No topic splits the captive insurance world more than the issue of life insurance — or, more specifically, whether or not a captive can purchase a whole life policy as part of its investment portfolio.
Those in favor point to the stable returns offered by whole life and the fact that banks are allowed to purchase BOLI as primary reasons for the policy.
Those against the practice cite anti-avoidance law along with the IRS’s long history of successfully attacking more aggressive life insurance plans as negative factors. Adding further fuel to the fire is the lack of any formal guidance from the IRS on the issue, leaving both camps with enough legal wiggle room to claim validation.
I have always fallen in the negative camp, largely based on anti-avoidance law concerns. By way of quick background, anti-avoidance law is a series of judicial doctrines used by the courts and the IRS to attack transactions largely on “substance over form” grounds. This doctrine has a long and extremely convoluted legal history, which can be traced to the Gregory v. Helvering case, and stretches to well over 1,000 citations in cases, law review articles and legal treatise. Highly questionable annuity and life insurance transactions are at the center of several of the more famous citations, such as Knetsch (which involves an annuity transaction) and In Re CM Holdings (which is one of four COLI cases from the 1900s and early 2000s).
Firmly hardening my antagonism to this transaction is a recent law review article by Beckett Cantley, law professor at John Hopkins School of Law in Atlanta. His piece, “Historical IRS Policy Weapons to Combat CIC Deductible Purchases of Life Insurance,” provides the most in-depth treatment of this transaction, highlighting the IRS’ successful attacks on more aggressive life insurance planning, the policy reasons behind those attacks and the application of the reasoning of those successful prosecutions to captive purchases of life insurance.
He concludes, “The IRS will likely view an arrangement where a small business owner funds a CIC for the primary purpose of obtaining deductions on life insurance premium payments (“Insurance Transaction”) as similarly abusive to prior listed transactions involving I.R.C. § 419 plans, I.R.C. § 412(e)(3) plans, and I.R.C. § 831(b) PORCs.”
Professor Cantley outlines the basic argument that would allow the IRS to successfully challenge these transactions.
The starting point is section 264(a) of the tax code, which states: “No deduction shall be allowed for — (1) Premiums on any life insurance policy, or endowment or annuity contract, if the taxpayer is directly or indirectly a beneficiary under the policy or contract.”
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.
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.