Don’t Get Caught in Section 79 Trap

Don’t Get Caught in Section 79 Trap

One doctor almost lost everything ………..

The Internal Revenue Service is looking very closely at all types of retirement plans these days, desperately trying to increase the federal treasury by uncovering and fining what it can call “abusive tax shelters.” Insurance agents, accountants and other financial advisors have been downplaying the Section 79 plans, convincing potential buyers that they need not worry about Section 79 plans because they are not on the IRS radar. We now have proof that’s not true, and anyone considering investing in a Section 79 plan should remember this story before they turn over their hard earned cash.

In 2006 Doctor X found himself in what he thought was the pleasant position of having a substantial amount of cash on hand that was not essential to the operation of his practice. That comfortable feeling did not last long. He quickly fell prey to a predatory insurance agent who sold him on the idea of Section 79 scam as a vehicle to obtain tax deductions. Of course what really interested the insurance agent was the funding vehicle, a large life insurance contract with American General as the insurance carrier, which just happened to net the agent a large commission.

Unfortunately, the large, questionable tax deductions claimed by Doctor X indeed attracted the attention of the IRS. As a result of their audit, the IRS not only disallowed all of the tax deductions, but also imposed back taxes, an array of penalties, and interest, turning the doctor’s anticipated investment vehicle into something that could cost him everything he was saving and more. As if that weren’t bad enough, even that draconian action was not the end of the story.

None of his so-called financial advisors had told Doctor X about IRC Section 6707A. Under this section of the code, huge fines can be imposed on those who fail to inform the Service about participation in listed or reportable transactions. Loosely defined, this means any transaction, which has the potential for tax avoidance or evasion. Since he had no knowledge of this requirement, the doctor did not make the proper filings under Section 6707A, and is now also being threatened with monstrous fines for that failure to submit the proper forms in the proper format.

Although these issues had the potential for great disaster and great financial loss for this doctor, all the anxiety and stress he has been suffering over this matter may soon have a happier ending than he expected at its onset because he had the sense to contact us for help, perhaps just in the nick of time. As a result of putting experts with a great deal of experience on his case, he now stands an excellent chance of having at least some of the penalties from the original audit abated. He will probably be able to recover the money that he sank into that large, useless American General life insurance contract as well. Last, but certainly not least, Doctor C also has an excellent chance of avoiding the large Section 6707A penalties, as our experts in the art of filing late without paying fines are currently at work on that as well.

Changes to Reporting under 6707A

January 15, 2010: Brand New Update:

The new proposed regulations specify a requirement that reporting forms filed under 6707A filed late must have additional attachments. Where in is described many additional details not covered in the original regulations. In addition, various parties must sign a statement on the attachments under penalty of perjury. The proposed regulations also specify that the late filing must be done in a specific manner.  If this filing is not done according to these rules, the one-year period for statute of limitations will not commence, etc. In addition, the form should include a statement at the top in the manner the IRS suggests.  If a tax payer fails to include, on any return or statement, for any taxable year, any information with respect to a listed transaction as defined in CODE SECTION 6707A, which is required to be included with such return or statement the time for assessment of any tax imposed by this title with respect to such transaction shall not expire before the date, which is one year after the earlier of; the date on which the secretary is furnished the information so required, or the date that a material advisor meets the requirements relating to such transaction with respect to such tax  payer. As you know, Congress has armed the IRS with many weapons for enforcement. Usually there is three-year statute of limitations granted to all taxpayers. In the situation above there will be no statute of limitations, unless the forms are filed in correctly with no errors at all.  In addition, the forms must be sent to the proper IRS authorities at their various locations. Lance Wallach’s commentary: It seems to me and to the only two people that I know who have been filing these forms correctly that that the IRS has purposely made it almost impossible for accountants and tax attorneys to properly fill out these forms and to comply with regulations under SECTION 6707A. The result is that a business owner in one of these plans asks his accountant or attorney to file the disclosures. The Business Owner then gets fined, on average, ABOUT A MILLION DOLLARS. Or the Business Owner does not file the forms and gets the same fine. The same goes for the Material Advisor. The two people that have been filing these forms properly to my knowledge have repeatedly had discussions with the authors of these regulations and various other IRS personnel, including the Office of Tax Shelter Analysis.  Based on those many conversations with IRS personnel, repeatedly re-reading the various regulations and experience in filing many of the form under these code sections, these two people have developed their expertise. I only have their word that no one has been fined that they have helped. One of these individuals has been preparing the forms after the fact, late, for the last few years. I am not endorsing using anyone in particular for these forms. I am just writing about my experience in this area.

