Court Issues Mixed Ruling in Case of Abusive Tax Shelter Plan

However, the Court of Appeal of the State of California Fourth Appellate District said Richard Kelter and Rio Vista West LLC failed to allege sufficient facts to state a breach of fiduciary duty claim against the plan co-developer Economic Concepts Inc. (ECI) or any claim against another co-developer Bryan Cave, both of which Kelter said participated in developing and marketing the pension plan and represented him in an IRS audit.  

A trial court found the statute of limitations barred Kelter’s lawsuit because his claims accrued when he established the pension plan and paid the first contribution. But the appellate court disagreed and concluded his claims did not accrue at that point because the contributions Kelter paid into the plan did not cause him any harm until the Internal Revenue Service made its final determination the plan constituted an illegal tax shelter.  

The case involves a defined benefit pension plan (Section 412(i) Plan or Plan) that allows an employer to hold in a trust an insurance policy on each plan participant‟s life. The employer funds the trust to pay the life insurance premiums and receives a tax deduction for the premium payments. When a plan participant retires, the employer sells the insurance policy on that participant‟s life and uses the proceeds to purchase an annuity. The revenue stream from the annuity pays the participant his or her retirement benefits.   

The IRS recognized that taxpayers often used these plans to shelter large amounts of income, and responded by identifying certain misuses of section 412(i) Plans as “abusive” tax shelters not entitled to any income tax benefits. These misuses include funding a plan solely with a life insurance policy that (1) provides death benefits exceeding the amount allowed for an approved Section 412(i) Plan; (2) pays extremely high fees and commissions to the salespeople; and (3) carries exorbitant surrender charges that essentially require an employer to forfeit the plan‟s assets if the employer terminates the policy early.   

According to the court opinion, in the late 1990‟s, a life insurance company (AmerUs Life Insurance Company), pension planner (ECI), and law firm (Bryan Cave) developed a defined benefits pension plan they called the Pendulum Plan. Although they were aware of the IRS‟s position, AmerUs, ECI, and Bryan Cave designed the Pendulum Plan as a Section 412(i) Plan and funded it solely with life insurance policies displaying the characteristics the IRS looks for in an abusive tax shelter.   

Even after AmerUs‟s professional advisers warned the company that the IRS might consider the Pendulum Plan an abusive tax shelter, the firm and ECI embarked on a nationwide campaign to market and sell Pendulum Plans as qualified Section 412(i) Plans without disclosing the significant risk that the IRS would audit an employer‟s plan, find it abusive, and assess substantial back taxes, interest, and penalties against the employer.   

In November 2003, Kelter met with a financial adviser who recommended a Pendulum Plan to take advantage of the income tax benefits it provided. During the sales process, Kelter consulted ECI several times. ECI represented the Pendulum Plan complied with all federal tax laws and Kelter would receive a tax deduction for the life insurance premiums he paid to fund the plan. In December 2003, Kelter established a Pendulum Plan entitled the Rio Vista West, LLC Defined Benefit Pension Plan. At no time did ECI or AmerUs advise Kelter about the tax risks associated with establishing the Rio Plan or that the Rio Plan featured all the characteristics the IRS looked for in an abusive Section 412(i) Plan.   

Following an audit the Rio Plan, the IRS notified Kelter it considered the plan abusive because it failed to satisfy Code sections 412(i)(3).  

Kelter began negotiating with the IRS to reach an agreement on the amount of back taxes, penalties, and interest he owed because the Rio Plan failed to qualify as a Section 412(i) Plan. As of May 2009, when Kelter filed his most recent pleading in the trial court, he had not reached an agreement with the IRS, which had yet to assess a specific amount for back taxes, penalties, and interest.