cash-value policies. It argues that because the IRS has used the same example on several occasions for explaining springing cash values, they are stuck with this construct.

Further, it points out that of course there is a difference between the surrender value and the policy reserves in the early policy years because there are policy expenses to amortize. This, the article suggests, legitimizes large increases in cash surrender values, say, from the sixth to tenth policy years.

The article doesn't give any figures, so I obtained a new proposal from the same seller of the 412(i) plan I previously reviewed, and discovered that the prior 39 percent compounding annual return on cash surrender values from the sixth to the tenth policy years was for wimps. It is now 56 percent! Certainly, the journal article has language about springing cash values that is more cautious than depicted in the proposal I obtained. It is also possible that the article's authors don't know how aggressive this 412(i) seller is with its plans, but the damage is done. I bet that most abusive 412(i) sellers have this article in their packet of information to convince prospective buyers and financial advisors that despite the critics, 412(i) plans funded with 100 percent life insurance and using springing cash values are legitimate.

Incidentally, the same journal that ran the article defending 412(i) published an article 11 years ago promoting a specific leveraged split-dollar design that the IRS smashed two years later.(2)

Mutating 419 Plans

Employee welfare benefit plans under Section 419 [mostly 419A(f)(6)] have been a favorite platform to promise Mr./Mrs. or Dr. Big tax-deductible life insurance premiums and often tax-free income benefits, with a few crumbs necessarily falling into the laps of their employees.

Like the flu, 419 plans frequently mutate. (I was asked to review a 419 proposal at the end of 2003 that had mutated from one version in August to another by November.) Contrary to 419 developers' claims that they use tax loopholes that an out-of-control IRS plugs retroactively, these developers' handiwork has been to constantly re-hide tax-avoidance schemes, which the IRS then identifies and smashes—like a long-running game of hide-the-pea, with new shells being added.

All of this resembles the perpetual battle between children (most acute with teenagers) and responsible parents about allowable activities. Responsible parents mean for their children to be safe and pursue activities that develop character, or at least don't create bad habits. Parents inform children of what is expected and often make specific pronouncements as situations warrant. The declaration that John and Janet not ride their bikes on Route 20 doesn't create the loophole to skateboard down Route 20 or mutate into in-line skating when skateboarding has also been prohibited. Mature adults understand the goals and behaviors of responsible parents, and that children will quite naturally push the limits. But elders should not accept children's logic and rationale for, say, believing skateboarding down Route 20 is different from riding bikes.

In what can only be explained by reference to a Daffy Duck scene where Daffy shuts, locks, nails up, and pushes furniture in front of a door to keep out an adversary, only to find this nemesis already standing in the middle of the room as he turns to lean against his fortress, the IRS has promulgated new 419A(f)(6) regulations. My position is that these regulations don't change the IRS' prior interpretations or create new rules in any important way. The new regulations are in place in an attempt to further emphasize that 419 plans can't be used as a tax-avoidance plan for Mr./Mrs. or Dr. Big. You couldn't do it in 1984 and you can't do it now. The item used for the actual tax avoidance in 419 schemes is always permanent life insurance, sometimes dressed up to look like term insurance, as in the Neonatology vs. Commissioner case. Because assets in a 419A(f)(6) trust are exempt from taxation, there is no justification for permanent life insurance in a legitimate 419A(f)(6) plan, and the new regulations don't change this perspective.

Yet this clearly stated position about permanent life insurance in 419A(f)(6) plans is not observed by a popular and respected financial/legal newsletter. The issue devoted to the new 419 regulations was in part a frustratingly dense examination of the dos and don'ts of permanent life insurance under the new regulations, with the editor and contributors essentially reporting that the game is still on. I believe this newsletter is accurate in its commentary about life insurance. And it is accurate to tell a lost balloonist he is 100 feet in the air in a basket—just not very helpful.

If the developers, promoters and sellers of permanent life insurance in 419A(f)(6) plans want to have conferences and publish articles in their own trade press about the wonderful reasons and results of such life insurance sales, please have at it. And if experts want to debate among themselves various interpretations of regulations and case law to convince themselves that permanent life insurance in 419A(f)(6) plans offers wonderful tax planning for wealthy clients, who am I to complain? But I would hope that ethical and professional newsletters, when offering their insights to financial planners who are too busy to track down the fine points of these arguments for themselves, would not split the difference between the interests of clients and sellers of life insurance when there is no demonstrable benefit to clients.

Endnotes

1. This redacted report can be reviewed at www.peterkatt.com under Life Insurance Perspectives, embedded in Vol. 5, No. 2 (March 2003), or use this direct link http://www.peterkatt.com/newsletters/412(i).html.
2. See Tax Court case Young v. Commissioner.
   

Reprinted with permission by the Financial Planning Association, Journal of Financial Planning, Volume 17, Issue 3, March 2004.

Peter Katt, CFP, LIC, sole proprietor of Katt & Co., is a fee-only life insurance adviser located in Kalamazoo, Michigan (269.372.3497).