Imagine your corporate client is approached by an
insurance agent with a plan that makes the following promises:
• Virtually
unlimited deductions for the employer;
• Ability to
vary contributions from year to year;
• Benefits
can be provided to one or more key executives on a selective basis;
• No need to
provide benefits to rank and file employees;
•
Contributions will not be limited by qualified plan rules and will not
interfere with pension, profit-sharing or 401(k) plans;
• Funds
inside the Plan will accumulate tax-free;
• Death
proceeds can be received both income and estate tax-free by beneficiaries;
• Money in
the Plan can be received tax-free at a later date;
• Funds in
the Plan are secure from the hands of creditors.
Those were among the promises made here and in many
similar cases.
We know now (and probably should have known all along)
that this tax alchemy is just another example of:
“If it sounds too good to be true, it probably is”
EXECUTIVE SUMMARY:
The Tax Court in White concluded that “The Indianapolis Life policies
purchased with the contributions to the xélan 419 plan and to the Millennium
plan were nothing more than Dr. and Mrs. White's personal investment in whole
life insurance policies that primarily accumulated cash value for Dr. and Mrs.
White personally.” The Court denied deductions for contributions made by
a medical practice to a section 419 welfare benefit plan on behalf of the
doctor and his wife. Since the individual insureds always had the ability
to cause the policies to be distributed to them and receive the value of the
underlying insurance policies, the Tax Court also held the amounts were
includible in the couple's income.
This case also provides a good review of why and when
the accuracy-related penalty will be imposed.
FACTS:
FAMILY AND BUSINESS BACKGROUND
Dr. White is the sole owner and provides medical
services as an employee of Brownsville Medical Clinic, P.A. His wife,
Claudia is a registered nurse who practices nursing at the clinics operated by
Brownsville Medical. The couple’s
daughter Margaret is a doctor who occasionally
performs services at one of the clinics owned by Brownsville Medical. The
couple’s son Eric is now a licensed pharmacy technician.
During the years at issue Dr. and Mrs. White owned
several other corporations including Brownsville Apothecary, Inc., a C
corporation, Cost Plus Pharmacy, Inc. an S corporation, and Diogenes,
Inc. which entered into a management agreement with Brownsville Medical and
Brownsville Apothecary. The agreement states that Diogenes "agrees to
furnish advisory and management expertise in all aspects of business to the
above."
EMPLOYEE BENEFIT PLANS
Xélan, the Economic Association of Health Professionals,
Inc. was part of a family of companies which provided its members with a
variety of insurance products. Dr. and Mrs. White became involved with xelan’s
419 plan. The xélan 419 plan was established in 1997 with a trust agreement
dated December 5, 1997, and was designed to be a "10 or more employer
plan" within the meaning of sections 419(e)(1) and 419A(f)(6)(B). xélan's
promotional materials described the xélan 419 plan as:
“[A]n employee welfare benefit plan providing
severance pay and pre-retirement death benefits to "C" corporation
employees through an institutionally trusteed multiple employer trust. * * *
The funding vehicle for the [xélan] 419 Plan is a specially designed life insurance
investment contract that meets the minimum death benefit corridor requirement
exceeding contract cash accumulations necessary to qualify the contract for tax
free earnings on cash accumulations. The [xélan] 419 plan is usually
administered as a 5-year funding plan and annual, deductible contributions of
up to 40% of corporate earnings for 5 years are permitted.”
Beginning sometime in March 1999 the law firm Williams
Coulson became legal counsel for the xélan 419 plan. Michael E. Lloyd, who
formerly served as a senior tax attorney for the Office of Associate Chief
Counsel, Employee Benefits and Exempt Organizations of the Internal Revenue
Service, participated in xélan-sponsored conferences for xélan financial
counselors, xélan advisory board members, client doctors, and special guests
and provided xélan with advice concerning, among other things, the xélan 419
plan. Lloyd also provided legal opinions for participants in the xélan 419 plan
but did not provide advice regarding or review the insurance products selected
by the xélan 419 plan, nor did he review or consider the employee census
submitted by employers to ascertain whether the employers were in compliance
with the xélan 419 plan requirements before issuing the opinion.