Challenges to 6707A Penalties

Is IRS Section 6707A Fair?

Even the IRS personnel continue to question both the legality and the fairness of the IRS’s imposition of 6707A penalties. An IRS appeals officer in an email to a senior attorney within the IRS wrote that “…I am both an attorney and CPA and in my 29 years with the IRS I have never {before} worked a case or issue that left me questioning whether in good conscience I could uphold the Government’s position even though it is supported by the language of the law.” The Taxpayers Advocate, an office within the IRS, even went so far as to publicly assert that the 6707A should be modified as it “raises significant Constitutional concerns, including possible violations of the Eighth Amendment’s prohibition against excessive government fines, and due process protection.”

Senate bill 765, the bill sponsored by Senator Nelson, seeks to alleviate some of above cited concerns. Specifically, the bill makes three major changes to the current version of Code section 6707A. The bill would allow an IRS imposed 6707A penalty for nondisclosure of a listed transaction to be rescinded if a taxpayer’s failure to file was due to reasonable cause and not willful neglect. The bill would make a 6707A penalty proportional to an understatement of any tax due.

Accordingly, non-tax paying entities such as S corporations and limited liability companies would not be subject to a 6707A penalty (individuals, C corporations and certain trusts and estates would remain subject to the 6707A penalty).

There are a number of interesting points to note about this action:

1.     In the letter, the IRS acknowledges that, in certain cases, the penalty imposed by section 6707A for failure to report participation in a “listed transaction” is disproportionate to the tax benefits obtained by the transaction.

2.     In the letter, the IRS says that it is taking this action because Congress has indicated its intention to amend the Code to modify the penalty provision, so that the penalty for failure to disclose will be more in line with the tax benefits resulting from a listed transaction.

3.     The IRS will not suspend audits or collection efforts in appropriate cases.  It cannot suspend imposition of the penalty, because, at least with respect to listed transactions, it does not have the discretion to not impose the penalty.  It is simply suspending collection efforts in cases where the tax benefits are below the penalty threshold in order to give Congress time to amend the penalty provision, as Congress has indicated to the IRS it intends to do.  

4.         The legislation does not change the penalty provisions for material advisors.

This is taken directly from the IRS website:

“Congress has enacted a series of income tax laws designed to halt the growth of abusive tax avoidance transactions. These provisions include the disclosure of reportable transactions. Each taxpayer that has participated in a reportable transaction and that is required to file a tax return must disclose information for each reportable transaction in which the taxpayer participates. Use Form 8886 to disclose information for each reportable transaction in which participation has occurred. Generally, Form 8886 must be attached to the tax return for each tax year in which participation in a reportable transaction has occurred. If a transaction is identified as a listed transaction or transaction of interest after the filing of a tax return (including amended returns), the transaction must be disclosed either within 90 days of the transaction being identified as a listed transaction or a transaction of interest or with the next filed return, depending on which version of the regulations is applicable.”

Is 6707A Constitutional?

IRC Section 6707A Penalty and Judicial Review

The imposition of a 6707A penalty is not subject to judicial review regardless of whether the penalty is imposed for a listed or reportable transaction. Accordingly, the IRS’s determination is conclusive, binding and final. The next step from the IRS is sending your file to collection, where your assets may be forcibly taken, publicly recorded liens may be placed against your property, and/or garnishment of your wages or business profits may occur, amongst other measures.

The 6707A penalty amount for each listed transaction is generally $200,000 per year per each person that is not an individual and $100,000 per year per individual who failed to properly disclose each listed transaction. The 6707A penalty amount for each reportable transaction is generally $50,000 per year for each person that is not an individual and $10,000 per year per each individual who failed to properly disclose each reportable transaction. The IRS is obligated to impose the listed transaction penalty by law and cannot remove the penalty by law. The IRS is obligated to impose the reportable transaction penalty by law, as well, but may remove the penalty when the IRS determines that removal of the penalty would promote compliance and support effective tax administration.

