IRS Attacks Use of Cash Value Life Insurance by Welfare Benefit Funds, Designates New Listed Transaction Category for Such Funds

Employee Benefits Alert

On October 17, the IRS issued Revenue Ruling 2007-65 and Notices 2007-83 and 84, which take aim at arrangements involving investment by welfare benefit funds (e.g., VEBAs and taxable trusts) in cash value life insurance policies, and which designate as listed transactions certain arrangements claiming treatment as welfare benefit funds under section 419(e) that pay premiums on such policies.

Although the apparent focus of the IRS’s concern is certain abusive welfare benefit fund arrangements that have been promoted to closely held businesses, involving an accumulation of excess values in the fund that are later diverted to business owners and key employees, the impact of the IRS attack, including the reach of the new listed transaction designation, will be felt more broadly. As a result, all companies whose VEBAs or other welfare benefit funding arrangements include the use of cash value life insurance will need to review their tax treatment under these guidance items carefully to determine whether the arrangements are listed transactions or are otherwise affected by the Service’s interpretation of the welfare benefit fund deduction rules -- and react appropriately.

Rev. Rul. 2007-65: Limitation on Deductions for Employer Contributions Used to Purchase Cash Value Life Insurance Policies. The basic legal argument for the three-part IRS attack is found in Rev. Rul. 2007-65, which addresses the employer’s deductions under the welfare benefit fund qualified cost rules with respect to premiums paid by the fund on cash value life insurance policies. The Ruling addresses two alternative situations where the fund invests in such policies on the life of each employee.

In Situation 1, the welfare benefit fund provided life insurance coverage qualifying as group term life insurance through a taxable trust. The trust had used company contributions to obtain a cash value policy on the life of each covered employee where the amount of the death benefit under each such policy was payable to the beneficiary designated by the employee. The trust retained all other rights in the policy. Except for the life insurance coverage, no other benefit was provided under the plan or the trust.

In Situation 2, the facts were similar with respect to the investment by the trust of company contributions in cash value life insurance policies. However, in Situation 2, instead of group term life insurance benefits, the plan provided disability benefits to current employees. In this situation, the trust was the owner of the policies in all respects; investment in the policies was intended as a source of funding disability benefits; the employees had no interest in the policies.

The essential holding of the ruling is that, in both Situation 1 and Situation 2, the employer may not deduct its cash contributions to the trust which correspond to the premiums paid by the trust for the purchase of cash value life insurance as qualified direct costs of a welfare benefit fund under section 419. The justification given for this holding is that, in both situations, the trust or employer is, in fact, the direct or indirect beneficiary of the policies and, therefore, any employer contributions used to pay such premiums are not deductible under section 264(a)(1). Section 264(a)(1) provides that no deduction is allowable for premiums on any life insurance policy, or endowment or annuity contract, if the taxpayer is directly or indirectly a beneficiary under the policy or contract. The IRS then points to section 419(c)(3) and to Q&A-6(c) of Temp. Reg. § 1.419-1T, which exclude from the qualified direct cost of a welfare benefit fund expenditures that would not have been deductible if they had been made directly by the employer. As an example of such an expenditure, the regulations provide that a fund’s purchase of land for an employee recreational facility would not be treated as a direct qualified cost, because the purchase would not have been deductible under section 263 if made directly by the employer.

The IRS also points to the history of the legislation that enacted section 419, the Deficit Reduction Act of 1984 (Pub. L. No. 98-369). In its explanation of “qualified direct cost,” the House Report states that other rules that generally limit deductions are also “passed-through” under the bill to limit deductions with respect to fund contributions. An example is given of fund expenditures for life insurance that would not have been deductible under section 264 if made directly by the employer. H.R. Rep. No. 432, 98th Cong., 2d Sess. at 1277-78 (1984). Based on these authorities, the IRS ruled in Situation 1 that the trust’s qualified direct cost for the taxable year did not include any amounts paid for premiums on the cash value life insurance policies paid by the trust. The ruling points out that this result would hold whether the plan benefits were provided through a VEBA or other type of welfare benefit fund or if the plan were a split-dollar arrangement. Furthermore, the ruling states that the same holding would apply even if the death proceeds were payable to the trust for the plan for the benefit of the employees’ beneficiaries. In contrast to Situation 2, discussed below, the IRS seems to indicate in Situation 1 that the employer would also not be allowed to deduct as qualified direct costs of the welfare benefit fund the amount of death benefits paid by the trust. Thus, it appears that the IRS is contending implicitly that the employer in Situation 1 will never be able to deduct its contributions. See and compare, however, Gibson & Roberts v. United States, 10 AFTR 2d 5451 (DC-WA), 08/17/1962 (amounts paid by taxpayer corporation to widow of deceased employee are deductible when paid by the corporation pursuant to an employment agreement even though funded by insurance. The corporation owned the policies and all incidents of ownership).

