You have retained my services to review and comment on a 412(i) plan presented to you by Acme Concepts (AC) via their local representative. AC has trademarked its 412(i) plan as the Plan. Generally, 412(i) plans are legitimate defined benefit retirement plans that use life insurance and annuity funding. AC's version is far more aggressive with respect to the amount of contributions they claim are legitimate and the termination of the plan after five years. This report addresses these two issues.

I have reviewed the AC literature including a plan design with life insurance illustration that you provided to me. My knowledge about the Plan has been supplemented from a discussion with Sandy Jones from AC's home office. I have also reviewed legal opinion letters provided to me by Ms. Jones. Attorney1 for Law Firm1 wrote a letter to ABC Life dated December 23, 1997 about certain aspects of the ABC Life life insurance policy being used as the funding asset in Plan and Attorney2 for Law Firm2 wrote a letter to AC dated September 10, 1999 about "general requirements of section 412(i)."

Plan Design

Without going into great detail the Plan has these characteristics:

1. Defined benefit pension plan designed to provide a specified retirement benefit beginning at age 55 with initial contribution levels based on the life insurance policy guarantees. Two variations were presented to you. The one I am commenting on would provide you with an $8,446 monthly benefit from an accumulated value of $1,804,020 at age 55. The initial annual contributions for this design are $309,969. The life insurance policy has a death benefit of $9,122,101.
   
   
2. The literature presented to you for the Plan highlights several times that you can purchase the life insurance policy from the Plan and either amend the plan to a traditionally funded defined benefit plan or terminate it altogether and roll the pension assets into an IRA. You have also informed me that this is what AC's representative emphasized to you as well.
   
   
3. The $9,122,101 of life insurance is about 10 times more than can be paid out to your beneficiaries. If you were to die while the Plan was active death benefits of $844,600 would be paid to your family but the $8,277,501 excess life insurance benefits overfund the Plan and to reach your family would be subject to excise taxes. I understand that your family may net out about 15% of the $8,277,501, or $1,241,625 of the excess death benefits in the event of your passing during the five years it is expected you would be in the Plan.
   
   
4. The reason for such excessive life insurance is because it is needed to accept the $309,969 annual contributions. Any smaller amount of life insurance would cause the policy either to be classified a modified-endowment-contract or fail the life insurance test altogether for this amount of contributions.
   
   
5. The Plan's design with annual contributions of $309,969 is three to four times greater than what would be expected for a conventional 412(i) plan.
   
   
6. The following table summarizes the ABC Life policy illustration provided to you by AC.

Summary of ABC Life Illustration

7. As previously noted, AC representatives have advised you that the key to their Plan is the purchase of the life insurance policy from the Plan after five years. Their claim of allowable contributions three to four times greater than conventional plans allow and the purchase of the life insurance policy after five years are the distinguishing features of their Plan.
   
   
8. The purchase price for the ABC Life policy from the Plan after the fifth year is based on its surrender value of $309,787. AC's proposal shows you having tax-free income of $456,451 for 10 years from ages 65 to 74 by taking loans from the ABC Life policy. Also, this policy has illustrated death benefits that range from the original $9,122,101 to nearly $1,000,000 at age 90. Finally, the $309,696 used to purchase the ABC Life policy after five years either funds an amended defined benefit plan or an IRA. I calculate this $309,787 will be able to provide you with income of $36,500, starting at age 60, which is fully taxable to you as pension income.
   
   
9. In summary, AC states you can make $309,969 tax-deductible contributions for five years totaling $1,549,299, buy the ABC Life policy for $309,787 in five years, have tax-free income totaling $4,564,510 plus lifetime taxable income of about $36,500 from age 60 from the restructured defined benefit plan or IRA and very large life insurance death benefits at your death.
   
   
10. The Plan promises many more benefits than a conventional 412(i) plan. While there are many possible ways of making a comparison between the Plan and a conventional plan the most direct method discloses the Plan has about a $313,000 present value advantage (i.e., $313,000 is the value in today's dollars for tax savings of $409,000 in five years, which are explained below). This is based on the amount of value that will escape taxation under the Plan compared to a conventional set-up.

