Notices and Revenue Ruling Issued on Tax Abuses.
The Internal Revenue Service (IRS) has issued two notices and one revenue ruling dealing with certain trust arrangements that are being sold to professional corporations and other businesses as welfare benefit funds, providing significant tax benefits that do not comply with IRS tax rules. In issuing the guidance, the IRS has targeted specific abuses and cautions employers about the use of these arrangements.

Notice 2007-83 deals with trust arrangements that utilize cash value life insurance policies to provide welfare benefits. Promoters of the arrangements claim full deductibility for all employer cost to purchase whole life policies within a trust. The trust is designed to purchase whole life policies for key employees and business owners and term life insurance for other employees. After a period of years, the trust and plan would be terminated, with cash value policies and other property distributed tax free or at a low tax cost to key employees. Promoters assert, in contradiction to IRS positions taken on these arrangements, that the insurance premiums are fully deductible but not includible at all in an employee’s income. The distributions to employees at the termination of the trust are purportedly tax free or at a low tax cost based on a purchase of a policy at a value significantly less than fair market value.

Notice 2007-84 deals with trust arrangements that are promoted as providing post-retirement medical and life insurance benefits. These arrangements purport to provide tax deductions for insurance policies based on a calculation of reserves necessary for post-retirement benefits that is unreasonable because few or none of the non-key employees would eventually receive post-retirement benefits. These arrangements sometimes use loans and are set up initially with the intent of subsequent amendments to change post-retirement benefits or to terminate the plan prior to the payment of any benefits with assets paid out to key employees.

Revenue Ruling 2007-65 addresses situations that purport to establish life insurance arrangements under the group-term life insurance rules but utilize cash value life insurance policies and claim deductibility under rules for funded welfare benefit plans. These arrangements again claim deductible costs for trust contributions that would not be deductible under applicable rules in the Internal Revenue Code dealing either with funded welfare benefit trusts or split-dollar life insurance arrangements.

In all of these cases, the IRS has pointed out abusive arrangements utilizing life insurance that in most cases should look too good to be true to a potential customer of the scheme. A healthy dose of skepticism and caution should be used whenever reviewing proposals involving the purchase of significant life insurance policies that purport to avoid or greatly minimize income tax obligations. (Notice 2007-83, Notice 2007-84, Rev. Rul. 2007-65)

Final Rule on Default Investments.
The Pension Protection Act of 2006 (PPA) provides relief to fiduciaries who invest in certain types of default investments in the absence of participant investment direction. The Department of Labor (DOL) issued final regulations regarding permissible default investment options for participant-directed defined contribution plans. This relief applies to, but is not limited to, plans with automatic enrollment features. The final regulations are effective beginning December 24, 2007.
The final regulations provide a safe harbor for fiduciaries investing assets in a qualified default investment alternative (QDIA). A QDIA must be one of following types of investments:

1. Life-cycle or target-retirement date fund, which determines the appropriate proportion of equity and fixed income investments using a participant’s age, life expectancy, or retirement date.

2. Balanced fund, which uses the demographics of the plan participant population as a whole to determine the appropriate investment selection.

3. Professionally managed account, which utilizes investment management services to allocate assets in a participant’s individual account using a participant’s age, life expectancy, or retirement date.

It is important to note that the final regulations also permit a plan to temporarily invest in a product or fund designed to preserve principal. This type of investment will be considered a QDIA for not more than 120 days after the date of a participant’s first elective contribution.

The final regulations also consider investments made to stable value funds prior to the effective date of the final regulations to be treated as QDIAs.

In addition to investing in a QDIA, certain other conditions must be met for fiduciaries to receive liability protection, such as:
• The plan must allow for participant-directed investment.
• On at least a quarterly basis, participants must be given the opportunity to shift investments from QDIAs, without financial penalty, to a wide range of investment options.
• The plan must provide an annual notice to participants at least 30 days before the start of the plan year. In addition, an initial notice must be given to participants 30 days prior to eligibility, 30 days prior to the initial investment into the default fund, or concurrent with eligibility in cases where a plan provides for immediate eligibility. The notice must describe the circumstances under which assets will be invested in QDIAs, the characteristics of the QDIAs, participant rights, and sources of additional information.
• Any material (i.e., proxy voting material, prospectuses, and account statements) provided to the plan relating to investments in a QDIA must be given to participants.
• A QDIA cannot hold employer securities except if they are held as part of certain regulated pooled investments or are acquired as a matching contribution.

Liability protection is not comprehensive. Plan fiduciaries are still liable for prudently selecting and monitoring funds, including the QDIAs, offered by the plan. The DOL specifically notes that consideration must be given to investment fees and expenses when choosing investment alternatives.