The 6707A penalty is particularly harmful in the small business context, where many business owners operate through an S corporation or limited liability company in order to provide liability protection to the owner/operators. Numerous cases are coming to light where the IRS is imposing a $200,000 penalty at the entity level and them imposing a $100,000 penalty per individual shareholder or member per year.

The individuals are generally left with one of two options:
  • Declare Bankruptcy
  • Face a $300,000 penalty per year.
Keep in mind, taxes do not need to be due nor does the transaction have to be proven illegal or illegitimate for this penalty to apply. The only proof required by the IRS is that the person did not properly and timely disclose a transaction that the IRS believes the person should have disclosed. It is important to note in this context that for non-disclosed listed transactions, the Statue of Limitations does not begin until a proper disclosure is filed with the IRS.

Many practitioners believe the scope and authority given to the IRS under 6707A, which allows the IRS to act as judge, jury and executioner, is unconstitutional. Numerous real life stories abound illustrating the punitive nature of the 6707A penalty and its application to small businesses and their owners. In one case, the IRS demanded that the business and its owner pay a 6707A total of $600,000 for his and his business’ participation in a Code section 412(i) plan. The actual taxes and interest on the transaction, assuming the IRS was correct in its determination that the tax benefits were not allowable, was $60,000. Regardless of the IRS’s ultimate determination as to the legality of the underlying 412(i) transaction, the $600,000 was due as the IRS’s determination was final and absolute with respect to the 6707A penalty. Another case involved a taxpayer who was a dentist and his wife whom the IRS determined had engaged in a listed transaction with respect to a limited liability company. The IRS determined that the couple owed taxes on the transaction of $6,812, since the tax benefits of the transactions were not allowable. In addition, the IRS determined that the taxpayers owed a $1,200,000 section 6707A penalty for both their individual nondisclosure of the transaction along with the nondisclosure by the limited liability company.

Attempts to Curb the Power of the IRS

Senator Ben Nelson (D-Nebraska) has sponsored legislation (S.765) to curtail the IRS and its nearly unlimited authority and power under Code Section 6707A. The bill seeks to scale back the scope of the Section 6707A reportable/listed transaction nondisclosure penalty to a more reasonable level. The current law provides for penalties that are Draconian by nature and offer no flexibility to the IRS to reduce or abate the imposition of the 6707A penalty. This has served as a weapon of mass destruction for the IRS and has hit many small businesses and their owners with unconscionable results.

Internal Revenue Code 6707A was enacted as part of the American Jobs Creation Act on October 22, 2004. It imposes a strict liability penalty for any person that failed to disclose either a listed transaction or reportable transaction per each occurrence. Reportable transactions usually fall within certain general types of transactions (e.g. confidential transactions, transactions with tax protection, certain loss generating transaction and transactions of interest arbitrarily so designated as by the IRS) that have the potential for tax avoidance. Listed transactions are specified transactions, which have been publicly designated by the IRS, including anything that is substantially similar to such a transaction (a phrase which is given very liberal construction by the IRS). There are currently 34 listed transactions, including certain retirement plans under Code section 412(i) and certain employee welfare benefit plans funded in part with life insurance under Code sections 419A(f)(5), 419(f)(6) and 419(e). Many of these plans were implemented by small business seeking to provide retirement income or health benefits to their employees.

Strict liability requires the IRS to impose the 6707A penalty regardless of innocence of a person (i.e. whether the person knew that the transaction needed to be reported or not or whether the person made a good faith effort to report) or the level of the person’s reliance on professional advisors. A Section 6707A penalty is imposed when the transaction becomes a reportable/listed transaction. Therefore, a person has the burden to keep up to date on all transactions requiring disclosure by the IRS into perpetuity for transactions entered into the past.

Additionally, the 6707A penalty strictly penalizes nondisclosure irrespective of taxes owed. Accordingly, the penalty will be assessed even in legitimate tax planning situations when no additional tax is due but an IRS required filing was not properly and timely filed. It is worth noting that a failure to disclose in the view of the IRS encompasses both a failure to file the proper form as well as a failure to include sufficient information as to the nature and facts concerning the transaction. Hence, people may find themselves subject to the 6707A penalty if the IRS determines that a filing did not contain enough information on the transaction. A penalty is also imposed when a person does not file the required duplicate copy with a separate IRS office in addition to filing the required copy with the tax return. Lance Wallach Commentary. In our numerous talks with IRS, we were also told that improperly filling out the forms could almost be as bad as not filing the forms. We have reviewed hundreds of forms for accountants, business owners and others. We have not yet seen a form that was properly filled in. We have been retained to correct many of these forms.

