Section 419 plans: friend or foe?

Changes in government regulations will better define these deferred income plans. Plan participants should exercise caution until then.

Issue: July 1, 2003

ByDave Hansen

In the past few years I have heard of an increasing number of physicians and dentists who are using 419 plans to stash thousands of dollars away on a pretax basis. When I first heard about 419 plans, I was interested to see how an insurance company could claim to allow an individual to shelter thousands of dollars while at the same time participating in a profit-sharing plan or 401(k) plan. My curiosity stopped shortly after I found problems with the plan. It also raised concerns in my mind when I found that insurance companies were the main providers of these plans. Perhaps a closer look at 419 plans will help those who are currently participating or considering doing so to think twice about getting involved.

What is 419 plan?

There are two Internal Revenue Code section codes upon which these plans are based. One is 419A(f)(5), which is the union plan, and the other is 419A(f)(6), the nonunion plan. This article will focus on the latter. They are also referred as Welfare Benefit Plans or VEBA plans. The Treasury Department has recently proposed regulations governing 10-employee or more types of these employer plans.

Basically, this 419 plan was originally meant to provide medical, disability and life insurance benefits for employees and independent contractors. Over the years some promoters of 419 plans have twisted the original intent of this section and have created aggressive plans that allow significant deductions to the participant. These deductions are meant primarily for the high-wage earners of a company and typically do not provide any benefits to rank-and-file employees.

Daydreaming

Imagine a trust where you could contribute an unlimited, tax-deductible amount for the benefit of yourself and perhaps a few key employees. Imagine further that the money put into this trust accumulates tax-free and can be distributed at a later date tax-free. If you die, the money in the trust goes to the heirs both income- and estate tax-free. If this sounds too good to be true, perhaps it is.

In July 2002, the Treasury Department issued proposed regulations designed to dramatically change the landscape for 10-or-more plans. Opponents of the proposed legislation claim the proposed regulations are merely that — “proposed” — and that the final legislation will allow many of the current plans to continue as though nothing had happened.

However, on November 14, 2002, the IRS and Treasury held a public hearing where six plan sponsors and/or attorneys testified. Another eight interested taxpayers submitted comments. Both sides took issue with the sweeping changes inherent in the proposed regulations. At this point, though, the Treasury and Congressional staff appear not to be very willing to make many modifications to the regulations as proposed.

Generally, most of the regulations are directed at the cash-value benefits that individuals were trying to make. If the proposed legislation passes as-is, it will be very difficult for individuals to purchase cash-value life insurance in a 419 plan and be able to deduct the entire premium. The deduction will more likely be equal to the term cost of the insurance. This would dramatically reduce the amount of the deductions available that individuals were taking in the past.

What to do

Many 419 plan participants are aware that their plan is aggressive. Perhaps they know there is pending legislation. The million-dollar question becomes, “What do you do now? Do you raise the white flag and write a letter to the IRS letting them know what you have and pray for leniency? Do you continue to fund your 419 plan as-is, hoping the legislation will not pass as proposed? Or do you just sit on the fence and not make any more contributions in a ‘wait-and-see’ mode?”

The one answer to these questions is, “It depends.” There are several things you could do right now to limit the future problems looming ahead. Many of the answers can only be determined after reviewing the documents issued along with the plan.

From my research, the true test of whether your plan is one that is being targeted is whether the payments upon termination of participation are welfare benefits or if they are deferred compensation. If they are deferred compensation, then your plan will not comply with the rules set forth by the IRS. The contributions will then not be tax deductible.

The following questions can help you determine if your plan is deferred compensation or welfare benefits:

Is the plan concerned with the well-being of the employees?
Are the benefits provided to employees based upon the employer’s earnings?
Do benefits increase for those who have been employed longer by the employer?
Are benefits provided to all employees?
Are the plan benefits a substitute for salary?

The best plan at this time, I believe, is not to make any more contributions into your plan. A proper review of your plan documents will determine if your plan will be targeted by the changes.

One option is to take a “what have I got to lose?” strategy. If I go ahead with the contributions and save the taxes and get caught later, I would only have to pay the taxes and chalk it up as a good try. While this strategy might work, there is far more risk than just repaying the taxes. A person trying this strategy could stand to lose as much as 80% of the contributions in accuracy-related penalties, personal tax deficiency, prohibited transaction excise taxes and legal fees. A closer look at this strategy is necessary when there are other retirement ideas that work and are not being targeted by the IRS. The cost of sleepless nights caused by not knowing the fate of these also should be worth something.

Alternate plans

There are other tried and tested plans that are not likely to become targeted by the IRS. They have withstood the test of time and offer some of the benefits of the 419.

Recently, the 412(i) plan has become popular with individuals wanting to make larger contributions than they currently are with their 401(k) or profit-sharing plans.

Do not confuse the 419 with 412. The 412(i) plans have been discussed extensively in different financial service publications. They are a defined benefit plan that allows much greater contributions that are invested with an insurance company. The 412 is a conservative approach to fund a defined benefit plan because the funds are guaranteed by the insurance company.

Recent tax law changes have made this plan an attractive way to fund a retirement plan, because higher amounts can be contributed. They have also become more popular because they provide a guaranteed return not subject to stock market declines.

Depending upon the demographics of the company, some 412 plans allow a physician or dentist to receive over 90% of the benefit from his business. They are ideal for physicians who have few employees per physician. If there are several employees who are much older than the physician, then required contribution for the employees with dramatically increase. The only way to determine how much needs to be contributed for the employees is to submit the data, and the actuaries will let us know how much of the annual funds will go to the physician.

By June, we should know what the finalized regulations are going to be, as they are expected to become law. A review of the 419 documents by the appropriate legal and/or tax professionals should be in order if you are a participant.

More important, if you are considering a 419, use caution. There are many other options available to give physicians deductions that will not be scrutinized as much as the 419 plan. They can provide great benefits by quality companies. They also can give you the peace of mind that you might want in these trying times.