Conclusion

Before going into detailed comments about the Plan let me state that it is more likely than not that this is an abusive 412(i) plan. The IRS is giving high priority to abusive 412(i) plans and are even going so far as to note there is a criminal side to these abuses beyond eventual tax penalties and fines (from Daily Tax Report of February 3, 2003 as reported by www.leimbergservices.com). All Plan employer sponsors must file Form 5500 so the IRS will be very aware of the funding aspects of the Plan. It is more likely than not that the IRS will not allow the Plan's level of deductions and that the Labor Department will treat the purchase of the life insurance policy as a Prohibited Transaction. If the level of contributions are in violation it is possible, even likely, that the IRS would treat the excess contributions as constructive dividends. This results in double taxation to you because the amount of the denied contributions would be subject to taxation by your corporation and again as income to you as a Plan participant. And if the purchase of the life insurance is a Prohibited Transaction there is a 15% excise tax.

Excessive Contributions

To provide you with a monthly benefit of $8,446 beginning in 16 years at age 55 a fund balance of around $1,840,000 is needed. Under a conventional 412(i) plan this would require annual funding for 16 years of around $92,000 using life insurance as the funding vehicle. Annual funding of $92,000 would require around $7,000,000 of death benefit. Even using a conventional 412(i) plan $7,000,000 grossly overinsures you because as previously noted any death benefits over ten times your monthly benefit ($844,600) will be reduced by 85% in taxes. (A 412(i) participant wanting very large life insurance amounts can buy term insurance outside the plan). The annual contributions to fund the same benefit via an annuity, the other 412(i) funding option, is only around $72,000 a year.

But conventional 412(i) contributions of between $72,000 and $92,000 are a pittance compared with the $309,969 claimed by AC's Plan. How can AC's contributions be so much higher?

1. Grossly overinsuring you because of the exaggerated $309,969 contributions. This huge amount of life insurance causes you to lose a tremendous amount of your contributions to policy acquisition costs, which are commissions and other compensation paid to AC. From a regulatory viewpoint this is legitimate but hardly good for you;
   
   
2. Claiming a very low life insurance value for five years. From the table above summarizing the ABC Life policy you can see that it has zero Account Value in years one and two, $80,548 in year three, $193,389 in year four and $309,787 in the fifth year. This $309,787 claimed policy value is compared with total contributions to the policy of $1,549,845. It is this very low ABC policy value that AC claims justifies continuing the $309,969 contribution for five years;
   
   
3. Exiting the Plan after five years by buying the policy for a claimed value of $309,787, after which the policy values go up at the compounding rate of 39% for years 6 through 10.

As the section below about springing cash values argues, ABC Life is claiming an artificially low policy value so that AC can justify the $309,969 contributions for five years. This artificially low policy value is also given as justification to purchase the policy from the Plan for $309,787 at the end of the fifth year. In defined benefit parlance this indicates an overfunded plan, which gets the IRS' attention because the contributions made to overfund the Plan are tax-deductible. The IRS takes a dim view of excessive contributions, which they consider the trademark of an abusive 412(i) plan.

The Plan is designed for you to purchase the policy insuring your life for its Account Value (cash surrender value) of $309,787 after the fifth year, but then is illustrated to grow to $1,585,014 by year 10. This increase in value from $309,787 to $1,585,014 in five years represents a compounding investment return of 39%. After the 10th policy year the Account Value is illustrated to grow at a conventional compounding rate of 5.05%, which is pretty accurate considering current financial markets. If the same illustrated growth rate is applied for policy years 6 through 10 as illustrated for years 11 through 16 the fair market value of this policy at the end of the fifth policy year is much closer to $1,239,000. With this test in hand the IRS might look to ABC Life's Accumulated Value of $1,332,494 at the end of the fifth year as the actual value. If the IRS uses $1,332,494 as the policy's value AC's Plan is clearly overfunded. Remember that the funding goal is for $1,840,000 at age 55. A conventional 412(i) plan funded with life insurance having annual contributions of around $92,000 would have a value of around $330,000 after five years in order to achieve $1,840,000 in another eleven years. Therefore, the IRS may claim your Plan is overfunded by about $1,000,000.

If this occurs it is likely the IRS would deny excessive contributions. This would kick off a battle of actuaries, but an approximation of the amount of denied deductions for each year is $218,000, the difference between the approximate contributions for a conventional 412(i) plan of $92,000 and the Plan's $309,969.

