by Alvin D. Lurie

10 or More Can Play—But You Can Get Hurt

"The IRS is building an enforcement web to catch and eliminate tax shelters. Taxpayers should come forward now, before they get tangled in the web. The IRS is collecting information about taxpayers and promoters who don't come forward so it can act on that information. It's time to come in from the cold." Treasury Assistant Secretary for Tax Policy Olson, quoted in IR News Release 2003-51 (4/15/03)

Perhaps you hadn't noticed, but it's getting pretty risky to buy into tax shelters offered by your friendly accountant or insurance broker, or even the cold caller who's got just the thing for people who don't like to pay taxes. Attacks on tax shelters are no longer something that happens to others. You know that the IRS feels very strongly about them. You didn't have to read the above News Release to know that. The daily broadsheets and the technical journals have been full of stories of shelters that blew up, and who got blown out of the water with them. The attacks have not all come from the IRS. The injured taxpayers who bought into them have been on the attack too, against everyone they could serve with a summons--the promoters, their lawyers and accountants, the financial institutions that provided the vehicles for implementing these programs,  the brokers and salesmen that sold the schemes. In one recent, highly publicized boardroom brouhaha, even the board of directors turned on the two highest executives of the company for having purchased tax shelters that were designed by the company's auditors for use of its executives -- the problem being the IRS was going to deny the tax deferrals, with disastrous consequences for the executives, whom the board assumed would likely sue the company's accountants. "O, what a tangled web we weave..." 

All of which brings me to today's sermon. Like flame to a moth, Section 419A(f)(6) of the Internal Revenue Code proved irresistible to benefit planners frustrated by the restrictive funding limitations on welfare benefit plans that Section 419 imposed. It seemed an easy way around the tight limits on additions to qualified asset accounts generally mandated for welfare benefit funds. For that very reason, of course, the provision, which provides an escape hatch for a "10 or more employer plan" (in the literal and colloquial phrase employed by the draftsman), has also had a strong attraction for the IRS, that has variously expressed its hostility toward the abuse of the mechanism, in audits, in the courts, even to the point of "listing" such plans as "potentially abusive tax shelters" under the authority of Sections 6011 and 6012, and most recently in the issuance of proposed regulations directed principally at the "experience-rating arrangements" concept of the statute.

Where a tax shelter is attacked, the principal target is the taxpayer who employed the device. But the Service's net is far wider, including promoters, advisers and others who are connected in ways that the recently finalized tax shelter regulations delineate in excruciatingly fine lines; and the Service is not the only one to level such complaints. Increasingly the taxpayers have turned on the promoters and advisers who brought the schemes to them or counseled them as to their tax efficacy. There have, in fact, been some recent decisions concerning shelters involving benefit plans that imploded, resulting in suits against their designers and others implicated in the promotions.

Most significant is Finderne Management, required reading for every active tax practitioner (except those indifferent to legal exposure to clients). The plaintiffs, closely held companies, were sold a multiple-employer Section 419A plan on the assurance of generous tax benefits backed by opinions of counsel -- that is, full deductibility, beyond the restrictive Section 419A limits, of contributions to a welfare benefit plan providing employees pre-retirement death benefits, funded by group term insurance, followed by post-retirement continuation of death benefits by means of conversion to individual policies. The conversion afforded the opportunity to borrow against the cash values accumulated in the policies, thus resulting in the additional benefit of tax free withdrawals.

It is helpful to put the case in some context for those unfamiliar with those twin protectors of the revenues, Sections 419 and 419A of the Internal Revenue Code. When benefit planners, particularly those catering to the small business market -- where a premium is often placed on maximizing contributions benefiting the principals of the firm and other key employees, without the drag of costly contributions for the rank-and-file -- became frustrated by the obstacles Congress increasingly placed on the use of qualified pension and profit sharing plans targeted to that goal and on the limits on amounts that could be contributed to qualified plans, they turned to the welfare benefit area. VEBAs ("voluntary employees' beneficiary arrangements", as they are quaintly named in the Code), a tax exempt vehicle quite the same as a qualified retirement plan, but long overlooked by the small business community, now became the vehicle of choice, usually as a supplement to a qualified plan. The sparsely worded statute on which they are founded, Section 501(c)(9), and the long-time absence of final regulations, proved to be an irresistible magnet. Deductions essentially unlimited...rules almost nonexistent...deferral of tax (for some benefits no tax ever)...tax-exempt inside build-up. A veritable tax planners' heaven.

