The COLI Wars

IRS investigators zero in on at least 50 highly leveraged, corporate-owned life insurance tax shelters.

When Congress passed a slate of tax changes in 1996 to curb the use of tax shelters by U.S. companies, corporate-owned life insurance (COLI) policies were at the top of the hit list. And judging from two court decisions in the past year, Internal Revenue Service hitmen are finding their mark.

On October 16, Judge Murray M. Schwartz, senior judge of the U.S. District Court of Delaware, ruled that the COLI VIII plan set up by Mutual Benefit Life Insurance Co. (MBL) for Camelot Music Inc. in February 1990 was a sham transaction, entered into only for the purpose of avoiding taxes. In a remarkably detailed, 143-page opinion, Schwartz upheld an IRS claim against Camelot and disallowed $13.8 million in tax deductions for interest payments on loans the company took out against its COLI policies. The IRS wants $6 million in back taxes from CM Holdings, Camelot’s parent company (now owned by Trans World Entertainment). After a similar ruling last year by the U.S. Tax Court, Winn-Dixie Stores was forced to take $42.5 million in charges against earnings this past August.

The two cases are the tip of the iceberg. Many other corporate buyers of leveraged COLI policies may soon find themselves stripped of previously claimed deductions, and liable for huge tax bills. The IRS has identified, but not disclosed, 85 taxpayers with similar plans, and was engaged in 50 investigations, with more expected. Securities and Exchange Commission filings show that many of the companies involved are large, household names. Lindy Paull, chief of staff of the Congressional Joint Committee on Taxation, estimates that there may be as many as 100 such cases, with $6 billion in taxes involved.

Over the Line?

The issue is not the COLI policies themselves, but the financing of them. Companies have purchased so-called key-man life insurance policies on senior managers for decades. These policies enable companies to collect substantial benefits in the event of the death of a key employee. But in the late 1980s, insurance companies began to offer COLI plans for wider pools of employees, and allowed companies to finance the policies with loans from the insurer. The plans were pitched as a tax-advantaged way to fund the rapidly rising costs of employee health-care benefits.

But they did so at the government’s expense, argues the IRS. The essence of both court decisions to date was that neither Camelot nor Winn-Dixie would have bought the insurance were it not for the tax deductions it afforded. Camelot’s insurance arrangement “crossed the line separating insurance against an untimely death and tax-driven or tax-
sheltering investments,” according to Judge Schwartz’s opinion.

The company bought high-priced policies on the lives of 1,430 of its employees for the taxable years starting in 1990. It took out big loans against the policies to pay the first three yearly premiums, and claimed deductions in 1991 through 1994 for interest paid on the loans.

The high premiums, coupled with the broad base of employees covered, created a big cash value for the policy, which was used to secure the biggest possible loans. In one version of the plan, annual premiums were as much as $10,000 per employee. The size of the loans and corresponding interest payments were designed to fuel big interest deductions aimed at producing positive cash flows in every year of the policy.

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