What Is a 79/38 Plan and How Does It Work?

A 79/38 plan is a tax strategy used by C-corporations to offer life insurance benefits to owners and key employees. The name refers to sections of the Internal Revenue Code (IRC) that provide its tax advantages. The structure is designed to provide a tax-advantaged death benefit to an employee’s beneficiaries while creating tax deductions for the sponsoring company.

The Mechanics of a 79/38 Plan

A 79/38 plan operates when a C-corporation establishes the program and makes regular contributions into a trust. These contributions are not paid directly to an insurance company. The trust is a Voluntary Employees’ Beneficiary Association (VEBA), a tax-exempt entity designed to hold assets for employee benefits.

The trust’s administrator uses the funds to purchase a cash-value life insurance policy on the life of the covered employee. The policy is designed to comply with the rules for group-term life insurance under IRC Section 79. Qualifying under this section allows the arrangement to be treated as a group benefit plan, which provides the tax treatments that make the plan attractive to both the employer and employee.

Tax Implications for Participants

For the Employer (C-Corporation)

For the C-corporation, the primary tax advantage is the ability to deduct contributions made to the trust. These payments are generally treated as ordinary and necessary business expenses under IRC Section 162, reducing the company’s taxable income. This allows the business to fund the employee benefit with pre-tax dollars.

For the Employee

The employee also receives tax-advantaged treatment. Under IRC Section 79, the value of the first $50,000 of group-term life insurance coverage is excluded from the employee’s income. This means the employee receives this initial amount of coverage tax-free.

For coverage amounts exceeding $50,000, the employee must recognize a certain amount of taxable income. This “imputed income” is not based on the actual premium paid but is calculated using rates from a specific IRS table, known as Table I. The rates in this table are based on the employee’s age, and the resulting taxable amount is often lower than the actual cost of the insurance.

Upon the employee’s death, the life insurance proceeds are generally paid to the designated beneficiaries. These proceeds are free of federal income tax under IRC Section 101.

IRS Position and Compliance Factors

The Internal Revenue Service has historically viewed 79/38 plans and similar arrangements with scrutiny. The agency has expressed concerns that some of these plans may be abusive tax shelters designed to generate excessive tax benefits without a legitimate business purpose. This has led to increased examination of such plans.

The IRS has, in the past, identified certain welfare benefit arrangements as “listed transactions,” a designation for strategies with a potential for tax avoidance. For example, the IRS used Notice 2007-83 to classify certain trust arrangements as listed transactions, though federal courts later invalidated this notice. While that specific reporting requirement was set aside, the structure of these plans remains subject to IRS scrutiny.

An area of compliance for these plans is the set of non-discrimination rules under IRC Section 79. These rules prevent plans from discriminating in favor of “key employees,” such as highly compensated officers or owners. To comply, a plan must satisfy tests related to both eligibility and benefits, ensuring that a broad class of employees benefits from the plan.

A plan that fails these non-discrimination tests loses its favorable tax status. Key employees would then be required to include the full cost of their insurance coverage in their taxable income.