Typically, whenever a new participant signed up for
participation in the xélan 419 plan, xélan would request a legal opinion for
the participant from Williams Coulson. Upon receipt of the information from
xélan, Williams Coulson would prepare an opinion letter addressed to the
participant of the xélan 419 plan. The opinion letters were based upon general
facts and assumptions; if the facts and assumptions were not as stated in the
letter, then the opinion and conclusions would not apply. If xélan asked,
Williams Coulson would backdate opinion letters to make it appear that the
letters had been issued in a prior tax year.
xélan solicited new clients for its products by
mailing promotional flyers to doctors and by inviting them to attend xélan
seminars. At the seminars attendees heard presentations, were given sales
promotional materials, and "received recommendations for 'doctors only'
tax, asset protection and investment management programs that prevent losses to
unnecessary taxes".
As part of the seminar participants completed a xélan
Loss Test which was used to identify which xélan products and programs would be
most appropriate for the participant's use. The promoters indicated that one of
the key aspects of the xélan program was that it "eliminates income taxes
on earnings other than what you need to live on."
The philosophy and programs xélan offered were
extensively promoted via brochures and other promotional materials. xélan
maintained a Web site, which contained additional information about its
organization, philosophy, personnel, and programs. The mechanics and philosophy
of xélan were further explained via audio and video tapes provided to its
members.
xélan marketed the xélan 419 plan as part of its tax
reduction program. xélan's Program Summary described the xélan 419 plan as not
only a convenient method to reduce current taxable income while providing life
insurance, but also as a retirement investment vehicle. At the seminars the
xélan 419 plan was described as a "non-qualified retirement plan".
xélan's Program Summary states:
The significant economic and tax advantages of these
specially designed insurance industry "non modified endowment"
investment and death benefit contracts, as compared to traditional qualified
retirement plans, is the tax free receipt by the owners of retirement funding
distributions, the tax free receipt by the lender of death benefit proceeds
equal to the contract loans, and tax free receipt by named beneficiaries of the
leveraged death benefit proceeds exceeding contract loans. The 419 Plan
distributions may be administered pursuant to the plan agreement so that they
are received by the insurance investment contract owners in the form of tax free
and interest free loans. At the death of the contract owner, any funds borrowed
from the contract to finance lifestyle costs are repaid to the insurance
company lender with a portion of the tax free death benefit. Unborrowed
contract reserves actuarially guarantee a death benefit for doctors' family
members that exceeds any loan balance borrowed for retirement spending purposes
by the doctor during the doctor participant's lifetime. At the death of the
doctor-owner-insured, tax free death benefits are provided to surviving family
members, or other named beneficiaries including charitable institutions. * * *
Dr. White learned about xélan in 1999 when he attended
a xélan seminar conducted by David Cline, a xélan financial counselor and
Indianapolis Life insurance agent. Even though Diogenes was not incorporated
until August 13, 1999, on June 30, 1999, Dr. White signed a "Corporate
Resolution and Application to Participate in the xélan Welfare Benefit Trust
Program" (application) and Diogenes initially committed to fund the
program for at least five years at a fixed amount of $218,000 per year and to
pay xélan a $600 annual administration fee for as long as it participated in
the plan. As part of the application xélan was paid $2,500, which included a
one-time setup fee of $1,900 and a first year administration fee of $600.
On the census form the following individuals were
identified as Diogenes employees as of June 30, 1999:
Name
Date of birth Hire date1 W-2
Wages Hours worked
________________________________________________________
Dr.
White
11/7/45
1973
$700,000 2,000
Mrs. White
3/14/51
1976
118,000 2,000
Margaret
9/6/64
1997
5,000 1,000
Eric
5/12/84
1994 12,000 1,200
Editor’s Note: Eric was 10 years old
in 1994. From 1999 through 2003 Dr. White never had wages of $700,000 and
Mrs. White never had wages of $118,000 as employees of Diogenes. Neither
Margaret nor Eric ever worked 1,000 or 1,200 hours, respectively, for Diogenes.
For the years 2001, 2002, and 2003, Diogenes paid Dr. White wages of $15,000,
$15,000, and $30,000, respectively, and paid Mrs. White wages of $30,000,
$30,000, and $60,000, respectively. Neither Margaret nor Eric received any
wages from Diogenes during the years at issue.
Included in the setup fee was the cost of a tax
opinion letter. On June 30, 1999, Dr. White signed a "Certificate of
Diogenes Holdings, Inc." in order to obtain a legal opinion from Williams
Coulson regarding the tax consequences and risks associated with participating
in the xélan 419 plan. In the certificate Dr. White represented, among other
things, that the salaries of the employees of the corporation would not be
reduced because of the participation in the xélan 419 plan.