The IRS cited Rev. Rul. 70-148, 1970-1 C.B. 60 in support of its conclusion that section 264(a)(1) is applicable. However, this reliance may be questionable, at least in the case of contributions to a VEBA trust, since such contributions may not be returned to the employer and may only be used to provide plan benefits to employees. Rev. Rul. 70-148, in contrast, involved the direct purchase of life insurance policies whereby the employer expressly reserved the exclusive right to terminate the policies and in such instance was an indirect beneficiary under the policies within the meaning of section 264(a)(1). In this regard, note that in a fairly recent Technical Advice Memorandum the IRS found no agency, conduit or other relationship to attribute premium payments of a VEBA on cash value insurance policies to the employer, so that the employer was not viewed as paying the insurance premiums within the meaning of Reg. § 1.264-1(a). Accordingly, the employer was not prevented under section 264(a)(1) from deducting its contributions to the VEBA that were used to purchase the cash value life insurance policies, a conclusion that seems at odds with Rev. Rul. 2007-65. TAM 200511015, 03/18/2005. Perhaps the key issue, therefore, is whether the limitation on employer deductions under section 264 is properly “passed-through” in this situation if an employer has no right to obtain any economic benefit from a cash value life insurance policy held by a VEBA other than the provision of death benefits to employees’ beneficiaries under the plan.

The IRS reaches the same conclusion in Situation 2 with respect to the treatment as qualified direct costs of the employer contributions corresponding to premium payments by the trust. However, because the benefit under the plan was other than life insurance coverage, the IRS ruled that the employer would be allowed to treat as a qualified direct cost of the trust for the taxable year the disability benefits paid by the trust for the year. Moreover, according to the IRS, a portion of the employer’s contributions might also be deductible as an addition to a qualified asset account for disability claims incurred but unpaid as of the close of the year. The IRS also pointed out that the conclusions of Situation 2 would be the same if the benefits under the plan were uninsured medical benefits.

Effective date of Rev. Rul. 2007-65. The IRS purports to give the ruling prospective application, but with a big “catch.” The ruling is generally effective for taxable years ending on or after November 5, 2007, e.g., starting with calendar year2007. For any taxable year of an employer ending before November 5, 2007, if a deduction is otherwise allowable, then, subject to an important limitation, IRS will not completely disallow the deduction. The allowable portion of the deduction in such event is the amount that was reported (or would have been reported but for the exclusion under section 79) by the employer as the cost of insurance on the employee’s Forms W-2 for that year. Thus, the ruling will have retroactive effect to open back years to the extent that the deduction exceeded the amounts that were reported by the employer as employee compensation on the W-2 (or were otherwise excludible under section 79).

Notice 2007-83. Notice 2007-83, like the revenue ruling, addresses the tax treatment of certain trust arrangements that utilize cash value life insurance policies to provide welfare benefits such as death benefits, disability benefits, and severance benefits, to active employees, where the trust arrangements are ultimately terminated in such a way as to shift a substantial portion of the trust assets to the business owners and key employees. The Notice states that promoters of such arrangements claim that the employer is allowed a deduction for its contributions which are used by the trustee to fund the cash value policies, even though such contributions are not fully includible as income by the covered employees. According to the IRS, it is also sometimes claimed that the distribution of policies on termination to the business owners or key employees is not taxable because the employee has purchased the policy even though the IRS asserts that the amount paid for the policy is significantly less than the value of the policy. The Notice indicates that the IRS intends to challenge the tax benefits purportedly achieved under these arrangements.

According to the Notice, the IRS may attack such arrangements on a number of possible grounds. For example, the IRS may assert: that contributions to the trust on behalf of a shareholder-employee constitute dividend income to that person; that the arrangement is a plan of deferred compensation under section 404(a)(5) that is also subject to section 409A, resulting in immediate inclusion of income and additional taxes to the employee, as well as employment tax liabilities to the employer; or that the arrangement is a split-dollar insurance arrangement subject to Treas. Reg. § 1.61-22, under which the employee must include the full value of the economic benefits provided under the arrangement for the taxable year without a corresponding employer deduction.

The IRS further indicates that if the arrangement is properly characterized as a welfare benefit fund under sections 419 and 419A, it will nevertheless assert that no deduction is allowed to the employer for contributions to the fund if the fund or the employer is directly or indirectly a beneficiary of the policies within the meaning of section 264(a)(1), applying the reasoning of Situations 1 and 2 of Rev. Rul. 2007-65, as discussed above. Finally, the IRS indicates that it may also challenge the values of property distributed from the trust.

Listed Transactions. Unfortunately, the IRS has seen fit to cast the net of “listed transactions” for purposes of Treas. Reg. § 1.6011-4(b)(2) and sections 6111 and 6112 much more broadly than would follow from the promoted transactions described in the Notice. In effect, the IRS sweeps in virtually any welfare benefit plan arrangement -- of both of large and closely-held employers -- that invests in cash value policies where the employer has taken excessive deductions as generally measured by the deduction rules set forth in Rev. Rul. 2007-65. As a result, taxpayers sponsoring welfare benefit funds investing in cash value insurance may need to disclose their participation in these transactions, and promoters (or other persons responsible for registering tax shelter transactions) may need to cause the transactions to be registered. In addition, material advisors must maintain lists of investors and other information with respect to these listed transactions.

