You have a new client named Allen. Allen worked his whole life to build his small successful business that now has five employees. He saved every dollar he could, and he invested very conservatively in anticipation of retirement.
Allen comes to see you and tells you a story that is disquieting. A few years ago, he was at the country club and played a round of golf with a happy, friendly insurance agent named Bill. They quickly became friends. Over drinks, Allen complained to Bill about taxes and expressed his concern about his investments. Bill told him about a new and bullet-proof retirement plan for his business. Allen told Bill he could not afford to pay for his employees’ retirement, but Bill assured him that he could arrange an “executive carve out” for the defined benefit plan. Bill convinced Allen to implement a 412i plan that would include life insurance that gives Allen tax deductions now and when he retires. Bill sold him the plan and life insurance provided by Colossal Insurance, an A+ company. Allen paid big money and took big deductions. Life was great until recently. Allen is having trouble getting information from Bill, and he is worried about his investment.
You look further into the situation. It turns out that Allen was in a hurry since Bill convinced him he’d lose the opportunity if he did not move quickly. He told Bill to do all the paperwork (filled with errors and inaccuracies), and Allen does not remember signing anything. You call Bill and Colossal, and everyone claims to be too busy to answer questions, but they will get back to you. Promise! After some digging, you conclude that there are serious misrepresentations on the life insurance application (where Allen’s signature is clearly forged) that may give the insurance company grounds to avoid paying benefits. Even worse, it looks like Allen’s got an unqualified plan for which he was never entitled to take tax deductions and a present tax problem – a serious one. The economy has been tough, and he does not have nearly enough cash to resolve potential IRS issues. What do you do?
One alternative is to develop a plan to engage with the IRS and come to some agreement. But the idea that the IRS is ready to help Allen exists only in IRS propaganda. And contacting the IRS without all the facts and all the paperwork can open your new client to serious risks. No matter what, an agreement with the IRS will probably be more than Allen can afford. Why should Allen suffer the losses that were caused by those he trusted?
Another alternative, since the IRS remedies are likely to outstrip his ability to pay, is to wait until Allen can develop some resources to handle the IRS situation. But how will he do that?
The answer to each question is the same – those who were responsible should pay for what your client has suffered. Let’s go through the process of establishing a defined benefit plan, what can and sometimes does go wrong, to whom your client can look for compensation, and what relief is likely available.
Establishing a Defined Benefit Plan
It’s no secret why business owners look at adopting defined benefit plans. Social Security payments (assuming they will be available at a reasonable age for retirement) are hardly sufficient to maintain the lifestyle of a typical business owner. Substantial supplementation of annual income will be required. A defined benefit plan can provide the means of funding the supplementation by providing very substantial benefits, even for those retiring early. Because of the funding levels and because of funding sources such as annuities and life insurance, there is great security to a plan. And along the way, there are valuable tax benefits that make establishing a plan attractive.
The ongoing obligations, once a plan is established, are not impossible to meet, but there are critical steps. Each year the business must file a Form 5500 with a Schedule B. An enrolled actuary (an actuary who meets the qualifications of and has been approved by the Joint Board for the Employment of Actuaries) must determine the funding levels. The enrolled actuary must sign the Schedule B.
Defined benefit plans can be complex to set up. Consequently, a business considering such a step should utilize a team of individuals with knowledge and experience. At a minimum that team should include a CPA, an attorney with an understanding of ERISA, and a knowledgeable insurance agent. A qualified team aware of all the rules of the road can establish a solid plan to protect the business and the plan’s beneficiaries.
What Could Go Wrong?
The most serious problem is that many business owners seldom consult a qualified team. Often, the owner consults a board of experts (mostly buddies who have inventive suggestions to dodge taxes) or a financial planner who may not be fully conversant about the technical requirements of defined benefit plans. The next step will be a consultation with an insurance agent who is marketing a defined benefit plan as a means of selling insurance products. And that’s where the problems can start.
Whether someone is a candidate for a defined benefit plan and, if so, what kind of plan, requires a balance of science and an art. There are a number of alternatives that can include a 412i plan, a 419 plan, a VEBA plan, and others. There are Earned income levels of the business, the number of employees and their potential eligibility, the ability to contribute, and the correct mix of annuity/insurance policies must all be weighed. The complex paperwork to establish a plan must be properly and fully completed.
Unfortunately, while most insurance agents are honest and knowledgeable, sometimes a client may encounter one who is so intent on selling products that he is not the best person to weigh the various factors and to properly set up everything. Why? Because the incentive to sell life insurance is overwhelming. Commission levels on life insurance sales can often exceed 100% of the first year’s premium, and there can be substantial additional benefits as the years go on. The commissions are many times greater than they are for annuities that may be sold and that must be a part of certain defined benefit plans. So what happens? Shortcuts are taken. Selling life insurance is job 1. The niceties of appropriate plan design are secondary, and the obligations to complete essential paperwork are sometimes only done once the plan administrator or the insurance company underwriting the products starts screaming for the proper forms. The result? Too often it is a plan that is unqualified or even one that can be considered a listed transaction which has its own severe penalty implications.
What Are The Dangers?
