COLI program lacked economic substance.

The Tax Court recently ruled that a corporate-owned life insurance (COLI) program lacked economic substance and business purpose (other than tax reduction) and was a sham for tax purposes (Winn-Dixie Stores, Inc., 113 TC No. 21).

Under its leveraged COLI program, Winn-Dixie (a major food retailer) purchased life insurance on approximately 36,000 of its employees and borrowed against the cash value of the policies to fund the premiums. The COLI program was designed so that annual premiums, fees and policy loan interest would exceed the policies' projected annual death benefits and net cash values. The program's design generated large amounts of interest on the policy loans, which Winn-Dixie intended to deduct for income tax purposes. The income tax savings from the deductions for interest and fees were projected to be substantially in excess of the projected net costs of maintaining the COLI program. In each year of operation, the COLI program projected a pretax loss and an after-tax gain.

On its fiscal-year 1993 return, Winn-Dixie claimed a $3.7 million deduction for accrued interest on loans from COLI policies purchased in 1993; in addition, the company claimed a $100,000 deduction for administrative fees related to the policies. The IRS determined a deficiency of $1.6 million for Winn-Dixie's 1993 tax year, finding that the COLI program was tax-motivated (i.e., unsupported by any independent business purpose) and lacked economic substance.

In analyzing the COLI program, the Tax Court first noted that the existence of an enforceable debt between a borrower and a lender was not dispositive of whether interest arising from the debt was deductible. To determine whether the program was a sham, the Tax Court turned to a method used by a majority of appellate courts--a flexible analysis focusing, on economic substance (apart from tax consequences) and business purpose.

For the economic substance of Winn-Dixie's COLI program, the court looked to the plan "in its entirety rather than any single step." The court discovered that,"[w]ithout the tax savings from the tax deductions for policy loan interest and fees, there would have been a substantial negative cash-flow in each year, and the costs of maintaining the COLI plan would have greatly exceeded benefits." Winn-Dixie argued that the plan could produce tax-independent benefits if a catastrophic event produced large, unexpected death benefits. The court disagreed, saying it was "convinced that this was so improbable as to be unrealistic and therefore had no economic significance." Viewing the plan in its entirety, the court concluded that the plan's sole function was to reduce Winn-Dixie's tax liabilities.

As to the plan's purported business purpose, the Tax Court rejected WinnDixie's argument that the COLI plan was to be used to fund a flexible benefits program (Winn-Flex) for its employees, noting that Winn-Dixie did not produce contemporaneously prepared documents showing that the policies were purchased to fund the program. In addition, projections for the COLI plan showed that death benefits and net cash values were going to be exhausted to satisfy the premiums and policy loan interest obligations. "The possibility that such tax benefits could have been used as a general source of funds for petitioner's WinnFlex obligations (or any other business purpose) does not alter the fact that the COLI plan itself had only one function and that was to generate tax deductions which were to be used to offset income from its business and thereby reduce petitioner's income tax liabilities in each year" the court concluded.

Winn-Dixie also argued that lack of economic substance did not warrant disallowing interest deductions, because the Sec. 264 safe harbor test and its legislative history indicate that Congress condoned such deductions. The Tax Court rejected this argument, noting that the right to deduct interest on an insurance policy loan is based on Sec. 163, not Sec. 264. Citing Knetsch, 364 US 361 (1960), the Tax Court noted that nothing in the legislative history of Sec. 264 suggests that Congress intended to protect sham transactions.

Accordingly, the Tax Court ruled that the deductions claimed by WinnDixie were incurred in connection with a sham transaction and were not deductible.

Taxpayers should not overreact to this development. While obviously not favorable for companies with COLI plans, the facts of the Winn-Dixie plan were not particularly strong. Further, Winn-Dixie is likely to appeal; in the meantime; other cases with stronger business purposes may surface. In addition, the Sec. 264 issues will probably be more important in the upcoming cases. Therefore, although the Service has scored this initial victory, it may be set back in subsequent litigation. Then, perhaps, reasonable settlement opportunities will emerge. Importantly, Winn-Dixie deals with leveraged COLI, not with unleveraged COLI purchased by some corporations and banks. In any event, this case serves notice that taxpayers should revisit their particular COLI programs and reassess their potential tax liability exposure and its adverse affect on financial statement earnings.

FROM JOHN MORRISSEY, WASHINGTON, DC