The United District Court for the Western District of Wisconsin found that the taxpayer and his S Corporation had participated in a listed transaction requiring disclosure for four years in the case of Vee’s Marketing, Inc. v. United States, Docket No. 3:13-cv-00481.
Generally a taxpayer must file a Form 8886 for each year the taxpayer participates in a transaction that is the same or substantially similar to one the IRS has identified as a listed transaction. A failure to file the report will trigger a penalty, regardless of whether the taxpayer actually is found to have a deficiency arising from the transaction, in the amount of 75% of the tax savings claimed on the return based on the transaction.
However a penalty can never be less than $5,000 (for a natural person) or $10,000 (for any other entity). There is also a maximum penalty provided of $100,000 for a natural person and $200,000 for any other entity.
The transactions in this case were for contributions to a purported 10 or more employer welfare benefit plan exempt from tax under IRC §419A(f)(6). Such a program, if it complies with the requirements of federal tax law, would grant the employer a deduction for the amount of contributions to the program without triggering a current tax on the employee participants.
The IRS became concerned regarding promotion of what it considered to be abusive arrangements claiming to meet the requirements for such plans.
As the Court noted:
As the IRS explains in Notice 95-34, it published the notice after becoming aware that promoters were offering trust arrangements purporting to satisfy the requirements for a 10-or-more employer welfare benefit fund exemption from income tax under 26 U.S.C. § 419A(f)(6), but falling short of the requirements for exemption under the statute. The Notice was intended "to alert taxpayers and their representatives to some of the significant tax problems that may be raised by these arrangements." Id. It warned of two factors that would prevent contributions to such arrangements from qualifying for tax exemption: contributions in excess of 10 percent of the total contributions by a single employer in the multi-employer group and experience rating with respect to individual employers. Notice 95-34.
The IRS argued in this case that the program triggered the second factor—it was experience rating with respect to individual employers.
The taxpayer contended that the program it had invested in was not the program described in the notice nor one substantially similar to it. However the Court found, looking at the description of the ten warning factors found in the notice, that the taxpayer’s program was effectively the program described in the notice.
The Court described how the first warning factor applied to the plan as follows:
To begin, the contributions of participants in the Trust were "typically invested in variable life or universal life insurance contracts." Both the MONY Life and the Fidelity Security insurance contracts were universal life insurance contracts, that is, insurance contracts in which the term insurance element is separate from the savings element and the premiums are flexible, so that in any given year, the cost of the premium may be paid out of savings, depending on the earnings in that account. These policies accumulated a reserve, as Scott Vee's did; they had flexible payments; and they were described by the issuers as universal life insurance policies.
For the second warning sign the Court noted:
Participation in the plan "require[d] large employer contributions relative to the cost of the amount of term insurance that would be required to provide the death benefits under the arrangement." Plaintiff's first year contribution to the CJA Plan was $165,000, which was far in excess of the $5400 cost of term insurance for the first year.
Continuing to run into trouble with each warning sign, the Court noted:
"The trust own[ed] the insurance contracts." In this case, the Trust owned the insurance contracts paid for by participants in the Plan.
Next up was access to cash value:
The trust administrator (CJA) could "obtain the cash to pay benefits, other than death benefits, by such means as cashing in or withdrawing the cash value of the insurance policies." As the evidence at trial showed, the Trust, acting through CJA, withdrew cash from Scott Vee's accumulation account on at least four occasions. It withdrew cash from Scott Vee's accumulation account at MONY Life to pay Vee's term insurance premiums in 2008; it withdrew approximately $165,000 from Vee's accumulation account at MONY to fund a new accumulation account at Fidelity Security; and it paid Vee $400,000 as a settlement for his claims against CJA. When marketing the Trust, CJA touted the ability of participants to withdraw funds before death, such as through viatical settlements that CJA would help arrange. (A viatical settlement is "an agreement by which the owner of a life insurance policy that covers a person (as the owner) who has a catastrophic or life-threatening illness receives compensation for less than the expected death benefit of the policy in return for a turning over (as by sale or bequest) of the death benefit or ownership of the policy to the other party (as a company specializing in such transfers)." M-W.com (visited May 20, 2015).)
Virtual assurance of receiving benefits also existed in the plan:
"Although in some cases, benefits may appear to be contingent on the occurrence of unanticipated future events, in reality, most participants and their beneficiaries will receive their benefits." To receive the value of his life insurance policy, Scott Vee did not have to die before his normal retirement age or become disabled; he was assured of receiving the value of his million dollar life insurance policy so long as his premiums were paid. Plaintiff never introduced any evidence to indicate that any participant in the Trust did not receive the benefits for which the participant had paid.
Separate accounts were also a feature of the program:
"The trusts often maintain separate accounting of the assets attributable to the contributions made by each subscribing employer." Defendant introduced extensive evidence of CJA's ability to learn the balance of any subscribing employer; plaintiff introduced no evidence to rebut this evidence or to suggest that the trust was not set up to segregate the accounts of individual employers (or of the individual employees of the same employer.).
The plan also tied benefits for employees specifically to the amount contributed by their employer:
Benefits are sometimes related to the amounts allocated to the employees of the participant's employer." The CJA Plan was set up to achieve this purpose: the benefits were designed to relate exactly to the amounts allocated to the employees of the participant's employer.
The Court concludes:
In short, the trial evidence showed that CJA's Affiliated Employers Health & Welfare Trust was an aggregation of separate plans maintained for individual employers that were experience-rated with respect to individual employers, that is, they were structured so as to assure each employer that its contributions would benefit only its own employees. The money that participating employers paid into the Plan bought insurance for only their own employees; there was no pooled risk.
I conclude that plaintiff has failed to show that the Affiliated Employers Health & Welfare Trust in which it participated was not the same or substantially similar to the arrangement described in Notice 95-34.
Advisers should be aware that promoters of such programs still exist and almost always claim their program is “nothing like” the one described in Notice 95-34. However, all too often a comparison of the program with the list of 10 warning signs will quickly show that the program is not only “substantially similar” to the one described in Notice 95-34, but quite likely appears to be a textbook example of the same.
Adviser should also note that these programs are promoted not to the Fortune 500, but rather to small, closely held businesses—and, in fact, they are the only entities to which the sales pitch would make sense. Thus the issue of “reportable” and “listed” transactions is not simply one that only needs to be worried about by tax professionals who deal with the largest publicly traded entities. While there are listed transactions that impact those entities, the reality is that the listed transactions list includes transactions directed at taxpayers of all sorts.