A legal opinion was provided by Lloyd to Dr. White
regarding the xélan 419 plan. In the legal opinion Dr. White was advised that
"The Opinions are directed solely to Xélan and
may be relied upon only by Xélan except that as part of our engagement with
Xélan, we have agreed to provide a copy of the Opinions to you in the form of
this letter" and that
"The Opinions provided in this letter are based
on the general fact pattern described below and documents which were provided
to us by Xélan. Accordingly, these opinions may not apply to your company to
the extent that your circumstances or the documents are different from those
described below."
Lloyd concluded the opinion letter by advising Dr.
White to call him if he had "any questions regarding the application of
the matters discussed in this letter to your specific case". Dr.
White did not contact Mr. Lloyd or Williams Coulson and did not separately
engage them or any other legal counsel to provide a legal opinion for Diogenes.
Dr. White did not compare the fact patterns described in the opinion letter
with the actual fact patterns of his business, and he sought counsel from
neither his former attorney nor his longtime C.P.A. Dr. White relied
"exclusively" upon the advice received from Mr. Cline and S.
Goldstein (On the advice of Cline, Dr. White used Goldstein & Associates to
prepare Diogenes' corporate tax returns for 1999 through 2003.)
As part of the xélan 419 plan, applications to
Indianapolis Life were prepared for Dr. and Mrs. White on June 30, 1999,
requesting the issuance of policies on each of them using an insurance product
known as the Executive VIP policy. The Executive VIP policy is "an excess
interest whole life plan" with its principal strategy such that the policy
"is initially purchased and owned by an entity other than the insured --
usually an employer or pension plan" and later "transferred to the
insured by gift or by sale."
According to Indianapolis Life, the Executive VIP
policy is targeted to executives, professionals, and business owners to address
customer needs for tax-favored retirement funds and for "[u]nlocking corporate
retained earnings." The Executive VIP policy purports to provide a
"[m]inimum fifth-year cash value to minimize tax on ownership
transfer" together with "[s]trong tenth-year cash value". The
policies were designed with a nine-year surrender charge period. However,
mortality and expense charges increase significantly in the eleventh year, and,
therefore, the Executive VIP policy provides for the exchange of the policy
after the 10th year without new evidence of insurability and without fees or
sales expense deductions from the cash value of the new policy. After an
exchange the new policy is a universal life policy and any existing loans are
automatically transferred. Following an exchange the loan values of the new
policy are available "without surrender charges, should you later choose
to make systematic withdrawals to provide retirement income."
The Executive VIP policies were front loaded with high
surrender charges to artificially suppress the value of the policies and
designed specifically as investment vehicles to be used to build cash
accumulations. Indianapolis Life described how the Executive VIP policy works
as follows:
Generally, a policy will be purchased and owned by a
corporation or individual which will pay premiums for five years. At the end of
the fifth year, the policy will be transferred or sold to the insured or
another entity. The recipient is responsible for any tax liability which may be
generated on the value of the policy at the time of receipt. (Relatively
speaking, this value will be minimal.)
Policy values may be used to pay premiums for the next
five years, if the policy has sufficient values (changes in current interest
rates, monthly expense and mortality charges may require additional
out-of-pocket premiums to keep the policy in-force). At the end of the policy's
tenth year, it is exchanged for a universal life policy and these values may be
used to generate cash flow for retirement, estate liquidity or other purposes.
The amount of insurance coverage purchased through the
xélan 419 plan was computed on the amount Dr. White had determined he wanted to
contribute to the xélan 419 plan, (revised downward to $200,000), and the
relative amounts of insurance Dr. White wished to purchase for each of his
family members. The insurance policies purchased for Dr. and Mrs. White had
face values equal to 3.905 times the amount of W-2 wages listed on the census
form signed by Dr. White. The insurance policies purchased for Margaret and
Eric had face values equal to approximately five times the amount of W-2 wages
listed on the census form. (As previously noted, the wages listed on the census
form were grossly overstated.)
In each of the years 1999, 2000, 2001, and 2002,
Diogenes paid $200,000 to the xélan 419 plan and the xélan 419 plan remitted
equivalent payments to Indianapolis Life.
Termination of the xélan 419 Plan
On May 29, 2003, the xélan 419 plan sent a letter to
Diogenes and Dr. White informing them that the trust had been terminated.
