Washington

A federal appeals court decision supporting a federal law outlawing private deductions on so-called charitable split-dollar arrangements does not impose any liability on the insurers that wrote the policies, according to the American Council of Life Insurers.

The decision in Addis v. Commissioner, handed down July 8 by a panel of the 9th U.S. Circuit of Appeals, based in San Francisco, gave unequivocal backing to federal government efforts to shut down a potentially lucrative tax shelter called charitable split-dollar that high-end insurance brokers had used to sell high-volume insurance products that provided a benefit for certain charities as well as a tax deduction in excess of their investment to the individual beneficiaries.

The arrangements, which flourished in 1997 and 1998, were shut down through a provision added to legislation enacted in 1999.

The Senate report on the legislation justified the provision by characterizing “charitable split-dollar arrangements as an abuse of the charitable contribution deduction where, in substance, the charity receives a transfer of a partial interest in an insurance policy, for which no charitable contribution deduction is allowed.”

The decision was an important one for the government, which moved to shut down the loophole after determining that a number of wealthy citizens were seeking to use it to shelter their income.

In its opinion, the panel cited testimony by the insurance marketer who sold the policy to the petitioners “that this was the first case that we ever sold” involving the split-dollar concept. The president of the National Heritage Foundation, which had been a party to the arrangement, testified before the Tax Court that 600 to 700 of the 4,500 foundations created by taxpayers to establish a split-dollar with the National Heritage Foundation were based on similar arrangements.

But Laurie Lewis, vice president and chief counsel, federal taxes, at the ACLI, said the decision does not impose liability on the insurance companies that wrote these policies. “The insurance companies did not devise these arrangements or promote them,” Lewis said. “In most cases, they were devised by independent marketers and promoted to charities, or developed by the charities own development personnel. The insurers were not involved in proposing or marketing them.”

One interesting thing about the case is that the IRS apparently has not been aggressive in auditing people involved in these arrangements despite the fact that the issue was presented to Congress as a blatant abuse that needed closing immediately because of its potential of costing the government millions in tax revenue. Lewis speculated that the agency pursued this case because the people involved had other issues that prompted the audit.

“It is surprising that even though the issue was high-profile, this is the first case to surface,” Lewis said. “That indicates that there were not a lot of cases involved.”

In denying the deduction to a farm labor contractor in California and his wife, the court refused to ignore IRS rules and the provision enacted in 1999 by rejecting the petitioners argument that the deduction they took for a charitable split-dollar deduction to the National Heritage Foundation qualified for an exemption from disclosure requirements for goods and services of “insubstantial value.”

Under the facts in this case, the petitioners would have been entitled to 44% of the initial death benefit plus the inside buildup even though the trust they were using to purchase the policy would pay only 10% of the annual premium.

The court also noted in its decision that even though they were paying only 10% of the premium, they would also retain the sole right to borrow on the policy or surrender the policy. If the petitioners chose to surrender the policy, they would have owned the net cash surrender value less the National Heritage Foundations termination account value.

The court heard the case after the U.S. Tax Court denied the petitioners request for a deduction.


Reproduced from National Underwriter Edition, July 16, 2004. Copyright 2004 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.