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Tax Shelter Litigation

Posted by attorney Christopher Vernon

Doctors, successful small business owners, and others are often targeted by investment and insurance professionals selling plans, products, or strategies with the promise of significant tax benefits. These sales pitches are often very sophisticated and present very complicated as well as purportedly cutting edge ideas. Additionally, the concepts are often accompanied by opinions or references to well-known tax and legal professionals.

Unfortunately, many of the targets of these sales pitches subsequently retain counsel to pursue the investment and insurance professionals on which they reasonably relied when they are informed by the IRS that they owe significant back taxes, interest, and penalties and that the expensive tax strategy they pursued is completely ineffective.

Although there are many variations of this type of litigation, set out below is a brief case study of one the cases we are currently pursuing in the Tampa Bay area that involves a product/strategy known as a 419 plan.

When properly designed and administered, Section 419 plans —so named because the law regarding them is found in Section 419 of the Internal Revenue Code — allow businesses to contribute tax deductible funds to a trust in order to provide certain tax-free benefits for business owners and their key employees. Benefits allowable under a properly created and implemented Section 419 plan may include health insurance premiums, uninsured medical care, long term care and death benefits.

Retirement income is not allowed as a benefit under a 419 Plan. But insurance agents holding themselves out as “retirement planning specialists" peddling “alternative investments" often lure business owners into buying high-commission life insurance policies with false promises, including promises of tax-free investment income.

In the pending lawsuit referenced above, the Complaint alleges one such Section 419 plan funneled retirement savings through a life insurance policy. According to the Complaint, these business owners were told at the time they agreed to buy the policy – from those who stood to benefit substantially from the sale — that they could reduce or even skip their annual contribution without affecting benefits. It turned out that they were, in fact, required to make a substantial minimum contribution each year or lose their entire investment.

Because of the volatility of the business they are in, the owners would never have agreed to a plan that did not allow flexibility in its contributions. But that was only the initial hardship and headache that came as a result of the advice given them.

In addition, the premiums paid for cash value life insurance policies as part of the plan were not tax deductible under the Internal Revenue Code since they were used to fund retirement income. That is true for Section 419 plans even if the funds are run through a so-named “welfare benefit plan," as was the case for these business owners. So in addition to being responsible for a large annual contribution, the owners were also on the hook for the back taxes due for those contributions as well as fines and penalties from the IRS.

The tax collecting agency has recently become more aggressive in its pursuit of fraudulent tax shelters, even when the owners of those shelters have been misled.

The pending 419 plan Complaint alleges that the clients were not warned of the possibility of such a devastating scenario. In presentations made in their own offices, the business owners were led to believe that: contributions to the plan were fully tax deductible, contribution amounts were flexible, the plan provided safety of the initial investment, the benefits were tax free, the plan provided retirement income and the plan could be terminated at any time.

To the contrary, even after the IRS declared the plan to be an illegal tax shelter, the 419 plan administrator refused to shut it down unless the business owners paid a hefty “termination fee."

If you are generating a lot of income or are selling businesses for substantial sums, we recommend you seek legal counsel to assist you in heavily vetting any tax strategy or product you are being pitched as well as vetting the qualifications and motivations of the promoter of the tax strategy. Avoiding these problems is far superior to having simultaneously and expensively deal with back taxes and possible IRS penalties while pursuing the promoters of these ill-conceived tax strategies.

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