Asset protection techniques that are effective should not be overlooked because they are simple or obvious. A simple but very effective technique for business owners is the 412(i) Defined Benefit Plan. A 412(i) plan offers what amounts to a business owner’s asset protection plan that is subsidized by favorable tax treatment. Because the bear markets of 2000-2002 hurt many retirement plans, Congress favors these plans as a means of “making up” lost retirement benefits.
A defined benefit plan is a qualified employer-sponsored retirement plan that provides to the employee a specific retirement benefit amount according to a formula. A 412(i) plan is basically a defined benefit retirement plan that complies with Section 412(i) of the Internal Revenue Code. So long as the plan complies with Section 412(i), it is exempt from the complex funding rules for other plans in Section 412. These plans typically have three features:
The Plan is funded solely with individual or group life insurance and/or annuity contracts that are part of the same series and use the same mortality tables and rates for all participants. [Conservative 412(i) plans tend to consist of no more than 50% life insurance and no less than 50% annuity, while some plans will go as high as 67% insurance and 33% annuity. Avoid aggressive plans having in excess of 67% life insurance.]
The insurance contracts must fund benefits using level premiums for all benefits. When a participant enters the plan, payments being and may extend no later that the retirement date stated in the plan.
Only the insurance contacts can provide the plan benefits, and an insurance company must guarantee these contracts.
412(i) Plans can be started late in the tax year but with full tax benefits.
These plans work well for small businesses and self-employed individuals. When properly structured, these plans also protect family and heirs by including an insured death benefit – which further reduces taxable income and increases tax deductions.
Advantages include:
Solid creditor protection (discussed more fully below).
Maximum current tax deductible contribution for the business.
Contributions are based solely on the guarantee provision of the level premium contacts, so there can be no over-funding or under-funding of the plans.
There is no full-funding limitation under ERISA section 404(a)(1)(A) or current liability test to limit contributions, and no actuarial certification is required.
Unlike traditional defined benefit plans, no quarterly contributions are required and the plan may be funded annually without interest.
Typically, the IRS will no challenge the plan assumptions since it is the contact guarantees that govern the required contributions. This permits higher deductions.
Potential disadvantages include:
Because of the large required contributions, these plans only work where the business is established and highly profitable. It usually works best where the business owner is within 10 years or so of retirement and is older than most of the firm’s employees, and there are relatively few employees.
The Plan should not make policy loans.
There is no flexibility in investments, since the Plan is funded entirely with insurance contacts.
There may be limitations to the deductions or the amount of insurance that is purchased, and there may be an income component that is re-captured by the business owner.
Creditor Protection
412(i) Plans offer tremendous tax-subsidized creditor protection. Essentially, the business owner is able to move several hundred thousands of dollars out of the business and into an asset-protective structure (the Plan). Essentially, the Plan should be exempt from creditors under the Employee Retirement Income Security Act of 1974 (ERISA). Because the plan is exempt from creditors, the Uniform Fraudulent Transfer Act should not apply to transfers made from the business to the plan (UFTA specifically excludes “exempt” assets). Thus, transfers from the business to the Plan are not susceptible to being set aside by creditors.
Essentially, 412(i) Plans allow business owners to take a deduction for perhaps several hundred thousand dollars out of their business and into the Plan – with favorable tax treatment. For small business owners who are capable of making contributions to these Plans, they are a very effective and efficient method of asset protection. The intelligent use of these plans serves to reduce the financial profile of the business and business owner, while securing additional retirement revenue streams and growing wealth.
Combined with Employee Benefit Arrangements
412(i) plans can be used in conjunction with 419 plans and VEBAs to increase employee benefits and maximize the employers deductions. In appropriate cases, through a combination of a 412(i) plan and either a 419 plan or a VEBA, an employer might conservatively take a year-end deduction of up to $500,000 in appropriate cases. As with all tax planning, be sure that your tax attorney reviews these arrangements before participating in them.