Risk Management

The Tax Noose Tightens

IRS investigators zero in on highly leveraged, corporate-owned life insurance deals.
David KatzOctober 23, 2000

The coils of COLI are tightening.

Past use of highly leveraged, corporate-owned life insurance(COLI), an alluring tax shelter in the early 1990s, is looming as a threat to many prominent corporations in the wake of a federal court ruling that dubbed one such arrangement a “sham” aimed solely at tax avoidance.

Sophisticated COLI deals, in which corporations borrowed big-time from their life insurers to pay whopping insurance premiums, taking deductions on their interest payments in the process, were the darlings of a decade ago.

They were an appealing, tax-advantaged way to fund the costs of employee health care, which were exploding then. Employers could collect on the policies’ substantial death benefits to finance the cost of their employee benefit plans, the theory went.

But with tightening tax scrutiny and cooling inflation, the plans’ appeal has waned.

Now, the Oct. 16 decision against Camelot Music–along with other recent cases and a bevy of Internal Revenue Service investigations—suggests that employers who used them in past years may be left holding the bag and paying more in taxes.

Upholding an IRS claim, Judge Murray M. Schwartz, senior judge for the U.S. District of Delaware, disallowed $13.8 million in tax deductions for interest payments on loans Camelot Music took out against its COLI policy. The IRS alleges that CM Holdings, Camelot’s parent company, now owes the IRS $6 million in taxes.

But many other corporate users of leveraged COLI may soon find themselves stripped of deductions, the judge says.

At the time of the Camelot trial, which lasted from March 27 to May 5, the IRS had identified 85 taxpayers with similar plans and was engaged in 50 investigations, with many more expected. (The judge did not identify the targets of the investigations.) Lindy Paull, chief of staff of the Congressional Joint Committee on Taxation, estimated that there may be as many as 100 similar cases, with $6 billion in taxes at issue.

Besides Mutual Benefit Life, Camelot’s COLI insurer, seven other life insurers have sold highly leveraged plans to many Fortune 500 and mid-sized companies, according to Judge Schwartz, who did not identify the other carriers. MBL’s COLI business was acquired by Hartford Life after MBL went into rehabilitation, which stemmed from unrelated matters.

In connection with a similar ruling last year made by the U.S. Tax Court disallowing COLI deductions, Winn-Dixie Stores in August reported charges against earnings of $42.5 million in the year to date. In yet another case, American Electric Power will challenge the disallowance of $317 million in deductions related to COLI in U.S. District Court in the Southern District of Ohio in Columbus on Oct. 30.

Reacting to the Camelot ruling, John J. Sullivan, CFO of Trans World Entertainment, the Albany, N.Y.-based corporation that bought CM Holdings in 1999, told CFO.com: “I understood we had a good case, and I’m just surprised that [the court] ruled against us.”

Sullivan, who said he had not yet had a chance to review the decision, added that the case involved “a tax claim we inherited.” The IRS alleges that CM Holdings, which filed for Chapter 11 in 1996, owes about $6 million in back taxes associated with the life insurance plan.

Crossing the Line
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 policy 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 to cover the high premiums.

In one version of the plan, annual premiums were as much as $12,000 per employee. The size of the loans and corresponding interest payments, were, in turn, 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.”

Says Jean Pawlow, a partner with the Miller & Chevalier law firm in Washington, who represents a number of leveraged COLI users: “I think that it’s fair to say that this case will cause taxpayers to stop and think what their likelihood of success is [if IRS comes calling,] and whether they can distinguish this case from their own.”

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