What Was a 412(i) Plan?
A 412(i) plan was a defined-benefit pension plan tailored for small business owners in the U.S. Classified as a tax-qualified pension plan, any contributions the owner made could be immediately taken as a tax deduction by the company. The plan was exclusively funded by guaranteed annuities or a mix of annuities and life insurance. On Dec. 31, 2007, the 412(i) plan was replaced by the more refined 412(e)(3) plan.
Key Takeaways
- The 412(i) plan was a defined-benefit pension strategy designed specifically for small business owners.
- Contributions to the plan were tax-deductible for the business owner.
- The plan was funded solely through guaranteed annuities or a combination of annuities and life insurance.
- The IRS replaced the 412(i) plan with the 412(e)(3) plan to lift it above tax avoidance schemes.
Understanding the 412(i) Plan
412(i) plans were particularly designed for small business owners who faced challenges in investing in their business while saving for employees’ retirement. One remarkable aspect of this plan was its fully guaranteed retirement benefits.
For the 412(i) plan, an insurance company had to be the sponsor, and it could only be funded by insurance products such as annuities and life insurance policies, providing the business owner the largest tax deduction possible.
An annuity is a financial product bought as a lump-sum payment or in installments. The insurance company then pays the purchaser a fixed stream of payments in the future, usually serving as an income stream for retirees.
Given the high premiums required annually, the 412(i) plan was more suited for well-established and profitable small businesses. For example, a startup with significant funding would be better positioned to create a 412(i) plan than one with limited or no external funding.
These companies often don’t generate sufficient free cash flow to consistently save for employees’ retirement, as profits or outside funding are often reinvested into the business to drive new sales and update core offerings.
412(i) Plans and Compliance Issues
In August 2017, the IRS identified various non-compliance issues, including abusive tax avoidance transactions, associated with 412(i) plans. To facilitate compliance, the IRS conducted surveys asking pertinent questions, such as:
- Do you have a 412(i) plan?
- How do you fund this plan? (i.e., annuities, insurance contracts, or a combination?)
- What is the death benefit relative to the retirement benefit for each plan participant?
- Have you had a listed transaction under Revenue Ruling 2004-20? If so, have you filed Form 8886, Reportable Transaction Disclosure Statement?
- Who sold the annuities and/or insurance contracts?
The IRS’s survey of 329 plans yielded the following results:
- 185 plans referred for examination
- 139 plans deemed “compliance sufficient”
- Three plans under “current examination”
- One plan noted as “compliance verified”
- One plan labeled as not a 412(i) plan
Transition to 412(e)(3)
Due to tax avoidance issues under the 412(i) plan, the IRS transitioned the provisions to 412(e)(3), effective for plans starting after Dec. 31, 2007. 412(e)(3) operates similarly to 412(i) but is exempt from the minimum funding rule. Requirements for 412(e)(3) include:
- The plan must be funded exclusively through annuities and life insurance contracts or individual annuities.
- Contracts must provide for level annual premium payments, continuing until retirement age for each participant.
- Plan benefits must match the guaranteed benefits provided by annuity/life insurance contracts at normal retirement age.
- Premiums must be paid in full and on time for the plan year and all prior plan years.
- No rights under the contracts can be subject to a security interest during the plan year.
- No policy loans should be outstanding at any time during the plan year.
Related Terms: Defined-Benefit Pension Plan, Annuities, Life Insurance, IRS Compliance.
References
- Association of International Certified Professional Accountants, Journal of Accountancy. “The Section 412(i) Retirement Alternative”.
- Internal Revenue Service. “Fully Insured 412(e)(3) Plans”.
- U.S. Department of the Treasury. “Treasury and IRS shut down abusive Life Insurance Policies in Retirement Plans”.
- Internal Revenue Service. “EP Abusive Tax Transactions - Deductions for Excess Life Insurance in a Section 412(i) or Other Defined Benefit Plan”.
