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Journal of Financial Planning - November 2002 "A couple of perp-walks to get the public's attention, strong prosecution with forfeiture of their profits, and jail time might just clean up this ethical morass." Protecting Clients from Life Insurance Schemesby Peter Katt, CFP, LIC The inherent complexities of permanent life insurance's make it a favorite asset for what some financial planners think of as cutting-edge tax planning. Developers, promoters and sellers promise tax-nirvana via permanent life insurance that generally comes in two flavors. One is tax-deductible premiums. The other is the manipulation of a policy's value for either income-tax or estate/gift-tax purposes. Sometimes these two flavors are mixed into one plan. Tax avoidance (or tax evasion, your pick) using permanent life insurance has become so aggressive and widespread that the Internal Revenue Service (IRS) has itself aggressively attacked the issue, with Neonatology v. Commissioner, new 419 proposed regulations and Notice 2002-59 as a partial list. This has separated many financial planners into either believing the IRS is an out-of-control bully striking back because oh-so-smart planning developers keep creating tax breaks using tax code loopholes, or that the IRS is simply trying to uphold the spirit of the law in order to maintain a level playing field for all taxpayers. Aside from having a position on this issue as ordinary taxpaying citizens, financial planners also must confront this issue in their work with clients. Many of you must explain to clients why they shouldn't buy such plans, and that potentially puts you at a competitive disadvantage with financial planners who are promoting them. You may be considering attending a seminar about how to sell such planning, or you already are selling this planning. If that's the case, this column is intended to be an ice-cold bucket of water. No Tax Authority Despite the apparent certainty advanced by developers of such planning, there is no tax authority for any planning that allows income tax deductions for permanent life insurance premiums or for the calculation of a policy's cash value that dramatically increases within several years without reference to future premium payments. The fact that the tax code does not explicitly prohibit an action does not mean it is a loophole to be used until Congress gets around to closing it with explicit language. The IRS applies a substance-over- form tax compliance methodology as well as disallowing transactions whose only purpose is to create a tax benefit. VEBA (voluntary employees' beneficiary association) plans and 419A (f) (6) plans, which are preferred vehicles for disguising tax-evasion schemes, are legitimate only for purposes that provide absolutely no tax advantages for owner/employees who are the targets of such planning. VEBA and 419A (f) (6) plans were enacted by Congress for employers to provide benefits to rank-and-file employees-not to be used to hide tax-evasion by owner/employees. It is impossible to keep up with the onslaught of new versions of old schemes, but we can learn, and perhaps apply, valuable lessons from schemes whose cards have all been turned over with no remaining obfuscations or promises. Front-Row Seat to Deceit I had a front-row seat in the Neonatology v. Commissioner fiasco (www.ustaxcourt.gov/InOpHistoric/NEONATOLOGY.TC.WPD.pdf), having advised several clients after they had purchased their so-called retirement plans and having advised a law firm that filed several individual lawsuits. (See also my September 1999 Journal of Financial Planning column, New Versions of Old Tricks: Springing Cash Values.) New Jersey doctors were promised a specified amount of tax-free retirement income and paid-up life insurance for specified tax-deductible contributions to a VEBA plan. No cautions, no caveats-everything guaranteed. The trick (or fraud) was the attempted disguise of permanent life insurance as term insurance with a conversion right. The overpaid term insurance premiums were fully expensed as a VEBA death-only contribution. These excessive premiums fully funded the cash values that appear only after the policy has been "converted" and is then owned by the doctor personally and therefore no longer within the VEBA plan. Judge Laro ruled there was only one policy with two components and the excessive premiums were not entitled to be expensed. The doctors have had their lives turned inside out from the moment the IRS denied their deductions until Judge Laro's ruling was upheld by the United States Court of Appeals for the Third Circuit in July 2002. They not only were denied their deductions but the excess contributions were deemed constructive dividends, so the doctors were hit with double taxation. In addition, they were assessed interest and accuracy-related negligence penalties. Both courts put heavy blame on the doctors and denied their defense that they merely relied on the advice of professional advisors. Indeed, adding insult to injury, the Court of Appeals pointed out that the only advice the doctors relied on was