Prohibited Transaction

As noted, the Plan is designed for you to purchase the policy insuring your life for its Account Value (cash surrender value) after the fifth year for $309,787, but then it is illustrated to grow to $1,585,014 in five years for a compounding return of 39%. A better measure of the policy's value is either the $1,239,000 calculated above or the Accumulated Value of $1,332,494. This manipulation of the ABC policy values purports to allow you to buy an asset with a real value of $1,332,494 for only $309,787, a difference of $1,022,707. According to the pension experts I have spoken with both the planned purchase of the policy after five years and the manipulated low purchase price contribute to the likelihood that the ABC policy purchase would be classified a Prohibited Transaction, which is designated by the Department of Labor with the 15% excise tax penalty collected by the IRS.

Springing Cash Values

The claim that the ABC policy has a value of $309,787 instead of the more accurate figure of $1,332,494 is a stealth technique that has come to be known as springing-cash-values (SCV). SCV is used to artificially claim a low value for a life insurance policy at the precise time it is being measured for tax purposes. In this case the claim is that you can purchase an asset with a value of $1,332,494 for only $309,787, with the difference coming out to you tax-free. In a 40% tax bracket this amounts to a benefit to you of $409,000. This is the real tax scam of AC's Plan even though the IRS will probably attack it from the excessive contributions angle. Even if there are excess contributions they would have to be dramatically reduced if the plan hasn't been terminated with the purchase of the policy using the SCV scheme. And without the SCV purchase all of the assets would remain in the Plan and be fully taxable to you as pension income.

The use of SCV in this case seems so blatant that it reminds me of the old joke of the woman that catches her husband with another woman and he adamantly denies there is even another woman in the room and asks of his wife whether she is going to believe him or her lying eyes? To understand this let me offer you a brief history of the IRS comments on SCV:

1. IRS Announcement 88-51 - IRS indicated it had noticed and was studying life insurance policy purchases and distributions from pension plans "that appear to have artificially low cash surrender values" and that after owned by the taxpayer the cash values dramatically increase. The IRS cautioned that this practice may not value the policy at its true "fair market value."
   
   
2. IRS Notice 89-25, Question and Answer 10 - The IRS was essentially noting the same regarding SCV as they had in 88-51, indicating that a policy's reserves may be a more accurate approximation of fair market value.
   
   
3. IRS Announcement 92-182 - IRS indicated that its examiners would not rely on any particular formula when determining whether an insurance policy is a SCV policy. It suggested that the premiums paid be compared with the cash surrender value in the year the policy is purchased. When the premiums paid are much higher than the surrender value an adjustment should be made to the policy's value.
   
   
4. IRS Announcement 94-101 - The IRS commented on its Handbook Manual…Chapter 300, Section 350 stating that published Manual guidelines are "not intended to be all inclusive, and may be modified based upon specific issues encountered" with respect to SCV appearing policies being distributed from or sold by qualified plans. The guidelines suggested looking at the premiums paid or the reserves.

Based on my conversation with AC and review of Attorney1's legal opinion letter regarding the ABC Life policy recommended to you it is apparent that they are relying on the IRS using the narrowest possible interpretation of SCVs. Attorney1's letter states, "In order to determine whether a policy is classified as a 'springing cash value' policy, Notice 89-25, Announcement 94-101 and Section 350 of the Manual instruct that important factors to consider include a comparison of the total policy reserves to the stated cash surrender value in the year the policy is distributed and a determination of whether the stated cash surrender value is expected to increase dramatically following the distribution of the policy." Attorney1 is arguing that it is more likely than not only that total policy reserves do equal the Account Value (surrender value) and this establishes the policy's fair market value.

This is not the time and I'm not the guy to argue whether the total policy reserves AC and ABC Life are using to claim that the policy is properly valued after five years is legitimate. Actuarial compliance arguments are far more esoteric and difficult than legal arguments and the life insurance business has devised policy pricing compliance that while possibly well intentioned seems to allow clever actuaries to lay down cover for truly unethical developers of tax scams using life insurance. But I don't think it matters a bit what the answer is on the total policy reserves because the IRS has signaled since Announcement 88-51 published in 1988 that they are going to measure a life insurance policy's value purchased from a pension plan at its fair market value. The IRS isn't trapped into accepting total policy reserves as the definition of fair market value.