For more information see www.vebaplan.com, www.lawyer4audits.com, or e-mail us at lawallach@aol.com

6707A Penalties You Should Know About

The moratorium on collection has been extended for two additional months until March 1, 2010

If you are a small business owner, accountant or insurance professional you may be in big trouble and not know it.  IRS has been fining people like you $200,000.  Most people that have received the fines were not aware that they had done anything wrong.  What is even worse is that the fines are not appeal-able.  This is not an isolated situation.  This has been happening to a lot of people.

Currently, the Internal Revenue Service (“IRS”) has the discretion to assess hundreds of thousands of dollars in penalties under §6707A of the Internal Revenue Code (“Code”) in an attempt to curb tax avoidance shelters. This discretion can be applied regardless of the innocence of the taxpayer and was granted by Congress.  It works so that if the IRS determines you have engaged in a listed transaction and failed to properly disclose it, you will be subject to a potentially draconian penalty regardless of any other facts and circumstances concerning the transaction. For some, this penalty has been assessed at almost a million dollars and for many it is the beginning of a long nightmare.

The following is an example:  Pursuant to a settlement with the IRS, the 412(i) plan was converted into a traditional defined benefit plan.  All of the contributions to the 412(i) plan would have been allowable if they had initially adopted a traditional defined benefit plan.  Based on negotiations with the IRS agent, the audit of the plan resulted in no income and minimal excise taxes due.   This is because as a traditional defined benefit plan, the taxpayers could have contributed and deducted the same amount as a 412(i) plan.
Towards the end of the audit the business owner received a notice from the IRS.  The IRS assessed the client penalties under the §6707A of the Code in the amount of $900,000.00.  This penalty was assessed because the client allegedly participated in a listed transaction and allegedly failed to file the form 8886 in a timely manner.

The IRS may call you a material advisor and fine you $200,000.00. The IRS may fine your clients over a million dollars for being in a retirement plan, 419 plan, etc. As you read this article, hundreds of unfortunate people are having their lives ruined by these fines. You may need to take action immediately. The Internal Revenue Service said it would extend until the end of March 1, 2010 a grace period granted to small business owners for collection of certain tax-shelter penalties.

"Clearly, a number of taxpayers have been caught in a penalty regime that the legislation did not intend," wrote Shulman. "I understand that Congress is still considering this issue, and that a bipartisan, bicameral, bill may be in the works."  The issue relates to penalties for so-called listed transactions, the kinds of tax shelters the IRS has designated most egregious. A number of small business owners that bought employee retirement plans so called 419 and 412(i) plans and others, that were listed by the IRS, and who are now facing hundreds and thousands in penalties, contend that the penalty amounts are unfair.
Leaders of tax-writing committees in the House and Senate have said they intend to pass legislation revising the penalty structure.

The IRS has suspended collection efforts in cases where the tax benefit derived from the listed transaction was less than $100,000 for individuals, or less than $200,000 for firms. They are still however sending out notices that they intend to fine.

Advisor Beware

Lines from Lance - Newsletter - updated 01/15/10:  

If you were or are in a 412(i), 419, Captive Insurance, or section 79 plan you are probably in big trouble. If you signed a tax return for a client in one of these plans, you are probably what the IRS calls a material advisor and subject to a maximum $200,000 fine. If you are an Insurance Professional that sold or advised on one of these plans, the same holds true for you. Business Owners and Material Advisors needed to properly file under section 6707A, or face large IRS fines. My office has received thousands of phone calls, many after the business owner has received the fine. In many cases, the accountant files the appropriate forms, but the IRS still levied the fine because the Accountant made a mistake on the form. My office has reviewed many forms for Accountants, Tax Attorneys and others. We have not yet seen a form that was filled out properly. The improper preparation of these forms usually results in the client being fined more quickly then if the form were not filed at all. I have been an expert witness in law suites on point. None of my clients have ever lost where I was their Expert Witness.