Enclosed with the termination letter were individual letters to Dr. White, Mrs.
White, Margaret, and Eric, notifying them of their options as insured
participants under the plan. The letters advised them that under the terms of
the xélan 419 plan all participants would be given an opportunity to purchase
the life insurance policies that were owned on their lives by the trust, and
that all policies not purchased would be surrendered.
Dr. and Mrs. White did not elect to
"purchase" the insurance policies acquired through the xélan 419 plan
because Dr. White did not trust the people he was dealing with and he wanted to
get the benefit of his original deal. Dr. White found it incredible that in
order to purchase his policy from the xélan 419 plan he would have to pay them
approximately $43,000 just to have them turn around and distribute the same
back to him. Rather, Dr. and Mrs. White decided to "transfer" the
insurance policies to a new plan, the “Millennium plan” (described below)
because Dr. White felt that it would allow him to complete the contract he
thought he had signed. Dr. and Mrs. White, Margaret, and Eric each signed a
"Participant's Voluntary Election and Direction of Plan to Plan
Transfer" by which they directed the xélan 419 plan to transfer their
insurance policies to the Millennium plan. On September 19, 2003, the xélan 419
plan sent letters to Dr. and Mrs. White, Margaret, and Eric confirming that
their requests to transfer their Indianapolis Life policies to the Millennium
plan had been processed.
The Millennium Plan
Millennium Marketing Group, L.L.C. formed in 2002 by
Norman Bevan and Scott Ridge to sponsor the Millennium plan.
The Millennium plan provides eligible employees of
participating employers with pre- and post-retirement death benefits and other
pre- and post-retirement welfare benefits, the latter including medical expense
reimbursement, disability benefits, and in certain limited circumstances
involuntary severance benefits. In 2003 the plan also provided a benefit in the
case of "hardship".
The General Product Information Guide is a marketing
brochure describing the Millennium plan. The Guide indicates that the
Millennium plan allows participating employers to fund valuable welfare
benefits for employees without having to limit deductions to current costs and
to fund pre- and post-retirement death, life, medical, and disability benefits
through the Millennium plan and presently deduct contributions for that
purpose. Under the Millennium plan "Employers select the employees they
want to become participants and they determine the targeted level of Death
Benefit and Life Benefits for each participant. Employers choose their
investment risk, by selecting the insurance product type (fixed, indexed or
equity) to insure the selected benefits."
Diogenes acknowledged and warranted that it had not
relied upon any legal or tax advice of the sponsor, the committee, the
third-party administrator, the underwriter, the trustee, or any agent of these,
in executing the adoption agreement. In fact, Diogenes elected not to seek an
individualized legal opinion pertaining to the Federal tax issues that may have
arisen from participation in the Millennium plan.
On November 20, 2006, Dr. and Mrs. White and Diogenes,
along with nine other plaintiffs, joined a lawsuit against Indianapolis Life
and Mr. Cline accusing Indianapolis Life and Mr. Cline of fraud, negligent
misrepresentation, breach of common law fiduciary duty, and breach of insurers'
duty of good faith with respect to their role in the promotion, marketing, and
participation in employee benefit plans funded with life insurance.
COMMENT:
Code Section 419(a) generally allows a deduction for
an employer's contributions paid or accrued to a welfare benefit fund but only
if they are otherwise deductible. Section 419(b) further limits the
deductibility of an employer's contributions to a welfare benefit fund to the
fund's qualified cost for the taxable year. Section 419A(f)(6), however,
provides that contributions paid by an employer to a multiple-employer welfare
benefit fund are not subject to the deduction limitation of section 419(b).
More specifically, to be deductible, contributions to
a 419A(f)(6) plan must be “Ordinary and Necessary” Business Expenses.
This means the taxpayer must prove that the item was:
(1) paid or incurred during the taxable year;
(2) for carrying on his, her, or its trade or
business;
(3) an expense;
(4) a necessary expense; and
(5) an ordinary expense."
Dr. and Mrs. White argued that Diogenes' contributions
to the xélan 419 plan and the Millennium plan satisfied the requirements of
section 162 and are thus deductible under section 162(a). They also contended
that the contributions were paid to a fund for the benefit of employees, were
intended to only directly benefit the employees, and were paid in amounts
reasonably based upon the services the company expected to receive from its
employees.