that of the insurance agents who stood to profit handsomely from commissions on the sale of the retirement plans. The insurance agents have also had their lives significantly affected because, as the last true believers in this scam, they finally stood completely exposed. Their firm broke up and they essentially went into hiding and were unavailable for quite some time. Contrary to the Appeals Court's opinion that the doctors relied only on the claims of the salesmen, the doctors relied on numerous legal opinion letters that appeared to support the retirement plan claims. In fact, these letters were examples of the awful art of sophistry that had a lot of impressive legalese, but did not address the only relevant issue: the trick of pretending to have two separate policies that were merely two components of the same policy. Also, the Medical Society of New Jersey endorsed this retirement plan, which the sellers pointed out at every opportunity, including having it on their letterhead. The doctors didn't know the Society was paid a fee for this endorsement. Finally, the salesmen repeatedly informed the doctors in writing that their plans continued to receive favorable determination letters that were claimed to be prepared by one of the top tax law firms in Chicago. In fact, such determination letters are not relevant when various components of the plan are a scam. Doctors who got into the plan in 1990 and 1991 lost all of their contributions because the insurance company, InterAmerican, was seized by the Illinois Insurance Department as insolvent. The plan's developers, administrators and salesmen still have not acknowledged the true facts of this situation, which is all the more interesting because the developer of this plan also owned InterAmerican. That is, not only have the doctors been subjected to double taxation on excessive contributions but many also have lost some of their contributions because of InterAmerica's insolvency occurred before anyone could have "converted" to gain access to cash values. The individual lawsuits on behalf of the doctors have been dropped because of court rulings that this litigation falls under ERISA (Employee Retirement Income Security Act) jurisdiction. This makes makes individual lawsuits essentially impossible because ERISA litigation doesn't allow punitive damages (which is why this is often the first motion the defendants make in these kinds of cases). The absence of punitive damages makes contingency-fee financing of litigation impossible. I understand that a class action has been filed, which is great for the attorneys but very unlikely to provide the doctors with much relief, and will probably greatly limit the defendants' financial exposures. The fact that ERISA eliminates punitive damages in individual litigation creates something of a moral hazard in that the developers of such schemes may face little financial disincentive to stop rolling them out. Indeed, there seems to be little that will stop these developers of "cutting-edge" tax planning. I recently had a long discussion with a developer of a 419A (f) (6) plan that I was trying to understand for a client, and the developer quoted from the Neonatology v. Commissioner opinion as support for his scheme-a scheme just as dubious the Neonatology retirement plan. Perhaps it's time for the Justice Department to take an interest in the developers of these schemes. A couple of perp-walks to get the public's attention, strong prosecution with forfeiture of their profits, and jail time might just clean up this ethical morass. You may also want to review the sordid history of Lowery R. Young, Jr., et ux. et al. v. Commissioner (T.C. Memo, 1995-379, Tax Ct. Dkt. No. 2861-94), which treated Dr. Young in a similar fashion as the New Jersey doctors for a "leveraged split dollar retirement plan" that promised tax-deductible life insurance premiums. This is a plan that was touted in a July 1993 article of the Journal of the American Society of CLU and ChFC. And despite this leveraged split-dollar plan being refuted by two Northwestern Mutual Life attorneys in a counterpoint article in the November 1993 Journal of the American Society of CLU and ChFC, the original article won the best article of 1993 by a vote of the readership. The promotion of these schemes in life insurance magazines and supposed professional journals is a familiar theme and is disgraceful. Keeping the Neonatology v. Commissioner and Lowery R. Young, Jr., et ux. et al. v. Commissioner rulings handy to show clients who are drawn to the promises of cutting-edge schemes may convince them that prudence is the better course. And I hope attention to these cases and the IRS's improving ability to discover and defeat these schemes will cause financial planners peddling them to stop for the sake of unsuspecting victims and their reputations.
Note: Please see an update to this article in my March 2003 column of Journal of Financial Planning. Reprinted with permission by the Financial Planning Association, Journal of Financial Planning, Volume 15, Issue 11, November 2002.
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