That changed in a big way when Congress enacted the Tax Reform Act of 1984, imposing severe limitations on the deductions that could be claimed, but with significant exceptions for a welfare benefit fund established under a collective bargaining agreement and for a fund that is "part of a 10 or more employer plan". The "10 or more" exception, predicated on the assumption that such a grouping would operate with the protections against abuse inhering in an insurance-like arrangement, drew planners (as noted in my flame figure of spech), seeming to provide a way to skirt the very severe constraints of Section 419 by the simple expedient of putting at least 10 otherwise unrelated employer sponsors under the umbrella of a single plan document. Do you smell an incipient abusive tax shelter? So did the more aggressive of the benefit planners.

There was one big catch in the statute. It would not apply to any plan "which maintains experience-rating arrangements with respect to individual employers." It was obvious what the legislative intent was, namely, to approximate the risk-sharing characteristics and uniform contribution criteria of a true insurance arrangement, so that individual employers could not in effect create their own segregated pool of funds comprised exclusively of their contributions dedicated to the benefits of only their employees. But what was not obvious was how to ascertain the absence of experience rating, while, at the same time, not exposing one employer’s contributions to the risks of other employers poor experience and, just as importantly, to limits on the amount of contributions that an employer might desire to exceed if they could be directed to its own participants. Obviously, that would in effect be a plan just for that employer, an end run around the Section 419 limits and not at all what Congress meant to permit under the 10-or-more exception. That did not prevent teams of planners from attempting to come up with just such a design.

There ensued a series of battles between IRS and these newly minted 10-or-more designs, eventuating in audits, private letter rulings, court cases, unsuccessful attempts by the Treasury to get additional legislation, and proposed regulations. It is not directly pertinent to this discussion to trace this history; but particular mention should be made of one of the earliest and most visible plans to emerge, the so-called PRIME plan, involving ingenious plan provisions designed to demonstrate how the plan did not rely on individual employers’ own risk experience in establishing contribution differentials. That issue was resolved by the Tax Court in the celebrated Booth case, which the Commissioner won, the court holding the 10-or-more exception inapplicable where there was not a single plan but rather an aggregation of separate welfare plans for each of the adopting employers. Consequently, the plan failed to satisfy the statutory proscription against maintenance of experience-rated arrangements with respect to individual employers in the plan.

It is to be noted that the Treasury is proposing to memorialize the result in Booth in a regulation issued in proposed form in 2002 and expected to be finalized shortly, defining an experience-rated arrangement. The badges of experience rating would include: separate accounting among employers; contribution differentials based on risk; lack of fixed benefits and cost; unreasonably high cost of benefits; and non-standardized benefit triggers, such as employer’s withdrawal from the plan.

Returning to the Finderne case, the IRS disallowed the deductions claimed for contributions to the plan, whereupon the taxpayers sued the insurance agents and financial planners who had promoted the transaction, the insurance companies that issued the policies, and the attorney who wrote the opinion letter supporting the predicted tax results. Those defendants in turn filed third-party complaints against various other attorneys (big names among them) and professionals who had rendered opinions, other insurance companies (big names too, including Cigna), insurance consultants who had marketed or given advice concerning the insurance policies, the plan trustees, and even an accountant. As wide as was the net of defendants and cross-defendants (the title of the case scrolling down almost two feet on a monitor screen), wider still were the counts of the complaint: violation of the state anti-racketeering statute, fraud, equitable fraud, negligent misrepresentation, breach of fiduciary duty, conspiracy, and aiding and abetting all the foregoing. These were claims sounding in state law causes of action, to successfully assert which the plaintiffs had to establish that ERISA preemption did not foreclose recourse to the state courts to pursue state law remedies.

The defendants claimed that a state law case, resting principally on misrepresentation of the tax benefits a section 419A plan afforded to these plaintiffs, should be dismissed because the plan in question was an ERISA plan and that ERISA preempted state law. But a New Jersey appellate court held that the claims of plaintiffs did not relate to an ERISA plan within the meaning of ERISA's preemption rule. Accordingly, the defendants now face charges under the New Jersey Racketeering Act and possibly a federal RICO count, as well as the other counts recited just above. Trial on the charges awaits another day, since the decision in the case, in its present status, concerns only standing of the plaintiffs to sue in the state court and to assert their state claims.