The IRS will be soon attacking section 79 scams I am told. My early articles by AICPA and others in the 90s predicted attacks on 419s, which came true. My 412(i) article predictions came true. The section 79 scams soon will be attacked. Everyone in them should file protectively. Anyone that has not filed protectively in a 419 or older 412(i) had better get some good advise from someone who knows what is going on, and has extensive experience filing protectively. IRS still has their task forces auditing these plans. Then they will move on to 79 scams etc. including many of the illegal captives pushed by the insurance companies and agents. Not all captives are illegal. I am an expert witness in a lot of cases involving the 412(i) and 419. It does not go well for the agents, accountants, plan promoters, insurance companies etc. The insurance companies settle first leaving the agents hanging out there. Then in many cases they fire the agents. I was just in a case as an expert witness where a large well know New England mutual based insurance company did just that.

If you are an insurance professional do not count on your insurance company to back you up. More likely they will stab you in the back, based on what I have seen. One of the agents was with the company over 25 years and was a leading producer with lots of company awards. Be careful. If you sold, gave tax advice, or signed a tax return and got paid a certain amount of money you may be a material advisor. Under the newest proposed regulations you had to file with the IRS to avoid the $200,000 $100,000 fines. You had to fill out the forms properly. You had to advise those that you advised about the plans or sold the plan to. You had to send them a note, or call them, giving them the number that the IRS had assigned to you as a Material Advisor. This is the number that you obtain after you file the appropriate forms for yourself. Even though you obtain a number you still may have filed your forms improperly or completed them wrong. Many accountants have called me after their clients were fined $800,000 or more by IRS for improperly filing, or not filing under 6707A. A plan administrator called me after a lot of his clients were fined millions. He told their accountants to file 8886, and most of them did. All of the clients were fined shortly thereafter. The forms need to be filled in exactly correct. In our numerous talks with IRS we were told if filed out wrong the fine is still imposed. BE CAREFUL please be advised we have not seen a form that has been filed out properly. Many accountants, tax attorneys, etc., send us their forms to be reviewed, most after they file for one client who then gets fined about one million dollars under the regulations. I DO NOT do the forms. A former IRS agent of 37 years, CPA, tax professor does them, as does another person that I know.

412i Plans attacked by IRS, lawsuits

April 24, 2012     By Lance Wallach, CLU, CHFC

IRS has been attacking abusive 412i plans for years. Business men have been suing the insurance agents who sold the plans.
The IRS has attacked 412i, 419 plans for years. As a result promoters are now promoting section 79 and captive insurance plans. They are just starting to be attacked by the IRS.

A 412(i) plan differs from other defined benefit pension plans in that it must be funded exclusively by the purchase of individual life insurance products.

In the late 1990's brokers and promoters such as Kenneth Hartstein, Dennis Cunning, and others began selling 412(i) plans designed with policies created and sold through agents of Pacific Life, Hartford, Indianapolis life, and American General. These plans were sold or administered through companies such as Economic Concepts, Inc., Pension Professionals of America, Pension Strategies, L.L.C. and others.

These plans were very lucrative for the brokers, promoters, agents, and insurance companies. In addition to the costs associated with adminstering the plans, the policies of insurance had high commissions. If they were cancelled within a few years of purchace the had very little cash value.

These plans were often described as Pendulum Plans, or other similar names. In theory, the plans would work as follows. After the plan was set up, the plan would purchase a life insurance policy insuring the life of an individual. The plan would have very little (and high surrender charges) for 5 or more years. The Corporation would pay the premium on the policy and take a deduction for the entire amount. In year 5, when the policy had little or no cash value, the plan would transfer the policy to the individual, who would take it at a greatly reduced basis. Subsequently, the policy would spring up with cash value, thus the name springing cash value policy. The insured would have cash value which he could withdraw almost tax free .

Attorney Richard Smith at the law firm of Bryan Cave issued tax opinion letters opinion which stated that the design of many of the plans met the requirements of section 412(i) of the tax code.

In the early 2000s, IRS officials began questioning the insurance representatives, brokers, promoters, and their attorneys and giving speeches at benefits conferences wherein they took the position that these plans were in violation of both the letter and spirit of the Internal Revenue Code. When I spoke at the annual national convention of the American Society of Pension Actuarys in 2002 I heard such a speech given by Jim Holland, IRS chief actuary.

