There are certain members of the life insurance industry that are in perpetual pursuit of the ultimate potential driver of life insurance sales-tax-deductible life insurance premiums. Some in this industry have previously used aggressive retirement plan funding, and numerous other tax vehicles for these purposes, but in the end the IRS has always succeeded in defeating such strategies through administrative enforcement and litigation. The latest attempt to achieve tax-deductible premiums is the formation of a small business captive insurance company ("CIC") for the pre-planned purpose of using the CIC funds to invest in life insurance. The owner of a small business forms an IRC S 831(b) CIC, and pays a presumably tax deductible premium to the CIC for business risk insurance issued by the CIC. Subsequently, the CIC uses a significant part of the tax-free premium immediately to purchase life insurance on the common owner of the small business and CIC. In general, life insurance premiums are not deductible as ordinary and necessary business expenses, and tax-deducted funds should not be used to purchase life insurance.
The IRS is likely to view the CIC created and funded for the primary purpose of purchasing personal life insurance for its owner, as an abusive tax shelter. The IRS would see this transaction as the CIC serving as a conduit for the life insurance premiums to follow a circuitous route to achieve the tax deduction. The IRS often argues that judicial tax doctrines should be applied to disallow claimed deductions on what the IRS perceives to be Congressionally unintended life insurance oriented abusive tax shelters. attacking the CIC pre-planned life insurance transaction, the IRS would likely utilize the following judicial doctrines: (1) the sham transaction doctrine (specifically, as a sham in substance); (2) the economic substance doctrine; (3) the doctrine of substance over form; and (4) the step transaction doctrine.
This article discusses
https://www.insurancejournal.com/news/national/2020/05/05/567454.htm
A short history of the use of taxation as a motivating force in the life insurance sales business
Life insurance is an important social safety net, protecting families against the loss of a breadwinner in often the most troubling of times. Without life insurance, this responsibility would likely fall on taxpayers via governmental assistance programs. In addition, many people make use of life insurance as a form of retirement fund for use later in life.
As such, life insurance companies have substantial investable assets in the form of life insurance reserves and retirement fund holdings that provide substantial liquidity in the US financial markets.[1] These functions, among others, are considered very important to the stability of the US economy. To foster and encourage the continuation of these purposes, Congress provides substantial tax incentives for people to purchase, hold, and invest in life insurance policies.[1]
https://www.thetaxadviser.com/issues/2020/jan/irs-time-limited-settlement-microcaptive-insurance-issues.html"A captive insurance arrangement is one in which an insurance company insures only the risks of companies related to it. Captive insurers designated "micro" are generally those intended to qualify as eligible to make a Sec. 831(b) election, by which certain small insurance companies may be taxed only on their investment income."
Internal Revenue Code ("I.R.C.") S 101(a) provides that death benefit proceeds of a life insurance policy paid to a beneficiary by reason of the death of the insured is tax-free to the recipient beneficiary. [1] Furthermore, the I.R.C. allows for tax-free internal build-up on the investment accounts for certain permanent life insurance policies. [2] This tax-free internal buildup is essentially a retirement account whose investments grow untaxed until retirement. [3] Congress has allowed the investment gain from the internal build-up to be deferred until the policy is cashed-out, and completely and forever excluded from income if the policy is held until the death of the insured.
"The overwhelming acceptance rate of the private settlement offer is a reflection of the success of the government's work to stop this abuse," said IRS Commissioner Chuck Rettig.
irs.gov/newsroom/irs-takes-next-step-on-abusive-micro-captive-transactions-nearly-80-percent-accept-settlement-12-new-audit-teams-established
Historically, life insurance companies and life insurance agents have made substantial life insurance sales by selling policies for estate planning purposes. [1] The life insurance proceeds can be used to pay the US Federal Estate Taxes ("Estate Tax")8 due at death on the transfer of the fair market value of estate assets, [2] especially where significant assets are illiquid (such as a family business). [3][4] However, given that the amount of assets that can be transferred free of Estate Tax has risen steadily over the last decade (over $5 million individually, over $10 million for a couple in the need for life insurance in estate planning has significantly reduced. [5] However, as the Estate Tax declined as a driver of life insurance sales, some in the industry have sought to use income tax incentives as a reason for taxpayers to purchase life insurance policies.
Some in the life insurance industry have unsuccessfully attempted to construct several arrangements to garner tax deductible life insurance premiums or to provide tax-deductible financing for the purpose of purchasing life insurance.
However, the IRS is very skeptical of any attempt by taxpayers to garner additional and arguably legislatively-unintended tax benefits since Congress has already granted the aforementioned valuable tax subsidies to the life insurance industry. [1] The end result for the taxpayer participants in such arrangements was generally expensive litigation, unfavorable results, and even accuracy-related penalties.
The latest attempt to provide an income tax incentive for the purchase of life insurance has been the creation of captive insurance companies ("CIC") by small business owners (ostensibly for insuring business risks), for the purpose of having the CIC invest in life insurance on the CIC/business owner's life.
The theory behind this arrangement is that the small business owner's funding of the CIC may be treated as an ordinary and necessary tax-deductible business expense under I.R.C. S 162, allowing CIC premiums to be made with untaxed funds. In the context of an I.R.C. S 831(b) CIC, [3] up to $1.2 million in annual premiums paid would also be excluded from the taxable income of the CIC. [4]
Theoretically, the CIC could then purchase the pre-planned life insurance on the small business owner's life with pre-tax dollars as an investment. [5] Although these separate steps each meet the formalities of the I.R.C., the IRS may still attack these arrangements under various judicial doctrines designed to combat abusive tax structures. These judicial doctrines include, but are not limited to, the "sham transaction doctrine;"22 the "economic substance doctrine;"23 the "step transaction doctrine, "24 and the doctrine of "substance over form.
The planned life insurance policy purchased by a small business owner's CIC may appear to be for business purposes, but this insurance does not benefit anyone other than the small business owner and their family—making the premium expense arguably personal in nature. The IRS utilizes the aforementioned judicial tax doctrines to ensure compliance with Congressional intent that premiums paid on personal life insurance be non-deductible. [1] The IRS has a long history of successfully attacking life insurance arrangements that alter the form of transactions for the purpose of garnering legislatively unintended tax benefits. [2] Therefore, small business owners would be wise to take notice of the inherent risks involved with participation in such a pre-planned CIC life insurance arrangement.
This article: (1) provides an overview of life insurance tax policy; (2) discusses the elements and case law history of the various judicial tax doctrines used by the IRS to combat such arrangements; and (3) specifically analyzes how each judicial tax doctrine may be extended to a CIC arrangement formed for the primary purpose of purchasing life insurance on the CIC-funding small business owner's life.
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