Summer 2008 - Welfare Benefit Plans

An Opportunity for Business Owners

By Mark Koczarski

Frequently, a client will ask if premiums paid to maintain a policy of insurance on his life are deductible for income tax purposes. The answer is usually no. However, a Welfare Benefit Plan (“Section 419 Plan”) can provide a taxpayer with a deduction for premiums paid on life insurance. Welfare Benefit Plans provide for an income tax deduction for premium payments made on a policy taken out on the business owner’s life.

If the plan is properly structured, the policy proceeds pass to the business owner’s beneficiaries free of gift and estate tax. Another feature of a Welfare Benefit Plan that benefits business owners is that participation in the Plan can be discriminatory, in that coverage does not have to be provided for employees. Additionally, portions of the cash surrender value of the policy can be accessed for disability benefits, accident and health benefits, long term care, unreimbursed medical expenses from insured programs and educational benefits.

There are two reasons you may not have ever heard of Welfare Benefit Plans. First, not all tax professionals understand these plans well enough to present them to clients since an understanding of the Employee Retirement Income Security Act (“ERISA”) and the Voluntary Employment Beneficiary Association (“VEBA”) rules is necessary. Second, many tax professionals do not advise their clients to establish Welfare Benefit Plans because in the past these plans have been scrutinized by several IRS audit programs.

However, the IRS recently issued new regulations that now provide clarifications and guidance. While primarily meant to defer Plan abuses, the regulations now give taxpayers and plan administrators a blueprint to follow that will keep the Plan from becoming abusive.

Annual plan administration expenses are usually in the $2,000 to $3,000 range. So before you establish a Plan, you want to make sure that the benefit of the income tax deduction outweighs the plan administration expense. For example, if your expected annual insurance premium will be between $7,000 and $10,000 you may want to think twice before establishing a Plan. However, if your annual premium will be in the $30,000 to $50,000 range you definitely should think of establishing a Plan.

Welfare Benefit Plans are ideal for small business owners. However, sole proprietors must change their business form in order to take advantage of a Welfare Benefit Plan. This can be accomplished by incorporating the business or making a spouse a business partner. Because incorporating can be somewhat expensive and unfavorable for income tax purposes, the solution for the sole proprietor is usually to form a partnership where the spouse is the partner. In order to do so, however, the partner spouse must “materially participate” in the business. The IRS scrutinizes “material participation” of a spouse on a rather relaxed basis where the family business generates the main income stream for the family.

The transfer of a business interest to the spouse is always gift tax free if the transfer is to a U.S. citizen spouse. A transfer to a non U.S. citizen spouse can raise a gift tax issue if the value of the gift is over certain limits.

The business owner should also be aware of the possible additional self employment tax (“SECA”) consequences of the spouse becoming a partner, especially when one spouse has reached the Social Security funding requirement and the other spouse has not. However, an offsetting benefit of the spouse becoming a partner is that the spouse is then able to fund a tax deductible pension plan.

Late in 2007, the IRS issued a ruling and notices cautioning taxpayers about participating in certain trust arrangements being marketed as Welfare Benefit Plans that in effect provide deferred compensation to taxpayers, which is not a valid benefit under a welfare benefit plan. The IRS also is requiring taxpayers to disclose in their income tax returns participation in Welfare Benefit Plans.

Please contact the author if you would like to learn more about Welfare Benefit Plans or are a participant in a plan already and would like to make sure that your Plan is properly structured.