Taxpayers who participate in a listed transaction or one similar to a described listed transaction and fail to disclose such participation face a penalty under IRC §6707A regardless of whether or not the transaction ends up resulting in a true understatement of tax.  And “similar” is interpreted broadly, as the taxpayer in the case of Vee’s Marketing, Inc. v. United States, CA7, Case No. 15-2441 discovered.

The penalty under §6707A for failure to disclose such a transaction is 75% of the claimed reduction in tax shown on the return (regardless of whether or not that deduction is ultimately found justified or not).  A minimum penalty of $5,000 for a natural person or $10,000 for any other taxpayer is triggered regardless of the level of savings, with the penalty similarly capped at $100,000 for a natural person and $200,000 for other taxpayers regardless of the claimed level of tax reduction.  The minimums and maximums are set at a lower figure for transactions that are “reportable transactions” rather than listed transactions (reportable transactions are defined by statute, not by direct IRS identification).

The disclosure must be made on each return affected by the transaction and is made on Form 8886, Reportable Transaction Disclosure Statement.

The IRS identifies what it considers potentially abusive transactions as “listed transactions” subject to the enhanced penalty and required disclosures.  In the case in question the listed transaction in question as described in Notice 95-34.

The transactions in questions claim to establish welfare benefit plans under the “10 or more employers” provision of IRC §419A(f)(6) to allow deductions of amount funded to such plans by the sponsoring employer.  As the IRS continues in the Notice:

In recent years a number of promoters have offered trust arrangements that they claim satisfy the requirements for the 10-or-more-employer plan exemption and that are used to provide benefits such as life insurance, disability, and severance pay benefits. Promoters of these arrangements claim that all employer contributions are tax-deductible when paid, relying on the 10-or-more-employer exemption from the section 419 limits and on the fact that they have enrolled at least 10 employers in their multiple employer trusts.

These arrangements typically are invested in variable life or universal life insurance contracts on the lives of the covered employees, but require 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. The trust owns the insurance contracts. The trust administrator may 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. Although, in some plans, benefits may appear to be contingent on the occurrence of unanticipated future events, in reality, most participants and their beneficiaries will receive their benefits.

The IRS believes that such arrangements are structured to assure that effectively separate accounts are maintained (most often for the owners) and used to not provide allowed benefits, but rather used to overfund insurance policies that are used to provide tax deferred benefits to the owner(s).

In this case Vee’s had entered into an arrangement that established a welfare benefit plan.  In this case, as the Court described the program Vee participated in:

When later Vee strategically terminated his participation in the plan, the plan used $147,000 from the reserve account to buy a paid-up life insurance policy for Vee with a face value of $400,000. That was the amount payable upon Vee’s death to his beneficiaries, but it wasn’t all that the reserve account could be used for. CJA told its customers that the paid-up policy could be sold, and it even helped find buyers. As explained in Ohio National Life Assurance Corp. v. Davis, 803 F.3d 904, 908 (7th Cir. 2015), it is lawful in many states (including Vee’s state, Wisconsin, although generally not until five years after the issuance of the policy, see Wis. Stat. § 632.69(12)) to purchase the beneficial interest in an existing policy on the life of the insured. Vee thus could if he wanted sell the beneficial interest in his post-retirement life insurance policy. He would be taxed on his income from the sale but he would not have been taxed on the income that had gone into his accumulation reserve and thus financed his acquisition of the life insurance policy that he then sold.

Vee was obtaining a tax deduction not only for payments that he made for the purchase of term life insurance but also for payments that he could use to fund benefits that do not qualify as health or welfare benefits, even though the plan is a health and welfare benefit plan. As explained in Prosser v. Commissioner, 777 F.3d 582, 585 (2d Cir. 2015), quoting Curcio v. Commissioner, 689 F.3d 217, 226 (2d Cir. 2012), such contributions are “a mechanism by which [owners of participating businesses—Vee is such an owner] could divert company profits, tax-free, to themselves, under the guise of cash-laden insurance policies that were purportedly for the benefit of the businesses, but were actually for petitioners’ personal gain.” If Vee keeps rather than sells his life insurance, upon his death the benefits will accrue to the beneficiaries designated in the insurance policy. Any benefit plan that allows Vee to convert tax-free contributions to guaranteed payments for either himself (the owner -- an “employee” only in name) or his beneficiaries is a listed transaction within the meaning of Notice 95-34.

The plan was structured to be funded with contributions in excess of what was needed to purchase a one year insurance policy to fund the benefit officially offered by the plan (a benefit if a covered employee died).  As the Court notes:

The Internal Revenue Service contends that Vee's plan is a "listed transaction" (the term does not appear in Notice 95-34, but a subsequent Notice, 2000-15, states that the transaction described in Notice 95-34 is indeed a listed transaction), so classified because it involves plan contributions that exceed the cost of the term life insurance (one-year insurance that yields proceeds only if the employee dies during that year, and that has no cash value), which is all that the contributions buy. The excess of contributions over expense leaves the plan administrator with a surplus with which to provide other benefits to the plan's beneficiaries.

In fact, the Court notes:

And like the transaction described in Notice 95-34, Vee’s plan is experience rated, meaning as we said that the employer’s contributions are allocated to his own employees. This feature too is inconsistent with the premise of a 10 or more employers benefit plan that contributions and risks are to be pooled. In effect though not in name Vee’s plan is what is called a “universal life insurance contract.”

Thus the Court sustained the lower court’s holding that Vee had been properly assessed four $10,000 penalties under §6707A (one for each year it failed to attach the Form 8886 to it’s return).  Note that this is true even though the actual validity of the deductions claimed under the plan is still being disputed by the taxpayer in a separate action in the United States Tax Court.

All too often clients are marketed various tax avoidance strategies and schemes that look too good to be true and seem to be much like programs the IRS has previously identified as being listed transactions.  Too often those marketing such programs suavely assure the taxpayer that his/her adviser’s concerns over it being a program that the IRS has attacked are misplaced, as this program is “different” due to some particular detail.

What advisers must tell clients is even if it is correct that the program is not exactly what was described by the IRS, if it “smells” like that program a failure to disclose could prove extremely costly—in this case to the extent of $40,000.  

As well advisers are well to be highly skeptical of the underlying program’s ability to survive IRS challenge.  Advisers must determine that the justification for program meets the minimum requirements (substantial authority for undisclosed positions, reasonable basis for fully disclosed positions) in order to determine if the taxpayer would face other penalties as well as whether the adviser him/herself may end up in violation of IRC §6694 (the paid preparer penalties) and the AICPA Statements on Standards for Tax Services No. 1.