Captive insurance companies and life insurance: A very bad combination

The underlying policy reason for this is to prevent tax-free accumulation of income, which would disproportionately benefit high-net-worth individuals. If this deduction were allowed, a high-net-worth business owner would be able to purchase vast amounts of coverage, deduct those premiums as a trade or business expense, and then have the tax-free proceeds benefit his family on his death. This transaction would disproportionately benefit high-net-worth individuals, which is why it’s disallowed.

The next step is the premium payment from the parent company to the captive, which is tax deductible under 162(a) as a trade or business expense. This is followed by the captive’s purchase of life insurance, which benefits the captive owner by either naming his family or business as a beneficiary. Note what’s transpired with this transaction: The business owner has deducted the premium payment for a property and casualty policy, the proceeds of which have been used to purchase a life insurance policy that in some way benefits him. He has done indirectly (purchased life insurance via some type of deductible payment) what he can’t do directly (take a deduction for a life insurance payment via 264(a)). A general underlying concept in tax law is a taxpayer cannot do indirectly what he can’t do directly. However, here, he has done just that.

See also: 10 common estate planning mistakes (and how to avoid them)

In addition, there are several basic anti-avoidance law theories which would underlie the services attacks; these involve application of the step transaction doctrine, the economic substance doctrine, general form over substance and the sham transaction doctrine. Professor Cantley outlines these arguments in far more detail in a forthcoming law review article titled, “Relearning the Lesson: IRS Judicial Doctrine Attacks on the Captive Insurance Company Tax Deductible Line Insurance Tax Shelter.”

One of the more unfortunate aspects of practicing law is we are forced to read the legal tea leaves when there is no formal guidance from the relevant authorities. However, in-depth research and a broad knowledge of the law often suffice where lack of guidance exists.

Here, the history of anti-avoidance law (which comes in at well over 1,000 citations in Lexis), the general tax policy of preventing a tax deduction (either directly or indirectly) for purchases of life insurance and the IRS’s long and successful history of challenging aggressive life insurance transactions provide a clear picture: Purchasing life insurance as a portfolio investment in a captive insurance company should be avoided.

Hale Stewart is a tax attorney with both a domestic and international specialty. He is also author of the book U.S. Captive Insurance Law.