Salvaging Leveraged COLI By Using ‘Unwinds’

by James L. Hess and

Amy Loether

Many large companies, including insurers, are paying close attention to what is happening in tax and district courts as some of their counterparts wage a battle with the Internal Revenue Service to protect their investments in leveraged COLI. Winn-Dixie, Camelot Music and AEP, the Ohio-based utility, lost their first rounds and are now in appeals. The next case is scheduled for early in 2002.

In 1996, federal legislation was enacted that phased out the deductibility of policy loan interest for corporations, with complete elimination beginning in 1999. Despite that legislation in 1996, virtually every purchaser of broad-based leveraged COLI is under IRS attack for all prior open tax years. In addition to concerns about the potential loss of historical deductions on loan interest payments by corporations, there looms large the formidable task of deciding how to manage the policies going forward.

With three wins for the IRSs position on leveraged COLI, there is also increased discussion of settlements involving partial disallowance of the loan interest. The current settlement offers now being made by the IRS generally include provisions that are designed to encourage policyholders to surrender their policies.

In some cases settlement offers even appear to be contingent on the surrender of the policies. For most policyholders, even though their policies remain heavily leveraged, the policies have been kept in force through what have been referred to as “unwinds.” Even though the policy loan interest is no longer deductible, these policies still have the valuable aspects of life insurancetax-deferred growth of the cash values and tax-free death benefits.

Unwinds are a structured approach to using standard policy provisions found in all life insurance policies, including those issued to individuals, to meet the needs of the corporate owner. The most typical approach is to elect extended term insurance, and continue paying loan interest in cash, so that the policies remain in force.

Loans are usually reduced, with funds derived through the withdrawal policyholder basis. The policies are usually maintained in this manner until either the policy is terminated by the death of the insured, or the policy can be surrendered without taxable gain.

Even with the recent settlement offers, unwinds can still be the most efficient way to overcome the now negative consequences of leverage. As corporate policyholders evaluate their choices, they are likely to need the assistance of their brokers and their insurance carriers in order to determine the strategy to follow in the future.

Unwinds are an ongoing process, rather than a single decision. While some of the steps, such as withdrawing basis from the policies, cannot be reversed once the withdrawal has been made, other steps, such as the use of dividends, can be changed. After an unwind has been initiated it will still need to be reviewed periodically.

Leveraged COLI as most corporations know it now may be a thing of the past very soon. No matter what they choose to do with these policies prospectively, corporations are almost certainly faced with a tax challenge. However, if they carefully consider their options, there are strategies that will help them meet financial strategies and goals.

While there are only a limited number of insurance companies and brokers that are affected by the leveraged COLI audits, all insurance companies and all insurance producers should be concerned about, first, the governments success in challenging the deduction of policy loan interest under the economic substance doctrine and, second, the fact that they are now actively encouraging policy surrender as part of settlement negotiations.

There are already indications that other non-leveraged forms of broad-based corporate-owned life insurance are beginning to receive IRS audit attention as a number of policyholders have received extensive requests for information on their corporate insurance programs.

James L. Hess is executive vice president, Aon Consulting, and Amy Loether is vice president, Massachusetts Mutual Life Insurance Company.


Reproduced from National Underwriter Life & Health/Financial Services Edition, June 11, 2001. Copyright 2001 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.


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