In February 2004, the IRS issued guidance on 412(i) and began the process of making plans "listed transactions." Taxpayers involved in listed transaction are required to report them to the IRS. These transactions are to be reported using a form 8886. The failure to file a form 8886 subjects individual to penalties of very large amounts, and failure of insurance agents, accountants and others to file 8918 results in a $100,000 fine.
In late 2005, the IRS began obtaining information from advisors and actively auditing plans and more recently, levying section 6707 penalties. First the IRS would audit the business owner and deny the deduction. The business owner would also owe interest and penalities. Then another unit of the IRS would assess large additional fines for failure to properly file, or failure to file 8886 forms. The directions for these forms is very complicated, expecially if the forms are filed after the fact. Many business owners still got fined even if they filed the forms. If the forms were not filled in exactly right a fine was still assessed.

The IRS's response to these 412(i) plans was predictable. They made it clear that the IRS would not be gentle and even indicated that potential criminal liability existed. The IRS made speeches and people like me wrote articles about the problems.

Insurance company representatives attended these conferences and heard the IRS warnings. Many of them ignored them.

Neither the brokers, promoters, or Insurance companies relayed this information to their clients and insureds at this time. When I would speak about the problems of 412i and 419 plans I would be attacked by promoters and salesmen. When I testified againt a springing cash value policy in my first court case I was challenged by the defendants attorney as not being an expert. The judge allowed the jury to hear whether I was indeed an expert. The result was a huge loss for the defense.

On February 13, 2004, the IRS issued a press release, two revenue rulings, and proposed regulations to shut down abusive transactions involving specifically designed life insurance policies in retirement plans, section 412(i) plans and 419 plans etc.

In October of 2005, the IRS invited those who sponsored 412(i) plans that were treated as listed transactions to enter a settlement program in which the taxpayer would recind the plan and pay the income taxes it would have paid had it not engaged in the plan, plus interest and reduced penalties.

MDL stands for Multidistrict Litigation. It was created by Congress in 1968 – 28 U.S.C. §1407.

The act created an MDL Panel of judges to determine whether civil actions pending in different federal districts involve one or more common questions of fact such that the actions should be transferred to one federal district for coordinated or consolidated pretrial proceedings. In theory, the purposes of this transfer or “centralization” process are to avoid duplication of discovery, to prevent inconsistent pretrial rulings, and to conserve the resources of the parties, their counsel and the judiciary. Transferred actions which are not resolved in the MDL are remanded to their originating court or district by the Panel for trial. Lots of people who were audited sued the insurance companys, agents, accountants and others.

Then, Pacific Life, Hartford Life & Annuity moved for summary judgment in the MDL. The court granted the motions in part, and denied the motions in part. Specifically, the court dealt with the issue of the disclaimers contained within the policies and signed by various policyholders.

Applying California law in evauating the disclosures and disclaimers, the Court ruled that the California Plaintiffs failed to raise issues of material fact that they reasonably relied on representations by Hartford and Pacific Life regarding the tax and legal issues related to their 412(i) plans.

Conversely, the court ruled that pursuant to Wisconsin law, the disclaimers were unenforceable. The court came to similar conclusion when applying Texas law to the Plaintiffs claims.

Plaintiffs have been more successful in suing 419 plan promoters, insurance companys, accountants ,etc. I have been an expert witness and my side has never lost a case.

I have been speaking with my IRS contacts about the newest abusive tax shelter trends, captives and section 79 plans. They have started auditing participants in these plans. The IRS has not yet decided if the plans are listed, abusive or similar to. I think that captive insurance companies and section 79 plans may become the next 412 and 419 problem for unsuspecting companies. Designed under IRS Code 831(b), these captive insurance companies are designed to insure the risks of an individual business. In theory and if properly designed, the premiums are deducted when paid to a related company, and depending on claims, profits can be paid out as dividends and when liquidated, the proceeds are taxed at capital gains rates.

The problem with Captives is that they are expensive to set up and operate. Captives must be opetate as a true risk assuming entity, not simply a tax avoidance vehicle. Some variations are to rent a cell captives that can work for a lot less money.
The IRS is looking into the sale of life insurance to fund Captives. They are also looking at most section 79 plans. This sounds very familiar.