What Was a 412(i) Plan?
A 412(i) plan was a defined-benefit pension plan that was designed for small business owners in the U.S. It was classified as a tax-qualified pension plan, so any amount that the owner contributed to it could immediately be taken as a tax deduction by the company. Guaranteed annuities or a combination of annuities and life insurance were the only things that could fund a 412(i) plan. The 412(i) plan was replaced by the 412(e)(3) plan after Dec. 31, 2007.
- A 412(i) plan was a defined-benefit pension plan that was designed for small business owners in the U.S.
- A 412(i) was a tax-qualified benefit plan, meaning the owner's contributions to the plan became a tax deduction for the company.
- Guaranteed annuities or a combination of annuities and life insurance were the only things that could fund the plan.
- Due to tax avoidance schemes that were occurring under 412(i), the Internal Revenue Service (IRS) replaced it with 412(e)(3).
Understanding a 412(i) Plan
Notably, 412(i) plans were developed for small business owners who often found it difficult to invest in their company while trying to save for employees' retirement. The 412(i) plan was unique in that it provided fully guaranteed retirement benefits.
An insurance company had to sponsor the 412(i) plan, and only insurance products like annuities and life insurance policies could fund it. Contributions to it provide the largest tax deduction possible.
An annuity is a financial product that an individual can purchase via a lump-sum payment or installments. The insurance company, in turn, pays the owner a fixed stream of payments at some point in the future. Annuities are primarily used as an income stream for retirees.
Due to the large premiums that had to be paid into the plan each year, a 412(i) plan was not ideal for all small business owners. The plan tended to benefit small businesses that were more established and profitable.
For example, a startup that had gone through several rounds of funding would have been in a better position to create a 412(i) plan than one that was bootstrapped and/or had angel or seed funding.
These companies also often don't generate enough free cash flow (FCF) to put away consistently for employees’ retirement. Instead, the founding team members often re-invest any profits or outside funding back into their product or service to generate new sales and make updates to their core offerings.
412(i) Plans and Compliance Issues
In August 2017, the Internal Revenue Service (IRS) identified 412(i) plans as being involved in various types of non-compliance. These also included abusive tax avoidance transaction issues. To help organizations with 412(i) plans come into compliance, the IRS developed the following survey. They asked:
- Do you have a 412(i) plan?
- If so, how do you fund this plan? (i.e., annuities, insurance contracts, or a combination?)
- What is the amount of the death benefit relative to the amount of 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?
- Finally, who sold the annuities and/or insurance contracts to the sponsor?
A survey of 329 plans yielded the following:
- 185 plans referred for examination
- 139 plans deemed to be "compliance sufficient"
- Three plans under "current examination"
- One plan noted as "compliance verified" (meaning no further contact was necessary)
- One plan labeled as not a 412(i) plan
Due to the abuses of the 412(i) plan resulting in tax avoidance schemes, the Internal Revenue Service (IRS) moved the 412(i) provisions to 412(e)(3), effective for plans beginning after Dec. 31, 2007. 412(e)(3) functions similarly to 412(i), except that it is exempt from the minimum funding rule. According to the IRS, the requirements for 412(e)(3) are as follows:
- Plans must be funded exclusively by the purchase of a combination of annuities and life insurance contracts or individual annuities,
- Plan contracts must provide for level annual premium payments to be paid extending not later than the retirement age for each individual participating in the plan, and commencing with the date the individual became a participant in the plan (or, in the case of an increase in benefits, commencing at the time such increase becomes effective),
- Benefits provided by the plan are equal to the benefits provided under each contract at normal retirement age under the plan and are guaranteed by an insurance carrier (licensed under the laws of a state to do business with the plan) to the extent premiums have been paid,
- Premiums payable under such contracts for the plan year, and all prior plan years, have been paid before lapse or there is a reinstatement of the policy,
- No rights under such contracts have been subject to a security interest at any time during the plan year, and
- No policy loans are outstanding at any time during the plan year