12(i) Plan is a defined pension plan designed for small business owners in the United States. Contributions from owners that are classified as tax-eligible annuity plans can be immediately considered tax deducted from the company. Guaranteed annuities or a combination of annuity and life insurance were the only ones that could fund the 412(i) plan. Plan 412(i) was superseded by Plan 412(e)(3) on or after December 31, 2007.
look at a glance
—A 412(i) plan was a defined benefit pension plan designed for small business owners in the United States.
—A 412(i) was a tax-eligible benefit plan, meaning the owner’s contribution to the plan would be tax deductible for the company.
—A guaranteed annuity or a combination of annuity and life insurance were the only ones that could fund this plan.
–Due to tax avoidance schemes arising under —412(i), the Internal Revenue Service (IRS) replaced them with 412(e)(3).
Realizing a 412(i) Plan
Specifically, the 412(i) plan was developed for small businesses who find it difficult to invest in a company while saving for their employees’ severance pay. The 412(i) plan
was unique in that it offered fully insured retirement benefits.
Insurance companies had to sponsor 412(i) plans and could only finance insurance products such as annuities and life insurance. Contributions to it provide the largest tax credit possible.
An annuity is a financial product that an individual can purchase in a lump sum or in
installments. The insurance company, in turn, pays the owner a fixed flow of payments at some point in the future. Pensions are primarily used as a source of income for retirees.
Due to the large premiums the plan has to pay each year, the 412(i) plan was not ideal for all small business owners. This plan has tended to benefit smaller businesses that are more stable and profitable.
For example, a startup that has received multiple rounds of funding would have been better positioned to develop a 412(i) plan than it would have received bootstrap and/or angel or seed funding.
In addition, these companies often do not generate enough free cash flow (FCF) to continue to accumulate for their employees’ retirement. Instead, founding team members often reinvest revenue or external funds into products or services to generate new sales and update core products.
412(i) Plans and Compliance Issues
In August 2017, the Internal Revenue Service (IRS) confirmed that the 412(i) plan was not compliant with various types of regulations. This also included the issue of malicious tax avoidance transactions. To help organizations with 412(i) plans to comply, the IRS has developed the following survey: they asked:
—412(i) do you have any plans?
—So how do you finance this plan? (e.g., annuities, insurance contracts or unions?)
—How much is the death benefit compared to the retirement benefit for each plan member?
—Were there any trades listed under the Revenue Regulations 2004-20? If so, did you file Form 8886, Reportable Transaction Disclosure Statement?
—Finally, who sold the annuity and/or insurance contract to the sponsor?
The survey results for 329 plans are as follows:
—185 Plan referenced in review
— 139 plans considered “good enough compliance.”
—Three plans of “current inspection”
— One plan marked as “Compliance Confirmed” (meaning no further contact required)
—412(i) One plan marked as not a plan
Because an abuse of the 412(i) plan resulted in a tax avoidance scheme, the Internal
Revenue Service (IRS) moved the 412(i) section to 412(e)(3), effective for plans beginning on or after December 31, 2007. 412(e)(3) functions similarly to 412(i) except that it is exempt from the minimum funding requirement. According to the IRS, the requirements for 412(e)(3) are:
—Plans must be financed only through the purchase of a combination of an annuity and life insurance contract or individual annuities.
—The plan contract extends to the retirement age of each individual participating in the plan and the date the individual become participating in the plan (or any increase in benefits, beginning at the time such increase becomes effective).
—The benefits offered by the plan are the same as those offered under each contract
at normal retirement age under the plan and are covered by the insurance company (authorized under the laws of the country in which the plan does business) within premium limits has been paid,
—For the Plan Year and all previous Plan Years, any premiums payable under these agreements were paid prior to expiration or policy reinstated.
—No rights under such agreement were subject to a security right during the planned year.
—No outstanding policy loans at any point in the planning year.