New Benefit Statement Guidance From the DOL.
In late 2006, the DOL issued Field Assistance Bulletin (FAB) 2006-03, providing guidance concerning the new pension benefit statement rules enacted by the PPA of 2006. In FAB 2006-03, the DOL indicated that, pending the issuance of further guidance, the furnishing of pension benefit statement information not later than 45 days following the end of the relevant period (e.g., calendar quarter or calendar year) constitutes good-faith compliance with the requirement imposed on individual account plans to furnish pension benefit statements. Many managers of individual account plans that do not permit participants and beneficiaries to direct the investment of assets in their individual accounts complained that they are not be able to comply within the 45-day period set forth in the FAB 2006-03. For example, there are profit-sharing plans where contributions are not determined or made until after the sponsor’s business tax return is completed. Also, many of these individual account plans are dependent on securing third-party valuations for assets that do not have a readily ascertainable value. Compliance with the 45-day good-faith period, in those cases, would be impossible or very expensive unless the benefit statements were based on data from the end of the prior plan year.

In October, after considering the practical problems faced by some plans in meeting the 45-day period for delivering participant benefit statements, the DOL announced, pending the issuance of further guidance, that plan administrators of individual account plans that do not provide for participant direction of investments will be treated as acting in good-faith compliance with the new PPA pension benefit statement rules. The DOL did specify that the statements must be furnished to participants and beneficiaries on or before the date on which the Form 5500 Annual Return/Report is filed by the plan (but in no event later than the date, including extensions, on which the Annual Return/Report is required to be filed by the plan) for the plan year to which the statement relates. (DOL Field Assistance Bulletin No. 2007-03)

409A Reporting and Withholding Rules for 2007 Issued.
In the latest round of guidance related to Internal Revenue Code Section 409A, the IRS recently extended for 2007 most of the withholding and reporting rules previously provided in Notice 2006-100 for 2005 and 2006. Under new Notice 2007-89, employers are not required to report amounts deferred under a nonqualified deferred compensation plan for 2007. Barring additional relief, amounts deferred in 2008 will have to be reported on a Form W-2 (for an employee or former employee) or Form 1099 (for a nonemployee director or independent contractor). Employers are also required to report in 2007 all amounts that are includible in income because of a failure to comply with Section 409A. The notice provides additional guidance for calculating the amounts to be reported. The rules vary based on the type of deferred compensation arrangement under which the failure occurred. If there is a Section 409A failure, compensation deferred under a plan for the taxable year and all preceding years is includible in gross income to the extent the deferred compensation is vested and has not previously been included in income. Amounts includible in an employee’s income under Section 409A in 2007 are treated as supplemental wages for purposes of withholding. Employers are not required to withhold the 20% additional tax or the underpayment of interest component levied on Section 409A failures. Rather, employees are required to report the includible amounts on their individual income tax returns and to remit the appropriate additional tax and interest penalty. As under the earlier notice, complicated rules provide limited relief for an employee whose employer fails to withhold the appropriate amount from the deferred amount. The guidance provided under Notice 2007-89 is intended as interim guidance only, and additional guidance on income inclusion, additional taxes, and reporting and withholding requirements related to Section 409A is expected. (Notice 2007-89)

Cases

Death Resulting From Driving While Intoxicated Not Accidental.
A divided Sixth Circuit Court of Appeals held that Metropolitan Life Insurance Company (MetLife) did not act arbitrarily and capriciously when it denied benefits under a personal accident insurance plan to an individual who died while driving with a blood alcohol content of more than three times the legal limit. The terms of the policy at issue stated that benefits were paid if an individual sustained “accidental” bodily injuries and suffered a loss of life. However, the policy contained an exclusion for any loss which is contributed to or caused by suicide, attempted suicide, or self-inflicted injury while sane or insane. MetLife denied benefits under the plan, stating that the act of driving impaired rendered the injuries or death reasonably foreseeable and thus not accidental. Further, MetLife concluded that the voluntary consumption of alcohol constituted intentional self-inflicted injuries and fell within the exclusion of the policy. The beneficiary of the policy challenged MetLife’s decision, and the district court ruled against MetLife, noting that a person is far more likely to make it home safely or be arrested for driving while intoxicated than to be injured or die in an alcohol-related accident. The Sixth Circuit overturned the district court opinion, with each of the three justices issuing separate opinions. The first justice overturned the district court opinion by finding that MetLife’s denial of benefits was factually correct. The second justice also overturned the district court decision by finding that MetLife did not act arbitrarily and capriciously and that the court did not need to determine whether MetLife’s decision was actually correct, only whether they acted arbitrarily and capriciously. The third justice upheld the district court decision by determining that the meaning of the word “accidental” should apply to situations such as this and would exclude only conduct where the insured would have viewed the injury as highly likely to occur as a result of the insured’s intentional conduct. Because many insurance plans include language similar to that at issue here, we can expect that further court cases will arise in this area. (Lennon v. Metropolitan Life Insurance Co., 6th Cir., 2007)

The Briefing is a periodic publication of Hodgson Russ LLP. Its contents are intended for general informational purposes only and should not be construed as legal advice or legal opinion on any specific facts or circumstances. Information contained in The Briefing may be inappropriate to your particular facts or situation. Please consult an attorney for specific advice applicable to your situation. Hodgson Russ is not responsible for inadvertent errors in this publication.