Fair Market Value

The common definition of fair market value is what a willing buyer and willing seller agree on. In a financial-markets-world of 2% money markets, and 4% US bonds what do you think a financial asset promised to have an approximate value of $1,585,014 in five years is worth. AC and ABC Life's claim that the proper value is $309,787 is absurd. But this is what AC claims legitimizes contributions three time larger than a conventional 412(i) plan would allow. If the IRS and Tax Courts don't buy this claim AC's Plans will be found to be overfunded due to excessive contributions.

What-Have-I-got-to-Lose

Some potential Plan participants (that I know does not include you) might see this as a what-have-I-got-to-lose issue. Let's execute the Plan, make the contributions three to four times larger than a conventional 412(i) plan, buy the policy in five years, terminate the plan rolling the policy purchase price into an IRA and quietly save $409,000 in taxes on future benefits. If I get caught and the Tax Court sides with the IRS instead of Attorney1 I pay my taxes and chalk it up to a good try. Ah, but there is so much more at risk than just repaying what you would otherwise own in taxes on future benefits.

If the IRS denies excessive contributions I believe they will be treated as constructive dividends to the sponsoring employer. This means that excessive contributions of $1,090,000 ($218,000 times 5) generate $327,000 of taxes in your corporation (30%) and personal taxes to you of $436,000 (40%). Then there would possibly be IRC 6662(a) accuracy related penalties of 20% of the personal tax deficiency and Prohibited Transaction excise taxes of 15%. This might be as much as another $381,500. Total taxes and penalties might amount to $1,144,500 or 74% of the contributions. Lets say this dispute with the IRS plays out over three years as this case winds its way through Tax Court with the developers and promoters of the Plan encouraging you to fight an out of control IRS. Let's say your share of legal fees are $100,000. Now the bill has risen to $1,244,500, or 80% of contributions. The cash value of the policy bought from the Plan is about $1,000,000. But we will count that when it arrives.

Now let's rewind the clock to before a decision was made to buy the Plan. Instead a conventional defined benefit plan is executed with contributions of $77,000 using an annuity. Although this isn't how such a conventional defined benefit plan works, let's assume contributions stop after five years. And the difference between the Plan contributions of $309,969 and the $77,000 contributions of $232,969 are paid to you as salary and subject to income taxes and then invested in a U.S. bond fund with an after-tax yield of 2.4%. Measured at age 55 the values are $817,000 in the conventional defined benefit pension plan and $975,000 in the bond fund.

Now back to what-have-I-got-to-lose - about $1,100,000, which is the difference between what prudent planning would produce compared with where you would be at age 55 with the Plan after the IRS gets done chewing it up.

The other thing that avoided is the sleepless nights caused by the mounting frustrations and pressures of trying to defend the indefensible while the promoters are pushing you on.

ABC Life

Just so no potential bad deed goes unnoticed you should know that ABC Life was the most prominent life insurance company involved in a very notorious tax scheme using life insurance that has come to be known as the Neonatology case. Neonatology is remarkably similar to this 412(i) Plan, although AC would sputter and scream their denials at this suggestion.

Legal Opinion Letters

I have already discussed the legal opinion letter written to ABC Life by Attorney1. Attorney2's legal opinion to AC about their Plan appears to cover all of the issues as if this plan wasn't overfunded, didn't have excessive contributions, didn't have manipulated ABC policy values and has no potential Prohibitive Transaction problem. I don't know whether these attorneys are: 1) far more professionally clever than the rest of us and that the Plan is in fact legitimate; 2) winners of the Hans Blix award for incompetence; or 3) ethically challenged weasels.

Conclusion (Redux)

In the face of IRS officials stating earlier this month that looking for abusive 412(i) plans is a priority and they will "…not be gentle when retroactively examining illegal Section 412(i) schemes," "No one should take comfort in the fact that there is no guidance yet," "There is a criminal side to such schemes…" and "Courts have not looked favorably on arguments that rely on the legal opinions put out by the promoters of such schemes." AC continues in their attempts to convince potential buyers that the Plan is just a conventional and prudent defined benefit plan. For the reasons stated this is a dangerous plan and should be avoided.

I look forward to our discussion about this report.

Very truly yours,

Peter Katt, CFP, LIC