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The COLI Wars

IRS investigators zero in on at least 50 highly leveraged, corporate-owned life insurance tax shelters.
David M. Katz, CFO Magazine
January 1, 2001

When Congress passed a slate of tax changes in 1996 to curb the use of tax shelters by U.S. companies, corporate-owned life insurance (COLI) policies were at the top of the hit list. And judging from two court decisions in the past year, Internal Revenue Service hitmen are finding their mark.

On October 16, Judge Murray M. Schwartz, senior judge of the U.S. District Court of Delaware, ruled that the COLI VIII plan set up by Mutual Benefit Life Insurance Co. (MBL) for Camelot Music Inc. in February 1990 was a sham transaction, entered into only for the purpose of avoiding taxes. In a remarkably detailed, 143-page opinion, Schwartz upheld an IRS claim against Camelot and disallowed $13.8 million in tax deductions for interest payments on loans the company took out against its COLI policies. The IRS wants $6 million in back taxes from CM Holdings, Camelot's parent company (now owned by Trans World Entertainment). After a similar ruling last year by the U.S. Tax Court, Winn-Dixie Stores was forced to take $42.5 million in charges against earnings this past August.

The two cases are the tip of the iceberg. Many other corporate buyers of leveraged COLI policies may soon find themselves stripped of previously claimed deductions, and liable for huge tax bills. The IRS has identified, but not disclosed, 85 taxpayers with similar plans, and was engaged in 50 investigations, with more expected. Securities and Exchange Commission filings show that many of the companies involved are large, household names. Lindy Paull, chief of staff of the Congressional Joint Committee on Taxation, estimates that there may be as many as 100 such cases, with $6 billion in taxes involved.

Over the Line?
The issue is not the COLI policies themselves, but the financing of them. Companies have purchased so-called key-man life insurance policies on senior managers for decades. These policies enable companies to collect substantial benefits in the event of the death of a key employee. But in the late 1980s, insurance companies began to offer COLI plans for wider pools of employees, and allowed companies to finance the policies with loans from the insurer. The plans were pitched as a tax-advantaged way to fund the rapidly rising costs of employee health-care benefits.

But they did so at the government's expense, argues the IRS. The essence of both court decisions to date was that neither Camelot nor Winn-Dixie would have bought the insurance were it not for the tax deductions it afforded. Camelot's insurance arrangement "crossed the line separating insurance against an untimely death and tax-driven or tax-
sheltering investments," according to Judge Schwartz's opinion.

The company bought high-priced policies on the lives of 1,430 of its employees for the taxable years starting in 1990. It took out big loans against the policies to pay the first three yearly premiums, and claimed deductions in 1991 through 1994 for interest paid on the loans.

The high premiums, coupled with the broad base of employees covered, created a big cash value for the policy, which was used to secure the biggest possible loans. In one version of the plan, annual premiums were as much as $10,000 per employee. The size of the loans and corresponding interest payments were designed to fuel big interest deductions aimed at producing positive cash flows in every year of the policy.

Judge Schwartz ruled, however, that Camelot's arrangement "lacked objective economic substance and a subjective business purpose other than the tax benefits flowing from the interest deductions." But John Sullivan, CFO of Trans World Entertainment, the Albany, New York­based corporation that inherited Camelot's COLI problem when it acquired the company in April 1999, insists, "There was a business purpose to the COLI policies. They were funding Camelot's employee benefit plans, and they're still in place." Trans World intends to appeal the decision.

The Camelot case and a bevy of IRS investigations suggest that employers who bought such COLI policies in the past may now be left holding a very expensive bag. Besides MBL, seven other life insurers have sold highly leveraged plans to many Fortune 500 and midsize companies, according to Judge Schwartz, who did not identify the other carriers.

With two convincing court victories for the IRS, other companies that took large deductions from leveraged COLI policies may decide it's not worth the cost and effort to fight any longer. "The Camelot case will cause taxpayers to stop and think what their likelihood of success is [if the IRS comes calling], and whether they can distinguish this case from their own," says tax attorney Jean Pawlow of law firm Miller & Chevalier, in Washington, D.C.

If the IRS wins its third COLI-related case — against utility American Electric Power (AEP), currently being tried in U.S. District Court in the Southern District of Ohio, in Columbus — many companies may decide to settle. "That would be three cases decided against the taxpayer," says Pawlow. "It would make it all the harder to convince a judge elsewhere that you're right."

In the AEP case, the Columbus-based utility is challenging the disallowance of $317 million in deductions related to the same COLI VIII policies from MBL. As CFO went to press, the company had made its arguments and the government was in the midst of presenting its case.

One positive aspect that companies may take from the Camelot decision, says Pawlow, is that Schwartz's opinion was built around facts specific to the case rather than a more general legal argument. For example, the judge had no problem with the deductions Camelot took in the first three years of the policies — deductions no longer permitted under the 1996 rule changes, Section 264 of the tax code (considered by most tax practitioners to be a "safe harbor"). This section of the tax code allows for that, says Pawlow. As long as a COLI-buying company didn't use debt to pay the premiums in more than three of the first seven years of the policies, the deductions are acceptable. Schwartz, however, determined that the premiums paid by Camelot after the third year were "factual shams, because they were primarily funded by loading dividends which were the product of circular accounting treatment." Schwartz therefore determined that Camelot did not meet the technical requirements of the safe harbor in Section 264 of the tax code. In other words, tax fraud. Schwartz recommended that penalties be imposed on Camelot.

AEP will argue that the terms and essence of its contract with MBL were significantly different from Camelot's. "Some policies may show a pretax profit in later years; some have lower interest rates, lower premiums, or no-loading dividends," says Pawlow. "There are lots of differences in policies and taxpayer situations."

In other words, the COLI wars may be a long way from being over.

David Katz is assistant managing editor of

COLIs in Dispute

The following are only a few of the estimated 100 companies that have COLI policies in dispute with the IRS.
Source: SEC filings

W.R. Grace & Co.
Hershey Foods Corp.
Proctor & Gamble Co.
Western Resources Inc.
Hillenbrand Industries Inc.
R.R. Donnelley & Sons Co.
The Dow Chemical Co.
Ruddick Corp.
National City Corp.
Bassett Furniture Industries Inc.

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