Key Points

• Section 419 plans, marketed as legitimate tax deduction vehicles funded by whole life insurance, have been classified by the IRS as abusive tax shelters and consistently rejected by the courts.
• Plan sponsors face a 100% excise tax on disqualifying dispositions, leaving few legitimate exit strategies for those stuck with large insurance policies held in trust.
• Transferring plan sponsorship to a related entity that is then sold to a third party with legitimate welfare plan expenses may be the most viable option, though professional guidance is essential.

From time to time during my 40-year career as a benefits attorney, I have encountered too many 419A-type arrangements, and in each case, I have been the bearer of some very bad news to the clients who have adopted them. Now some 20 or more years later, these plans keep coming my way.

First some background. Section 419 plans ostensibly are designed to provide welfare benefits to participants. In reality these plans were designed as a marketing scheme by some enterprising insurance “professionals” and sold to unsuspecting clients as a device to obtain legitimate tax deductions. Invariably, these arrangements were funded with expensive whole life insurance. From the outset the IRS opposed these tax deductions and eventually classified them as abuse tax shelters.

In the case of Section 419A(f)(6) plans, a legitimate deduction is available for contribution to a welfare plan sponsored by 10 or more unrelated employers. Inherent in this arrangement is a pooling of risks and contributions, a critical requirement that was ignored in these arrangements.

Other arrangements purported to qualify as 419(e) arrangements suffer from similar impairments. Typically, these arrangements provide “death benefits” or retiree health benefits but usually exclude most or all of the rank-and-file employees from participation. The IRS considers these arrangements disguised deferred compensation plans and has classified any arrangement where the insurance whose face amount exceeds the benefit payable by the plan by more than $100,000 as a listed transaction.

The courts have generally supported the IRS position, which is articulated in the landmark case of Neonatology Associates, P.A. v. Commissioner. Notwithstanding the unacceptably high degree of risk, some promoters continue to advocate 419 plans as a legitimate way to generate corporate tax deductions. In my opinion, this practice is at minimum irresponsible and unprofessional.

Most sponsors are “stuck” with one or more large insurance policies held by a trust. The tax and regulatory landscape leaves many 419 plan sponsors with few legitimate exit strategies. Code Section 4976 imposes a 100% excise tax on “disqualifying dispositions” from a welfare plan. A disqualifying disposition includes return of funds to the employer and payment of benefits to highly compensated individuals, except as part of a broad-based, nondiscriminatory benefit program (which is rarely the case with a plan designed as a tax-sheltering device). The statute of limitations on the excise tax does not begin to run until Form 5330 reporting the disqualifying disposition is filed.

Given the array of unfavorable alternatives, a financial transaction whereby sponsorship of the plan is transferred to a related entity that is sold to a third party with legitimate welfare plan expenses is the most viable option. While such a transaction is not free from risk, the plan sponsor has a credible argument that no disqualifying disposition has occurred.

Given the complexity of the tax laws relating to welfare plans, and continuing hostility of the IRS to plans favoring owners and other highly compensated individuals, plan sponsors are well advised to seek the advice of experienced professionals before proceeding.

Harvey Katz is a seasoned employee benefits attorney with more than 40 years of experience counseling plan sponsors. He can be reached at hkatz@foxrothschild.com.

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