Life insurance is an extremely important social safety net, protecting families against the loss of a breadwinner is often the most troubling of times. Without life insurance, this responsibility would fall on taxpayers via governmental assistance programs. In addition, many people make use of life insurance as a form of a 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. 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.
Internal Revenue Code (“I.R.C.”) § 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.2 Furthermore, the I.R.C. allows for tax-free internal build-up on the investment accounts for certain permanent life insurance policies. This tax-free internal build-up is essentially a retirement account with investments growing untaxed until retirement. Congress has allowed the investment gain from the internal build-up to be deferred until the policy is cashed-out and completely excluded from income if the policy is held until the death of the insured. Since Congress has already granted these valuable subsidies to the life insurance industry to the significant detriment of the IRS’ collectible revenue, the IRS is very skeptical of any attempt by the life insurance industry to garner additional legislatively unintended tax benefits.
Historically, life insurance companies and life insurance agents have made substantial life insurance sales by selling policies for estate planning purposes. The life insurance proceeds can be used to pay the US Federal Estate Taxes (“Estate Tax”) due at death on the transfer of the fair market value of estate assets, especially where significant assets are illiquid (such as a family business). However, given that over time the amount of assets that can be transferred free of Estate Tax has risen steadily over the last decade, the need for life insurance in estate planning has been significantly reduced. To make up for these reduced life insurance sales, the life insurance industry has continually attempted to provide new reasons for consumers to purchase life insurance, including several programs that make use of income tax incentives.
The life insurance industry has 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. These arrangements have included I.R.C. § 419 plans,12 I.R.C. § 412(e)(3) plans, Company Owned Life Insurance (“COLI”) plans,14, and I.R.C. § 831(b) Producer Owned Reinsurance Companies (“PORCs”). However, in most of these arrangements, the IRS has quickly closed the tax loopholes by designating these transactions as “listed transactions,” and in each of them, the IRS has undertaken strong enforcement measures against the transaction. The result for taxpayer participants in such arrangements has been expensive litigation, generally unfavorable results, and even accuracy-related taxpayer penalties.17
The life insurance industry’s latest attempt to provide an income tax incentive for the purchase of life insurance has been the creation of a captive insurance companies (“CIC”) by small business owners (ostensibly for insuring business risks) and 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 business expense under I.R.C. § 162.19 An ordinary and necessary business expense is tax 12 See, e.g., Neonatology Associates, P.A. v. Comm’r, 115 T.C. 43 (2000) (wherein a scheme was devised to garner impermissible tax-deductible life insurance premiums by artificially inflating the amount of life insurance premiums deductible for what was claimed to be permissible key man term life insurance coverage, when in fact it was not simple term life insurance coverage since there existed an investment component to the transaction) deductible, so the CIC premiums are made tax-free. In the context of an I.R.C. § 831(b) CIC, such business-risk insurance premiums may be deductible up to $2.2 million per year, and these premiums are also not included in the taxable income of the CIC. Theoretically, the CIC could then purchase life insurance on the small business owner’s life with pre-tax dollars as an investment. Although these separate steps each meet the formalities of the I.R.C., the IRS may still attack these arrangements as against the public policy behind the individual Congressionally mandated tax subsidies comprising the whole arrangement.
Congress intended that premiums paid on personal life insurance be nondeductible. Life insurance 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 owners and their families. The IRS has a long history of successfully attacking life insurance arrangements that alter the form of transactions for the purpose of garnering tax benefits, and small business owners would be wise to take notice of the inherent risks involved with participation in such an arrangement. Part II of this article discusses: (A) the IRS general policy against tax-deductible life insurance premiums; (B) IRS enforcement actions against specific insurance-oriented tax vehicles and the IRS tax policies that grew out of these challenges; and (C) the Congressionally created tax benefits of life insurance. Part III discusses (A) the current attempted use of an I.R.C. § 831(b) CIC as a tax vehicle to create tax-deductible life insurance premiums (“Insurance Transaction”); and (B) how the IRS may challenge the Insurance Transaction, tying in the tax policies formed in prior tax-oriented insurance vehicle enforcement actions.
As a general rule, life insurance premiums are not deductible as ordinary and necessary business expenses, nor should tax-deducted funds be used to purchase life insurance. The United States government has staunchly defended this position through Congressional action and a series of United States Tax Court (“USTC”) cases brought by the IRS. The IRS has also made announcements of intent to “vigorously” pursue taxpayers who claim invalid ordinary business expense deductions associated with the purchase of life insurance. The IRS has declared that it will impose accuracy-related taxpayer penalties as a deterrence mechanism on taxpayers in appropriate cases. The taxpayer ultimately bears the burden of proving that a claimed expense or loss is deductible. The following section of this article discusses specific statutory and case law expressions of this policy of non-deductibility.
Section 264(a)(1) of the I.R.C. provides that, in general, premiums on any life insurance policy are non-deductible if the taxpayer is directly or indirectly a beneficiary under the policy. Section 264(a)(2) further provides that interest on policy loans or other indebtedness with respect to life insurance is generally nondeductible.32 Section 264(f)(1) states that “no deduction shall be allowed for that portion of the taxpayer’s” [loan] interest expense which is allocable to “unborrowed policy cash values.” Un-borrowed policy cash values are the excess of the cash surrender value of the life insurance policy over the amount of any loan made with respect to the life insurance policy.35 Congress has made an exception to the general rule by allowing business owners to deduct a limited amount of interest on borrowed funds used to pay premiums on key man life insurance policies. However, in Giannaris v. C.I.R., the IRS successfully challenged the deductibility of interest expense on loans taken out against existing life insurance policies. Next, this article discusses specific tax vehicles, successfully combated by the IRS, specifically involving the tax-deductible or tax-advantaged payment of life insurance premiums.
