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S Corp Incurs Hefty Penalties for Failure to Report Welfare Benefit Fund on Form 8886.

(Parker Tax Publishing June 15, 2015)

A federal district court determined that because taxpayer had enrolled his S corporation in a welfare benefit fund that was a tax avoidance transaction, penalties imposed for failure to file forms reporting his participation in a listed transaction were appropriate. Vee's Marketing Inc. v. U.S., 2015 PTC 166 (W.D. Wis. 2015).


After a profitable year brokering onions as the sole employee of his S corporation, Vee's Marketing, Inc. (VMI), Scott Vee faced a sizable tax bill for 2004. A sales representative from CJA and Associates (CJA) suggested he could reduce his tax burden by setting aside money in its Affiliated Employers Health & Welfare Trust (the Trust), which CJA marketed as a 10-or-more multiple employer welfare benefit fund that was tax-exempt under Code Sec. 419A(f)(6). The salesman told Vee that payments into the fund would reduce the amount of his taxable income, and would provide term insurance plus a paid-up $1,000,000 of life insurance that could, if Vee wished, be used upon retirement for reimbursement of medical expenses.

Vee enrolled VMI in the plan in 2004, contributed $145,000 to the Trust, and paid $1250 in fees. CJA used $5400 of the contribution to pay for one year of term life insurance on Vee's life; the remainder went into an account to fund Vee's death benefit. VMI made additional $20,750 contributions each year from 2005 to 2007. In total, for the years 2004 to 2007, VMI contributed $227,250 to the Trust and deducted that amount from its business income, reducing Vee's taxable income.

When CJA set up the Trust, it chose to maintain each participant's account independent of the account of any other participant. The Trust also owned the insurance contracts used to fund the death benefits, which effectively operated as universal life insurance policies. As of 2010, VMI was one of more than 50 employers contributing to the Trust.

In 2011, the IRS determined that VMI should have filed Form 8886, Reportable Transaction Disclosure Statement for each year as a participant in the Trust, claiming that the CJA plan was substantially similar to a tax avoidance transaction described in Notice 95-34. The IRS assessed a $10,000 penalty per year for 2004 to 2007 under Code Sec. 6707A, which imposes penalties on persons who fail to include information on their returns with respect to a reportable transaction. VMI paid the penalties and filed a claim for refund.


Code Sec. 419 and Code Sec. 419A generally limit deductions taxpayers can take for contributions to welfare benefit funds. Code Sec. 419A(f)(6) provides an exemption from these limitations for 10-or-more employer plans. In general, for this exemption to apply, no employer may contribute more than 10 percent of the total contributions and the plan must not be experience-rated with respect to individual employers (i.e. structured so that each employer's contributions benefit only its own employees).

In Notice 95-34, the IRS discussed certain trust arrangements that purportedly qualify as multiple employer welfare benefit funds exempt from the limits of Code Sec. 419 and Code Sec. 419A, concluding that such arrangements do not provide the tax deductions that trust promoters claim and, instead, are tax avoidance transactions. Among other warning signs, these arrangements typically invest 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 term insurance required to provide death benefits under the arrangement.

The District Court determined that a close look at the Trust showed that although it purported to operate as a 10-or-more employer welfare benefit fund exempt from income tax, it clearly exhibited the warning signs identified by the IRS in Notice 95-34.

The court noted contributions of participants in the Trust were typically invested in variable life or universal life insurance contracts, and VMI's first year contribution to the CJA plan was $165,000, which was far in excess of the $5400 cost of term insurance for the first year.

The court found the Trust exhibited additional warning signs, such as the fact it owned the insurance contracts paid for by participants, and that the Trust, acting through CJA, withdrew cash from Vee's accumulation account on at least four occasions. The court pointed out that when marketing the plan, CJA touted the ability of participants to withdraw funds before death, a feature in common with the listed transaction in Notice 95-34.

The court noted that to receive the value of his life insurance policy, Vee did not have to die before his normal retirement age or become disabled; he was assured of receiving the value of his million dollar life insurance policy so long as his premiums were paid, which was another aspect of the Notice 95-34 transactions. Additionally, since the benefits were designed to relate exactly to the amounts allocated to the employees of the participant's employer, the money that participating employers paid into the plan bought insurance for only their own employees, making the Trust experience-rated with respect to the individual employers.

Finding that the Trust shared substantially all of the features of the listed transactions in Notice 95-34, the District Court determined that the welfare benefit plan in which Vee enrolled VMI was a tax avoidance transaction. Because the plan was a reportable transaction, Vee should have filed Form 8886 for each year in which he participated and the court held the penalties imposed were proper.

For a discussion of welfare benefit plans, see Parker Tax ¶ 98,900. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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