The IRS countered that although employers are
generally not prohibited from funding term life insurance for employees and
deducting the premiums paid as business expenses under section 162(a),
employers are not allowed to disguise investments in life insurance as
deductible benefit-plan expenses when the investments accumulate cash value for
the employees personally.
EDITOR’S NOTE:
Diogenes may have arguably been entitled to deduct the
costs of current life insurance protection for term life insurance but such
deductions were never requested.
The Tax Court has denied deductions for contributions
to plans similar to the xélan 419 plan and the Millennium plan under section
162(a) in at least four previous cases: Neonatology Assocs.,(Employee Benefits
and Retirement Benefits Newsletter # 129) V.R. DeAngelis M.D.P.C. v.
Commissioner (Estate Planning Newsletter # 1214), Curcio v. Commissioner
(Estate Planning Newsletter #1667), and Goyak v. Commissioner.
NEONATOLOGY:
In Neonatology, Neonatology Associates substantially
overpaid the VEBA for term life insurance. The Court found
"incredible petitioners' assertion that the employee/owners of Neonatology
* * * would have caused their respective corporations to overpay substantially
for term life insurance with no promise or expectation of receiving the excess
contributions back." Because the plan participants could retrieve their
policies from the plan, the Court concluded that "the purpose and
operation of the Neonatology Plan * * * was to serve as a tax-free savings
device for the owner/employees and not, as asserted by petitioners, to provide
solely term life insurance to the covered employees." The portions of the
contribution that exceeded the cost of term life insurance were found to be
"nondeductible distributions of cash for the benefit of their
employee/owners and do not constitute ordinary or necessary business
expenses."
DeANGELIS:
In V.R. DeAngelis M.D.P.C., a partnership named
VRD/RTD enrolled in what purported to be a multiple-employer supplemental
benefit plan and trust (STEP). The STEP was supposed to provide eligible
employees with severance, and, if elected, life insurance benefits. Each year
the partnership deducted the full amount of its contribution to the plan in
that year as an ordinary and necessary business expense under section 162(a),
and the plan invested the contributions in whole life insurance policies that
accumulated cash for the doctors personally. The Court found that
The insurance premiums at hand pertained to the
participating doctors' personal investments in whole life insurance policies
that primarily accumulated cash value for those doctors personally. * * *
The use of whole life insurance policies and the
direct interactions between the participating doctors and the STEP plan
representatives support our finding that the participating doctors in their
individual capacities fully expected to get their promised benefits and that
any receipt of those benefits was not considered by anyone connected with the
life insurance transaction to rest on any unexpected or contingent event. Each
whole life insurance policy upon its issuance was in and of itself a separate
account of the insured doctor, and the insured (rather than the STEP plan)
dictated and directed the funding and management of the account and bore most
risks incidental to the account's performance. The STEP plan in essence and in
operation was simply an aggregation of separate plans for the participating
doctors and not, as petitioners claim, one single plan in which various
employers participated. * * *
The Court concluded that the contributions by VRD/RTD
to the STEP plan were distributions to the partners and were not ordinary and
necessary business expenses under section 162(a).
The facts in White are similar to those of Neonatology
and V.R. DeAngelis M.D.P.C. The Indianapolis Life policies purchased with the
contributions to the xélan 419 plan in 2001 and 2002 and to the Millennium plan
in 2003 were nothing more than Dr. and Mrs. White's personal investment in
whole life insurance policies that primarily accumulated cash value for Dr. and
Mrs. White personally. Dr. White worked with Cline to develop an investment
amount and strategy that was suitable to Dr. White. Dr. White determined the
amount of contribution and coverage for himself, his spouse, and his children.
Moreover, Dr. and Mrs. White believed that the investment would be "tax
free in, tax free out". Dr. White knew the investment was into a cash
value life insurance product and expected that, in addition to tax savings, his
after-tax return on investment would equal or exceed the amount that would have
to be contributed. The cash value of the insurance policies was suppressed
during the initial years with high surrender charges. In 2003 when the xélan
419 plan terminated the "cash value" of the policies was approximately
$127,000 but the total "accumulation value" was $642,220.87.8 Dr.
White's decision to transfer the policies to the Millennium plan after the
termination of the xélan 419 plan was to continue his original investment plan
in order to "salvage the $800 thousand that * * * [he] had already pumped
into Xélan."
