Almost every physician-investor has beenpitched the 412(i) defined-benefit plan. Atleast once they've been told how it's thegreatest income tax reduction plan for smallbusiness owners today. If you purchased a 412(i)defined-benefit plan in the past few years as a tax shelter,however, you could be in a world of trouble.
Popular Pitch Sinks
Let's discuss how the 412(i) plan works. If a physician-investor puts $250,000 into a 412(i) plan everyyear for 5 years as a tax-deductible expense, they'lleventually fund $1.25 million over that period. Thecash surrender value (CSV) of the policy at the end ofthe 5th year will be $250,000. The physician-investorwill then purchase the life policy from the 412(i) planfor that $250,000 CSV and think they got a great dealsince the cash account value (CAV) of the policy isreally $1.1 million. After waiting for surrender chargesin the life policy to evaporate, they will take incometaxâ€“free loans from the policy.
Buying a policy with a low CSV and a high CAVseems like a steal of a deal since the investor only pays20% of the value of the asset when they purchase it outof the 412(i) plan. This was supposed to save theinvestor 80% of the tax on that money. If this soundstoo good to be true, it didn't to many physician-investorswho allowed insurance agents to sell them 412(i) plans.After looking at the plan, the IRS eventually shut itdown. Ironically, the beginning of the end of 412(i) plansstarted on Friday, Feb. 13, 2004.
Washington Takes Over
IRS Revenue Procedure 2004-16 basically statesthat the fair market value of a life insurance policythat comes out of a 412(i) defined-benefit plan shouldbe based on the premiums paid and not on the CSV orinternal reserve value of the insurance company. Howwill this affect a recently implemented 412(i) plan?The investor will not be able to purchase the life policyfrom the 412(i) plan for the CSV, which is 80%lower than the premiums paid. Instead, they will haveto use the premiums paid as the value (minus minorterm costs), which basically destroys the tax-favorablenature of a 412(i) plan.
In addition, Revenue Procedure 2004-20 states thatthe IRS doesn't want excess life insurance purchasedinside a 412(i) plan. In this case, the IRS is referring toinsurance contracts where the death benefits exceed thedeath benefits provided to the employee's beneficiariesunder the terms of the plan, whereby the balance of theproceeds revert to the plan as a return on investment.IRS Revenue Procedure 2004-20 also states that if excessdeath benefits are purchased, those deductions will bedisallowed in the current tax year and will be spread out,if allowable, over future years. Furthermore, any nondeductiblepremiums will be subject to a 10% excise tax.
Finally, Revenue Ruling 2004-21 says that a qualifiedplan cannot discriminate in favor of highly compensatedemployees by buying life policies for nonhighlycompensated employees that aren't inherentlyequal. The word inherently seems to indicatethat the IRS has no idea how to define certain standardsor rules in their attempt to give final guidanceto taxpayers. As is the case with a lot of revenue rulingsand regulations on advanced tax topics, the IRSdoesn't always know how to give guidance on whatshould be done. Instead, it tries to muddy the watersand scare investors so that certain tax plans aren'tused due to uncertainty about the law.
Roccy DeFrancesco is an attorney and author of"The Doctor's Wealth Preservation Guide." Hehas run a medical practice and lectured for manystate and national medical associations. For a freeasset protection, income, and estate tax reductionCD, or for questions, call 269-469-0537 or firstname.lastname@example.org.