Distinguish Tax Shelters from Tax Shams

Lee R. Phillips, JD

Physician's Money Digest, November15 2003, Volume 10, Issue 21

Tax time is coming, and now isthe time to put your tax plansin place. A number of IRS rulings,court rulings, and socialchanges have been made this year, and2 of the more popular big tax savingplans have been affected.

Case in Point

Wells Fargo v Commissionerof Internal Revenue

In the area of benefit plans, the IRSslapped final regulations on 419 multiple-employerVoluntary Employee BeneficiaryAssociations (VEBAs). The regulationshave had a chilling effect on theplans. Multiple-employer VEBAs arenot dead, but you have to be very IRS-savvyto use one today. However, thesimple single-employer VEBA is muchmore secure as the result of a recentcourt case, . The case didn'tchange the law governing single-employerVEBAs; it simply clarified a pointthat makes them even more powerful taxtools than previously thought. With thecourt case in place, you can feel verycomfortable using the single-employerVEBA, which can save you hundreds ofthousands of dollars this year in taxes.

As the arguments in the Wells Fargocase were made, it became obvious thatadvisors hadn't been looking at single-employerVEBAs as they should havebeen. The case affirmed that for post-retirementdeath benefits, the cost of thebenefit must be amortized over theworking life of the employee. The costof funding the death benefit is deductiblein the year that it is paid.

How It Works

You can put hundreds of thousands oftax-deductible dollars away each yearbetween now and the time you retire.With that money, you're providing yourfamily with a large life insurance policy,which can be paid out income and estatetax-free at your death. You need to purchase a benefit with the money you deduct,but life insurance is unique becauseit includes a way to store cash, through acash-value component. In later years, thecash values can be used to provide otherbenefits, such as tax-free disability payments,health insurance or direct healthcare payments, and other benefits. If youneed the cash value later for reasons otherthan the purchase of benefits, you can terminatethe VEBA plan, and the cash-surrendervalue of the policy will be paid outas ordinary income.

A VEBA is not a retirement plan,because you can't receive a cash flowfrom the plan. It's like a retirement planin that you receive a tax deduction formoney going into the plan, and themoney grows within the plan withouttaxation. Receiving very large tax deductionsand having the funds growwithout taxation gives you an immensewealth-accumulation tool.

Uncovering Shams

VEBAs have a bad name becausemost plans are shams. Somehow, mostVEBA plans, such as those throughloans made from the insurance policies,figure out a scheme so that you can usemoney from the plan for any purposewithout paying income tax. All suchplans are shams. The same shams havemoved to the 412(i) arena. Anytime youcan get large tax deductions, have themoney grow tax-free, and then use themoney tax-free at your discretion,avoid the plan. It's a sham.

Wells Fargo & Co (fkaNorwest Corp) and Subsidiaries v Commissionerof Internal Revenue

Your advisors will likely have theknee-jerk reaction that VEBAs are bad,pointing to the final regulations passedthis summer. You will have to point outthat the regulations apply only to multiple-employer plans. Your advisor willlikely bring up , whichyou counter by pointing out that thecase applies to single-employer VEBAs.If your advisor won't spend the time toinvestigate, saying they know better, it'stime to get another advisor.

Popular Defined Benefits

In the area of retirement plans,412(i) defined-benefit plans havebecome more popular, and the patent-pendingversion of the variable 412(i)plan has gained acceptance. A 412(i)plan is a simplified type of defined-benefitplan. It has been a very clean retirementplan for 30 years. You can puthundreds of thousands of dollars intothis type of retirement plan each yearand get a full tax deduction for the contribution.A 412(i) plan avoids the hasslesand expenses commonly associatedwith defined-benefit plans.

Proceed with caution:

When the IRS issued final regulationson multiple-employer VEBAs, it effectivelyshut down the groups promoting419 plans designed as tax frauds. Sincethe 419 regulations, groups havedesigned 412(i) plans that are actuallytax frauds.The412(i) world is fraught with scams.Easily spotted, these scams all provide atax deduction going in and tax-freegrowth. Through loans, special rollouts,or some other mechanism, they also giveyou tax-free use of the money stored inthe plan. Again, if it's too good to betrue, it's probably a scam.

When the 2 laws, 412(i) and419A(c)(2), are properly followed, youshould be able to shelter up to severalhundred thousand dollars each yearfrom income taxes. Both plans have tobe adopted by the end of the year. Theplans are more complicated than openingan IRA at the bank, so they probablycan't be put in place if you waituntil late December. The VEBA must befunded by the end of the year. However,the 412(i) does not have to be fundeduntil your taxes are due.

Lee R. Phillips, an attorney of theUS Supreme Court, has taught morethan 5000 classes to insurance,accounting, legal, medical, dental,and other professionals, and haswritten hundreds of articles. Hewelcomes questions or comments at 800-806-1997or lee@legalees.com.