The xélan 419 plan permitted Diogenes to terminate its
participation and to withdraw from the plan at any time. Upon termination, the
underlying insurance policies could be distributed to the participating
employees. Dr. White had complete control over Diogenes and thus had the
ability to cause the policies to be distributed.
In 2003 when the xélan 419 plan terminated, Dr. White
was presented with the option of receiving the policies by
"purchasing" the policies or transferring them to Millennium. He was
told that if he chose to purchase the policies he would have to pay the xélan
419 plan approximately $43,000, but that the $43,000 would be returned to him.
Since by then Dr. White no longer trusted xélan, he chose to have the policies
transferred to Millennium.
The Millennium plan was selected by Dr. White to
continue his original investment plan, and its operation was similar to that of
the xélan 419 plan. While there were subtle differences in the insureds'
ability to have the underlying insurance policies distributed to them upon the
employer's termination of participation, it is clear from the record that
Millennium, at least through 2006, was willing to allow Dr. White and Diogenes
to "void" their participation in the Millennium plan and have the
underlying insurance policies returned to them.
The Tax Court concluded, as it did in the previously
cited cases, that Diogenes' contributions to the xélan 419 plan in 2001 and
2002 and to the Millennium plan in 2003 were payments on behalf of Dr. and Mrs.
White personally and were not ordinary and necessary business expenses. Because
of this holding, the Court found it unnecessary to decide whether the
contributions were subject to and limited by the rules of section 404(a)(5) or
whether the arrangement was a welfare benefit fund to which the exceptions
under section 419A(f)(6) apply.
CONSTRUCTIVE DIVIDENDS:
Code Section 301 provides that funds (or any other
property) distributed by a corporation to a shareholder over which the
shareholder has dominion and control are taxable to the shareholder as a
dividend – but only to the extent of the corporation's earnings and
profits."
Dr. White was the 100% owner and only shareholder of
Diogenes. Diogenes' contributions to the xélan 419 plan in 2001 and 2002 and to
the Millennium plan in 2003 conferred an economic benefit on Dr. and Mrs.
White. Dr. and Mrs. White always had the ability to terminate Diogenes'
participation in the xélan 419 plan, which would have resulted in the
distribution of the Indianapolis Life policies to Dr. and Mrs. White. Thus, the
policies were always available for distribution. According to the Tax Court,
the $200,000 annual contributions made by Diogenes were constructive distributions
of cash rather than payments of ordinary and necessary business expenses, and
there is no indication that Diogenes expected any repayment of the cash
underlying the conferred benefit.
After disallowing the deductions for its
"contributions" to the xélan and Millennium plans, Diogenes had
earnings and profits of at least $200,000 during each of the years in issue and
so the Tax Court sustained the IRS’s determination that the distributions are
taxable dividends to Dr. White.
ACCURACY-RELATED PENALTIES:
The IRS met its burden of proof when it showed that
Dr. and Mrs. White caused Diogenes to improperly deduct hundreds of thousands
of dollars used to purchase cash-accumulating whole life insurance policies
which could later be distributed to Dr. and Mrs. White for free or for a small
fraction of the value of the insurance policy. According to the Court, this was
enough to indicate that it is appropriate to impose accuracy-related penalties.
Under accuracy-related penalty rules, there is a
substantial understatement of income tax for any taxable year in the case of a
corporation other than an S corporation or a personal holding company (as
defined in section 542), if the amount of the understatement for the taxable
year exceeds the greater of 10% of the tax required to be shown on the return
for the taxable year, or $10,000. The understatements of tax on both Dr. and
Mrs. White's Federal income tax returns and on Diogenes' corporate tax returns
are substantial.
REASONABLE CAUSE?
Dr. White argued there was both reasonable cause and
substantial authority for the deduction of contributions to the xélan 419 plan
and the Millennium plan. But was there?
"Reasonable cause requires that the taxpayer have
exercised ordinary business care and prudence as to the disputed item."
The reasonable cause requirement may be met upon a
showing of good-faith reliance on the advice of an independent, competent
professional as to the tax treatment of an item. But reliance on an opinion or
advice must be based upon all pertinent facts and circumstances and the law as
it relates to those facts and circumstances.
To be reasonable, the professional tax advice must
generally be from a competent and independent adviser unburdened with a
conflict of interest and not from promoters of the investment. "Courts
have routinely held that taxpayers could not reasonably rely on the advice of
promoters or other advisers with an inherent conflict of interest such as one
who financially benefits from the transaction."
