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412(i) Plan: A "Dream" or "Nightmare" for the Small Business Owner? - March 28, 2003

The so-called 412(i) plan appears to be the “dream” retirement plan for the small business owner.  In many instances, it is sold as a plan that generates a very large tax-deductible contribution like a defined benefit pension plan, provides benefits that inure primarily to older higher paid employees (the business owner) and distributes tax-free retirement and death benefits.  All of these goodies absent the complications typically associated with a traditional defined benefit pension plan (i.e., contributions that may fluctuate dramatically based on investment performance; high cost to establish and maintain the plan; etc.).  Are these plans a dream come true for the small business owner or just another nightmare hiding behind a provision in the Internal Revenue Code? 

We will find out the answer sometime soon because the IRS is planning to come down on abusive 412(i) plans.  A formal announcement outlining the IRS concerns relative to certain insurance products used to fund these plans is expected shortly.

Background  Internal Revenue Code Section 412(i) refers to defined benefit pension plans that are funded entirely through insurance contracts (life insurance and/or annuities).  A 412(i) plan must follow the same qualification rules as traditional pension plans, including the limits on retirement and death benefits.  However, unlike a traditional defined benefit pension plan, the required plan contribution is based on insurance policy premiums.  If properly structured, a 412(i) plan may be a useful retirement planning tool since it provides level funding based on scheduled insurance premium payments.

IRS Concerns  Certain insurance carriers developed special 412(i) insurance contracts designed to:

  • Apply atypically high expense loads in the early policy years;

  • Generate very low cash and reserve values in the early policy years; and

  • Provide atypically high death benefits based on these values.  

One benefit of this 412(i) plan policy design is a product that provides an exceptionally high tax-deductible premium.  The other benefits of this unorthodox policy design are apparent upon further examination of the "Dream" scheme.

The "Dream" Scheme  The 412(i) plan insurance policy illustrations indicate that the contract cash value remains relatively low at the end of the first five policy years (compared to the premiums paid to date) at which time the pensioner buys the policy out of the plan.  The illustrations also show that the cash value of the policy grows substantially in policy years 10-12.  This "springing" cash value is typically shown on the illustration as an amount that is equal to or greater than the premiums paid.  The scheme concludes with the pensioner borrowing (or withdrawing) the cash value from the policy on a tax-free basis

The "Nightmare"  The IRS believes that this scheme circumvents the intended rules by manipulating the policy valuations when it is initially purchased through the 412(i) plan and again when it is distributed to the pensioner.  They further believe that this scheme is in violation of the maximum benefit rules which results in a loss of the deduction for a large portion of the insurance premiums and taxation of a significant portion of the benefit at the time of distribution.  It may also violate the “exclusive benefit rule” which states that a plan must be maintained for the exclusive purpose of providing retirement and incidental death benefits.  

Commentary  Until the Service issues a formal announcement, one might say that the jury is still out on this subject.  However, if this scheme sounds familiar, you are not dreaming.  The IRS addressed a similar issue relative to “springing" cash values in life insurance contracts back in 1989 when they issued IRS Notice 89-25.

Excerpt from Notice 89-25 addresses "springing" cash values in life insurance contracts

Bottom Line  Proceed with caution (if at all) if you are considering the establishment of a 412(i) plan.

Access Article: Pending Guidance on 412(i) Plans Discussed at ASPA Convention - November 3, 2003

Access Article: IRS Recognizes Milberg Consulting as Pension Compliance Advocate

© 2003 Milberg Consulting LLC  All Rights Reserved

We intend the information in this publication as a general resource, not as legal or plan compliance advice or counsel. If you consider any actions discussed herein, we suggest that you consult a tax or ERISA professional. Milberg Consulting LLC and Barry R. Milberg do not warrant and are not responsible for any errors and omissions from this information.

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