More specifically, a transaction that has all of the following elements (or is substantially similar thereto) is a listed transaction:

(1) The transaction involves a purported welfare benefit fund.

(2) The plan is a single employer (rather than a collectively bargained) plan for deduction purposes.

(3) The fund pays premiums on one or more cash value life insurance policies (or similar side fund cash value life insurance arrangement).

(4) The employer deducted its contributions to the fund for any taxable year with respect to benefits provided under the plan (other than post-retirement medical or life insurance benefits and child care facilities) in an amount that exceeds the sum of:

(a) For uninsured benefits provided under the plan,

(i) claims incurred and paid during the taxable year;

(ii) the reserves for claims incurred but unpaid at year end under section 419A(c)(1) and for SUB or severance pay benefits under section 419A(c)(3);

(iii) amounts paid during the taxable year to satisfy prior-year claims (if not previously deducted); plus

(iv) amounts paid during the taxable year or a prior taxable year for administrative expenses attributable to uninsured benefits that are properly allocable to the taxable year (if not previously deducted);

(b) For insured benefits provided under the plan,

(i) insurance premiums paid during the taxable year that are properly allocable to the taxable year (other than premiums for cash value insurance policies described in (3) above);

(ii) insurance premiums paid in prior years that are properly allocable to the taxable year (other than premiums for cash value insurance policies described in (3) above); plus

(iii) amounts paid during the taxable year or a prior taxable year for administrative expenses attributable to insured benefits that are properly allocable to the taxable year (if not previously deducted);

(c) For taxable years ending prior to November 5, 2007, the greater of :

(i) the aggregate amounts reported as the cost of insurance with respect to the cash value policies described in (3) on the employees’ Forms W-2 (or 1099) for the year plus the amount that would have been includible but for the section 79 exclusion; and

(ii) with respect to each employee insured under a cash value policy, the aggregate cost of insurance charged under the policy or policies with respect to the amount of current life insurance coverage provided to the employee under the plan (limited to the product of the current life insurance coverage under the plan multiplied by the current year’s mortality rate in the higher of the 1980 or 2001 CSO Table); and

(d) the additional reserve for medical benefits under section 419A(c)(6) (if not previously deducted) provided by a bona fide association (as defined in section 2791(d)(3) of the Public Health Service Act (42 U.S. 300gg-91(d)(3)).

As should be readily apparent, the listed transaction elements outlined above are closely geared to Rev. Rul. 2007-65 and do not depend upon the small business features otherwise described in Notice 2007-83. Though companies (large and small) will want to review these elements and make appropriate calculations in conjunction with their tax counsel and actuaries, it appears that any company that deducts (or has in the past deducted) its welfare benefit fund contributions with reference to the fund’s premium cost on cash value life insurance may run afoul of this criteria and find that it has engaged in a listed transaction.

Notice 2007-84. In this Notice the IRS addresses trust arrangements that are being promoted to and used by small businesses to avoid income taxes through abuses of the welfare benefit rules of sections 419 and 419A with respect to the provision of post-retirement medical and life insurance benefits to employees. Contrary to the potentially broad reach of Notice 2007-83, the abuses addressed and dealt with in this Notice appear to be limited to the promoted small business arrangements described in the Notice. That is, Notice 2007-84 describes purported welfare benefit funds that are claimed to provide nondiscriminatory post-retirement medical and life insurance benefits through advance funding, which may or may not involve funding through cash value life insurance policies, but that, in operation, typically provide benefits only to the sponsor’s owners (or other key employees) and frequently in operation divert excess benefits to the owners or key employees through the medium of loans, other permissible benefits, or distribution on termination.

According to the IRS, those promoting these arrangements usually claim that the contributions to the fund are tax-deductible under sections 419 and 419A as additions to a qualified asset account in the nature of a retired lives reserve, and with no corresponding income inclusion by the owner (or key employee). As noted by the IRS, many of these single-employer plan arrangements involve plans that had previously claimed to be 10-or-more employer plans under section 419A(f)(6) and that were thwarted by Notice 95-34, 1995-1 C.B. 309. The IRS also asserts that the amounts of employer contribution are frequently based upon unreasonable assumptions that all of the covered employees will receive post-retirement benefits under the plan or based upon unreasonable actuarial assumptions.

The IRS states in the Notice that it intends to challenge these arrangements on various grounds, many of which are the same grounds outlined in Notice 2007-83 against cash value insurance arrangements involving closely-held businesses, including asserting: that contributions to a purported welfare benefit fund on behalf of an owner may be dividends or deferred compensation subject to sections 404(a)(5) and 409A; and that the arrangement may be subject to the rules for split-dollar arrangements. In addition, the Notice indicates that the IRS may attack the arrangements on their use of unreasonable actuarial assumptions, including violation of the limitation on funding future increases in medical costs and the $50,000 limit on life benefits; failure to meet nondiscrimination requirements; failure to establish a true retired lives reserve; application of the tax benefit rule; challenges to the valuation of distributed assets; and applicability of the 100% excise tax under section 4976 on disqualified benefits.

For further information, please contact any of the following lawyers:

Fred Oliphant,, 202-626-5834

Lee Spence,, 202-626-5965

Adrian Morchower

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