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Reprinted from the “Orange County Lawyer,” March 2004 - page 5 / 6

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Every vigilant against abuses, both real and perceived, the IRS has stepped up its audit campaign, not against contributions per se, but against prohibited transactions or PT’s.

What is a PT? It is anything that you are not supposed to do. This can include: improper exclusion of otherwise eligible participants such as, but not limited to, “leased employees;” improper calculation of employee benefits; lack of notification of substantive changes in the plan; improper loans that may be excessive, un-documented or not repaid timely; lack of documentation regarding plan contributions; lack of timeliness in remitting employee deferrals and of course improperly valued plan assets. Errors in asset valuation could understate or overstate a participant’s account in a Defined Contribution Plan (i.e., Money Purchase Pension Plan, or Profit Sharing Plan). Improperly valued assets in a Defined Benefit Plan could generate contributions that are higher or lower than what is proper for minimum or maximum funding requirements.

412(i) PLANS

Section 412(i) of the IRC says that if you have a fully insured plan (all assets are in life insurance and/annuities with a commercial carrier) you can rely on the issuing insurance company guaranteed interest rates for purposes of developing the contributions.

During the period of the Small Plan Actuarial Audit Program wherein the IRS was attempting to require the use of interest rates of not less than 8% and retirement ages of not less than 65, the prospect of a fully insured 412(i) plan looked enticing. A 4% interest assumption for a 45 year old retiring at 65 compared to an 8% interest assumption meant a contribution increase of 60%. However, when the IRS lost its case in Tax Court (12 out of 13 Tax court judges ruled against the IRS. One of the judges abstained because he “didn’t know enough about the subject”), actuaries routinely began to use 5% interest assumption (or 4% in special circumstances). A 4% interest assumption generates a contribution in the above example of only 12% more than what is obtainable with a 5% interest assumption. Immediately, the “interest” advantage of a 412(i) plan was minimized.

However, it is important to note that when a 412(i) plan prematurely terminates, the plan suffers a large decrease in the surrender values, which pays for commissions and the cost of medicals and underwriting. Additionally, there can be no investments of the plan other than in insurance products. No mutual funds, stocks, bonds, real estate, collectables, etc. Employee costs can become exorbitant since they too must receive benefits that are comparable and/or non- discriminatory when compared to that of the owners.

We are aware of cases whereby some insurance companies have been promoting 412(i) plans that use Whole Life insurance exclusively. This violates two IRS principles. First, a plan that uses only insurance is not a qualified plan. Second, the maximum amount of insurance is subject to either 100 times the projected monthly pension or if RR74-307 is used the maximum amount of insurance is limited to the Whole Life premium, which is restricted to no more than 2/3 of the Normal Cost. The insurance industries response was “use 5% for annuities and 95% for whole life insurance.” This addressed the first principal but the resulting face amount was still far in

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