There are substantial dangers from having an unqualified plan or a listed transaction. And for a time your new client may be able to run – but not hide. Your client must be constantly worried what will happen in the event of an IRS audit. The costs of participating in that audit, between your fees and those of an actuary who may be brought in to assist, may be immense. The end of the audit can be crushing for some businesspeople because it may involve interest and penalties on deductions improperly taken and even listed transaction penalties that can cause your client’s ultimate liability to skyrocket.
Your first goal will be to try to control the process. You want to contact the IRS before the IRS contacts your client. But that decision can be very costly. You will have to amend previous years’ taxes to fix improper deductions and probably negotiate interest and penalties. In addition, your client will have to spend money to get the plan right. Taking the steps to bring a faulty plan into compliance may well include significant past benefits and future qualification for employees who should have been included in the plan in the first place to make it legitimate.
Who Should Pay?
Who do you look to help defray the costs? The easy answer is the agent who sold your client the plan. However, your client is not looking at minor inconveniences. Instead, the combined costs of correction can often be hundreds of thousands of dollars, or even an obligation into the seven figures, to do everything necessary to solve the problems caused by people he trusted. Insurance agents are unlikely to have resources and malpractice coverage sufficient to solve your client’s issues.
The real answer is to look at those who should have been looking all along to make sure that the plan was established in full compliance with the law and to protect your client against financial fraud. The first of those is the broker for whom the agent worked. That broker has the statutory obligation to oversee and be responsible for the work of its agents to prevent pension plan malpractice. The next is the third party administrator for the plan. One of its primary obligations is to make sure the plan is appropriately administered. A plan that is defective when set up or not appropriately maintained is being administered negligently. The deepest pocket, often overlooked, is the insurance company sponsoring the plan or that issued the insurance policies and annuities that fund the plan. The insurance company has complex and comprehensive obligations under state laws and federal regulations to ensure compliance to ensure that its policy holders are not victims of retirement plan malpractice. Those obligations are supposed to be met by systems designed to ensure that the plans that are sold and the annuity and insurance policies that are underwritten comply with the law.
The Defense Strategy
Once a lawsuit is threatened, the likely defense strategy, especially from the insurance company, is predictable. The defendants will stonewall. Getting information from them prior to the lawsuit or even once it is filed, even though there are laws and regulations requiring that they provide documentation and information to insureds, will be difficult. Expect protests that they have done nothing wrong. Claims that they are the experts and that they could not possibly have done something the wrong way are par for the course. And finally threats to use massive resources to wear out your client will hardly be subtle.
So what do you do? Work with experienced lawyers who understand how to deal with those who have damaged your client. Experienced counsel will know what to do. They will understand the process of constructing the case. They will know what documents and materials to insist on in discovery to use in proving the case. Most importantly, experienced counsel know how to use the lofty sales puffery of insurance companies against them.
Sales puffery? By a major too-big-to-fail stalwart of the insurance industry? Absolutely! Insurance companies are noted for the lofty claims of how they exist solely for their policy holders. Listen to the advertising claims of any insurance company, and you will conclude that their insureds don’t need anyone else in life looking out for them. The insurers are there to help with policies that are solely for the insureds’ benefit. They are there to provide rock solid advice. They are there with their highly trained specialists who ensure every need is fulfilled. They are there to make sure that the insured spends the future at a palatial lakefront manse with a golden retriever gracefully jumping off the dock into the water. And all of this security is overseen by its omnipotent bulldog investigation unit to protect policyholders against fraud. Comforting isn’t it?
Don’t buy the hype. Experienced counsel will often be able to show that is often just a bunch of malarkey, and that insurance companies are sales machines that must keep the premiums flowing even if “shortcuts” must be taken. Their specialists are often ill-trained salespeople, and their investigative departments are used to protect the insurance companies and not insureds.
What Can be Recovered?
The potential recoveries can be substantial.
- Your client should be entitled to recoup his out of pocket expenses associated with hiring you and other professionals to deal with the IRS, including the costs involved in going through an audit.
- Your client should be able to recoup interest and penalties and even listed transaction penalties.
- Quite clearly, your client’s defined benefit plan will have to be brought into compliance. There will be associated costs that the client should be able to recover.
- It is likely that one of the costs of bringing the plan into compliance will be related to an employee census and funding or paying employees who were not appropriately originally provided for in the defective plan. Those costs should be an element of damages sought in any legal action.
- Depending on state law your client may be eligible for other compensatory damages for going through the ordeal.
- There may be statutory damages available for what your client has gone through if state law so provides.
- Most state laws will allow for punitive damages for a victim of a pattern of abuse, particularly where the insurance broker, TPA, and insurance company knew of or should have known of the wrongful activities of the agent.
- Finally, under appropriate state statutes, there may be rights to attorneys’ fees for the lawyer bringing the action and for expert witness fees for you and other professionals who provide valuable information for the jury considering the case.
It Can Be Done
Clients like Allen who come to you with a defective benefit plan must travel a rocky and dangerous road to arrive at a safe solution. But there are resources available to help fund that trip. Help your client not only get the plan into compliance and solve the issues with the IRS, but also help your client seek the means to fund the solution including compensation for what he has gone through and will go through. Consult experienced counsel who can help you protect your client’s rights.
*This article is for educational purposes, and it is not to be considered legal advice. Feel free to contact Mahdavi, Bacon, Halfhill & Young, PLLC at www.mbhylaw.com or at (703) 420-7620 if you have questions.