Retirement Planning

412(i) plan

What is a 412(i) plan?

A 412(i) plan is a defined benefit pension plan designed for small business owners in the United States. It is classified as a tax-compliant pension plan, so any amount the owner contributes to it is immediately considered a tax corporation deduction. Guaranteed annuities, or a combination of annuities and life insurance, are the only things that can fund a 412(i) plan. After December 31, 2007, the 412(i) plan was replaced by the 412(e)(3) plan.

key takeaways

  • The 412(i) plan is a defined benefit pension plan designed for small business owners in the United States
  • A 412(i) is a tax-eligible benefit plan, which means that the owner’s contributions to the plan become a tax deduction for the corporation.
  • A guaranteed annuity or a combination of annuity and life insurance is the only thing that can fund the plan.
  • The Internal Revenue Service (IRS) replaced it with 412(e)(3) due to tax avoidance schemes that occurred under 412(i).

Understanding 412(i) Plans

It’s worth noting that 412(i) plans are for small business owners who often find it difficult to invest in companies when saving for employees’ retirement. A 412(i) plan is unique in that it provides fully guaranteed retirement benefits.

An insurance company must sponsor a 412(i) plan, and only insurance products such as annuities and life insurance policies can fund it. Contribution to it provides the greatest tax relief.

Annuities are financial products that individuals can purchase on a one-time or installment basis. In turn, the insurance company pays the owner a fixed stream of payments at some point in the future. Annuities are mainly used as a source of income for retirees.

Because of the large annual premiums that must be paid into the plan, a 412(i) plan is not suitable for all small business owners. The program tends to benefit more established and profitable small businesses.

For example, a startup that has gone through several funding rounds is more likely to have a 412(i) plan than one that is self-reliant and/or has angel or seed funding.

These companies also often fail to generate sufficient free cash flow (FCF) to consistently fund employee retirements. Instead, founding team members often reinvest any profits or outside funding into their product or service to generate new sales and update their core product.

412(i) planning and compliance issues

In August 2017, the Internal Revenue Service (IRS) determined that 412(i) plans involve various types of violations. These also include the issue of abusive tax avoidance transactions. To help organizations with 412(i) plans comply, the IRS conducted the following investigations. They have asked:

  • Do you have a 412(i) plan?
  • If so, how are you funding the program? (i.e. annuities, insurance contracts, or both?)
  • What is the amount of the death benefit relative to each plan participant’s pension amount?
  • Have you ever been listed under the 2004-20 Revenue Rules? If so, have you filed Form 8886, Reportable Transaction Disclosure Statement?
  • In the end, who sold the annuity and/or insurance contract to the sponsor?

A survey of 329 programs concluded the following:

  • 185 plans submitted for review
  • 139 programs deemed ‘adequate compliance’
  • “Check Now” Three Plans
  • A program is marked as “Compliance Verified” (meaning no further contact is required)
  • A plan marked as a non-412(i) plan

412(e)(3)

Due to misuse of 412(i) plans resulting in tax avoidance schemes, the Internal Revenue Service (IRS) moved Section 412(i) to 412(e)(3), effective for plans beginning after December 31, 2007. 412(e) (3) functions similarly to 412(i), but it is not subject to the minimum funding rules. According to the IRS, the 412(e)(3) requirements are as follows:

  • Plans must be fully funded through the purchase of a combination of annuities and life insurance contracts or individual annuities,
  • The plan contract must provide for the payment of a level of annual premiums not later than the retirement age of each individual participating in the plan and from the date the individual becomes a participant in the plan (or, if benefits, from the time such increase becomes effective) ),
  • The plan provides benefits equal to the benefits the plan provides under each contract at normal retirement age and is guaranteed by an insurance company (licensed to do business with the plan under state law) to the extent of premiums paid,
  • Premiums payable under such contracts for the plan year and all prior plan years have been paid prior to the lapse or reinstatement of the policy,
  • Rights under such contracts are not subject to security interests at any time during the plan year, and
  • No policy loan outstanding at any time during the plan year

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