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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."

Lance Wallach, National Society of Accountants Speaker of the Year and member of the AICPA
faculty of teaching professionals, is a frequent speaker on retirement plans, abusive tax shelters,
financial, international tax, and estate planning.  He writes about 412(i), 419, Section79, FBAR and
captive insurance plans. He speaks at more than ten conventions annually, writes for more than 50
publications, is quoted regularly in the press and has been featured on television and radio financial
talk shows including NBC, National Public Radio’s “All Things Considered” and others. Lance has
written numerous books including “Protecting Clients from Fraud, Incompetence and Scams,”
published by John Wiley and Sons, Bisk Education’s “CPA’s Guide to Life Insurance and Federal
Estate and Gift Taxation,” as well as the AICPA best-selling books, including “Avoiding Circular 230
Malpractice Traps and Common Abusive Small Business Hot Spots.” He does expert witness
testimony and has never lost a case. Contact him at 516.938.5007, or visit

The information provided herein is not intended as legal, accounting, financial or any type of advice
for any specific individual or other entity. You should contact an appropriate professional for any
such advice.