Here, the Court notes, Dr. White did not seek
independent advice regarding the deductibility of the contributions to the
xélan 419 plan or the Millennium plan. He relied on the advice of Cline and
Lloyd. Cline was associated with xélan and involved in promoting the xélan 419
plan for his personal benefit and gains. As to Mr. Lloyd, Dr. White did not
hire him nor pay for the opinion letter he wrote; rather, xélan did. The
opinion letter stated that Mr. Lloyd's law firm, Williams Coulson, had been
engaged by xélan to prepare the opinion letter, that it was directed solely to
xélan, and that it could be relied upon solely by xélan.
When the xélan 419 plan terminated and the
Indianapolis Life policies were made available to Dr. and Mrs. White, the only
person they consulted was Cline. Cline's advice was relied upon by Dr. and Mrs.
White in choosing to transfer the policies to the Millennium plan in 2003.
Accordingly, the Tax Court held the Whites did not act
with reasonable cause and in good faith when they entered into the xélan 419
plan and the Millennium plan relying primarily, if not solely, upon the advice
of promoters and other interested parties that stood to benefit financially
from the transactions.
WAS THERE SUBSTANTIAL AUTHORITY FOR DR. WHITE’S
POSITION?
The amount of an understatement is reduced by that
portion of the understatement which is attributable to: (1) the tax treatment
of any item by the taxpayer if there is or was substantial authority for such
treatment, or (2) the taxpayer's adequately disclosing relevant facts in the
return or in a statement attached to the return, with a reasonable basis for
the tax treatment of such item by the taxpayer.
Only the following are authority for purposes
determining whether there is substantial authority for the tax treatment of an
item:
· Applicable
provisions of the Internal Revenue Code and other statutory provisions;
· proposed,
temporary and final regulations construing such statutes;
· revenue
rulings and revenue procedures;
· tax
treaties and regulations and Treasury Department and other official
explanations of such treaties;
· court
cases;
· congressional
intent as reflected in committee reports,
· joint
explanatory statements of managers included in conference committee reports,
and floor statements made prior to enactment by one of a bill's managers;
· General
Explanations of tax legislation prepared by the Joint Committee on Taxation
(the Blue Book);
· private
letter rulings and technical advice memoranda issued after October 31, 1976;
· actions on
decisions and general counsel memoranda issued after March 12, 1981 (as well as
general counsel memoranda published in pre-1955 volumes of the Cumulative
Bulletin);
· Internal
Revenue Service information or press releases; and notices, announcements and
other administrative pronouncements published by the Service in the Internal
Revenue Bulletin.
TAXPAYERS HAD PLENTY OF WARNING IN PLENTY OF TIME:
In 1999 when Dr. and Mrs. White and Diogenes began
their participation in the xélan 419 plan, the Court had already issued Booth
v. Commissioner, 108 T.C. 524 (1997), and the IRS had issued Notice 95-34,
1995-1 C.B. 309. In Booth the Court did not impose an accuracy-related penalty
because the question of whether the Prime Plan was within the scope of section
419A(f)(6) was at the time a novel question.
In Notice 95-34 the IRS provided guidance on the tax
problems raised by certain trust arrangements in seeking to qualify for
exemption from section 419.
Furthermore, before any of the years at issue, the Tax
Court had issued Neonatology Assocs., P.A. v. Commissioner, 115 T.C. 43.
So the Court concluded that there was not substantial
authority supporting the deductions for the contributions to either the xélan
419 plan or the Millennium plan.
Life insurance is certainly one of the single most
important and useful of all estate planning tools! But it can – and
unfortunately all too often is – abused! As incredible as life insurance
is and as amazing as its tax benefits can be if it is properly arranged, life
insurance planning must follow the laws of tax gravity. Clients must understand
that - even with life insurance – there is no free lunch!
HOPE THIS HELPS YOU HELP OTHERS STAY OUT OF HARM’S
WAY!
419 plan promoters and insurance companies selling product
to 419 welfare benefit plans had noticed going back as far as 1995 that the IRS
would take action. When an insurance company is sued and they alleged that the
policyholder signed a disclaimer, that disclaimer is in fact false because the
insurance company failed to disclose potential IRS problems with 419 plans.
This excellent article by Steve Leinberg which was published years
ago is one of many indications of the above fact.
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