Dolan
Media Newswires
Small business
retirement plans fuel litigation
Small
businesses facing audits and potentially huge tax penalties over certain types
of retirement plans are filing lawsuits against those who marketed, designed
and sold the plans. The 412(i) and 419(e) plans were marketed in the past
several years as a way for small business owners to set up retirement or
welfare benefits plans while leveraging huge tax savings, but the IRS put them
on a list of abusive tax shelters and has more recently focused audits on them.
The
penalties for such transactions are extremely high and can pile up quickly -
$100,000 per individual and $200,000 per entity per tax year for each failure
to disclose the transaction - often exceeding the disallowed taxes.
There
are business owners who owe $6,000 in taxes but have been assessed $1.2 million
in penalties. The existing cases involve many types of businesses, including
doctors' offices, dental practices, grocery store owners, mortgage companies
and restaurant owners. Some are trying to negotiate with the IRS. Others are
not waiting. A class action has been filed and cases in several states are
ongoing. The business owners claim that they were targeted by insurance
companies; and their agents to purchase the plans without any disclosure that
the IRS viewed the plans as abusive tax shelters. Other defendants include
financial advisors who recommended the plans, accountants who failed to fill
out required tax forms and law firms that drafted opinion letters legitimizing
the plans, which were used as marketing tools.
A
412(i) plan is a form of defined benefit pension plan. A 419(e) plan is a
similar type of health and benefits plan. Typically, these were sold to small,
privately held businesses with fewer than 20 employees and several million
dollars in gross revenues. What distinguished a legitimate plan from the plans
at issue were the life insurance policies used to fund them. The employer would
make large cash contributions in the form of insurance premiums, deducting the
entire amounts. The insurance policy was designed to have a "springing
cash value," meaning that for the first 5-7 years it would have a
near-zero cash value, and then spring up in value.
Just
before it sprung, the owner would purchase the policy from the trust at the low
cash value, thus making a tax-free transaction. After the cash value shot up,
the owner could take tax-free loans against it. Meanwhile, the insurance agents
collected exorbitant commissions on the premiums - 80 to 110 percent of the
first year's premium, which could exceed $1 million.
Technically,
the IRS's problems with the plans were that the "springing cash"
structure disqualified them from being 412(i) plans and that the premiums,
which dwarfed any payout to a beneficiary, violated incidental death benefit
rules.
Under
§6707A of the Internal Revenue Code, once the IRS flags something as an abusive
tax shelter, or "listed transaction," penalties are imposed per year
for each failure to disclose it. Another allegation is that businesses weren't
told that they had to file Form 8886, which discloses a listed transaction.
According to Lance
Wallach of Plainview, N.Y. (516-938-5007), who testifies as an expert in cases
involving the plans, the vast majority of accountants either did not file the
forms for their clients or did not fill them out correctly.
Because
the IRS did not begin to focus audits on these types of plans until some years
after they became listed transactions, the penalties have already stacked up by
the time of the audits.
Another
reason plaintiffs are going to court is that there are few alternatives - the
penalties are not appealable and must be paid before filing an administrative
claim for a refund.
The
suits allege misrepresentation, fraud and other consumer claims. "In
street language, they lied," said Peter Losavio, a plaintiffs' attorney in
Baton Rouge, La., who is investigating several cases. So far they have had
mixed results. Losavio said that the strength of an individual case would
depend on the disclosures made and what the sellers knew or should have known
about the risks.
In
2004, the IRS issued notices and revenue rulings indicating that the plans were
listed transactions. But plaintiffs' lawyers allege that there were earlier
signs that the plans ran afoul of the tax laws, evidenced by the fact that the
IRS is auditing plans that existed before 2004.
"Insurance
companies were aware this was dancing a tightrope," said William Noll, a
tax attorney in Malvern, Pa. "These plans were being scrutinized by the
IRS at the same time they were being promoted, but there wasn't any disclosure
of the scrutiny to unwitting customers."
A
defense attorney, who represents benefits professionals in pending lawsuits,
said the main defense is that the plans complied with the regulations at the
time and that "nobody can predict the future."
An
employee benefits attorney who has settled several cases against insurance
companies, said that although the lost tax benefit is not recoverable, other
damages include the hefty commissions - which in one of his cases amounted to
$860,000 the first year - as well as the costs of handling the audit and filing
amended tax returns.
Defying
the individualized approach an attorney filed a class action in federal court
against four insurance companies claiming that they were aware that since the
1980s the IRS had been calling the policies potentially abusive and that in
2002 the IRS gave lectures calling the plans not just abusive but
"criminal." A judge dismissed the case against one of the insurers
that sold 412(i) plans.
The
court said that the plaintiffs failed to show the statements made by the
insurance companies were fraudulent at the time they were made, because IRS
statements prior to the revenue rulings indicated that the agency may or may
not take the position that the plans were abusive. The attorney, whose suit
also names law firm for its opinion letters approving the plans, will appeal
the dismissal to the 5th Circuit.
In
a case that survived a similar motion to dismiss, a small business owner is
suing Hartford Insurance to recover a "seven-figure" sum in penalties
and fees paid to the IRS. A trial is expected in August.
Last July, in response to a letter from members of
Congress, the IRS put a moratorium on collection of §6707A penalties, but only
in cases where the tax benefits were less than $100,000 per year for
individuals and $200,000 for entities. That moratorium was recently extended
until March 1, 2010.
But tax experts say
the audits and penalties continue. "There's a bit of a disconnect between
what members of Congress thought they meant by suspending collection and what
is happening in practice. Clients are still getting bills and threats of
liens," Wallach said.
"Thousands
of business owners are being hit with million-dollar-plus fines. ... The audits
are continuing and escalating. I just got four calls today," he said.
A bill has been introduced in Congress to make the penalties less draconian,
but nobody is expecting a magic bullet.
"From what we know, Congress is looking to
make the penalties more proportionate to the tax benefit received instead of a
fixed amount."
