July 2002

Money Matters
Answers to Your Finance & Tax Questions
By John McGill, MBA, CPA, JD

Q Recently I read that all interest on student loans is now fully deductible. Is this correct?

A The new tax law continues to allow deductions for up to $2,500 of student loan interest each year under Section 221 of the tax law. However, under the new law, interest paid during the entire loan repayment period can be deducted, rather than only during the first 60 months. Moreover, the income limits for deducting student loan interest have also been increased. Beginning with the 2002 tax year, the deduction is phased out for single doctors whose modified adjusted gross income exceeds $50,000, and for married doctors whose modified adjusted gross income exceeds $100,000.

Q During the past year, I have been contacted several times by a group promising huge tax deductions using a Section 419 retirement plan. Since this plan is not covered by the regular retirement plan rules, I am told I can make large contributions for myself to fund a future severance benefit, with only minimal contributions required on behalf of staff. This sounds too good to be true, and my accountant advised against it. What do you think?

A Run, do not walk, away from this advice. In Neonatology Associates, P.A. vs. Commissioner 115 TC 43 (7/31/00), several doctor groups made contributions to separate plans formed under two purported Section 419 VEBA plans crafted by insurance salespeople, and marketed to the professional small business owners as a viable tax-planning device.

Each plan provided that the doctors would receive term life insurance benefits. However, the premiums on the underlining insurance policy substantially exceeded the cost of the term life insurance, with the excess being applied to convert, at the doctor’s option, the term insurance into a universal life insurance policy with substantial cash value. As a result, after five years, the doctor could withdraw any earned amount or borrow against it with no out-of-pocket expense.

In this situation, the tax court found that the plans were not designed, marketed, purchased, or sold as a means to provide welfare benefits to the employees of the corporation, but rather were designed solely for the tax benefits provided to the owner-doctors. Accordingly, the tax court disallowed all the deductions for contributions to the plan that exceeded the minimal costs of the group term life insurance. In addition, the disallowed contributions were taxed twice (one to the corporation, and again as constructive dividends to the doctors). Finally, the judge slapped the doctors with substantial penalties for negligence and intentional disregard of the rules and regulations of the tax laws.

The IRS recently served notice that Section 419 plans are now “listed transactions.” This requires the promoter to file with the IRS a listing of all such programs, along with the individuals participating, and this investment must be disclosed on the individuals’ tax returns. Accordingly, despite what you have been told, these transactions are on the IRS “hit list,” and if you decide to participate, you could face a substantial likelihood of an IRS audit, possible disallowance, and potential penalties. It’s not worth the risk.

Mr. McGill is a tax attorney with McGill and Hassan, P.A., a legal firm in Charlotte, N.C., that specializes in financial issues. He formerly worked with the Office of Chief Counsel, the legal branch of the Internal Revenue Service in Washington, D.C.