IRS denies COLI deductions.

According to Ann. 2002-96, the Service will terminate the Office of Appeals (Appeals) corporate-owned life insurance (COLI) settlement initiative, subject to a 45-day window within which taxpayers can enter into the IRS's current settlement arrangement. The IRS and the Justice Department intend to defend or prosecute all future COLI litigation.

Questionable Deductions

Sec. 264(a)(3) generally disallows deductions on any amount paid or accrued on debt incurred or continued to carry an insurance contract, if part of a plan to systematically borrow the increase in cash value. However, this exclusion will not apply if a taxpayer meets the "four of seven" safe harbor available under Sec. 264(d)(1), which recognizes the significance of borrowing on an insurance policy for reasons other than tax savings. This exception applies if no part of four of the annual premiums due during a seven-year period (beginning on the date the first contract premium was paid) is paid under such plan by means of debt.

Many COLI programs have evolved into highly leveraged broad-based programs tailored to satisfy the Code's requirements for deducting interest expense on borrowings against COLI. Despite a program meeting the Sec. 264(d)(1) four-of-seven safe-harbor rule, the IRS has been going beyond that requirement, looking to the essence of COLI transactions and arguing that they lack economic substance apart from the tax benefits.

No Substance nor Purpose

Winn-Dixie. The Eleventh Circuit upheld a Tax Court decision denying deductions for a COLI plan's policy loan interest and administrative fees (Winn-Dixie Stores, Inc., 254 F3d 1313 (11th Cir. 2001), aff'g 113 TC 254 (1999), cert. den). In 1993, Winn-Dixie entered into a COLI program, under which it purchased whole-life insurance policies on more than 36,000 employees. Winn-Dixie was the sole beneficiary of these policies. It borrowed against the policies' account value at an interest rate over 11%. The high interest and administrative fees generated from the COLI program outweighed the policies' net cash surrender value and benefits. Although Winn-Dixie lost money on the program on a pre-tax basis, the deductibility of the interest and fees yielded a projected post-tax benefit.

CM Holdings. A Delaware district court ruled in the Service's favor, disallowing interest deductions generated from a COLI program (CM Holdings, Inc., 301 F3d 96 (3d Cir. 2002)). The court reached its conclusion based on economic indicators that measured cashflow and earnings. It found that, without an interest deduction, the taxpayer would never have realized a positive cashflow or generated a profit during any COLI plan year. The court rejected the taxpayer's argument that it could have possibly expected a profit from policy value buildup, because the plan projected zero net equity at the end of each plan year.

The court also held that Sec. 6662 accuracy-related penalties applied; the taxpayer did not have substantial authority to support its interest deductions, because the COLI program did not have economic substance and, thus, could not qualify for the Sec. 264(d)(1) four-of-seven safe-harbor exception.

AEP. An Ohio district court ruled that American Electric Power's (AEP's) COLI interest deductions were disallowed, because its COLI program was a sham (American Electric Power, Inc., 136 F Supp. 762 (DC OH 2001)). The taxpayer did not meet the four-of-seven safe-harbor exception.

As in CM Holdings, the court looked to certain economic indicators to reach its conclusion that AEP's COLI program lacked economic substance and a business purpose other than tax savings. Economic forecasts based on policy loan interest rates illustrated that AEP's cashflow from the program would have been negative without the tax savings derived from interest deductions.

Conclusion

The IRS has attempted to resolve tax-shelter cases involving COLI programs quickly, either through settlement offers with taxpayers under Appeals or through a tax amnesty program (which ended on April 23, 2002). The amnesty program allowed taxpayers to disclose questionable transactions involving tax shelters. In return, the taxpayers obtained a waiver of certain accuracy-related penalties.

The Service's current COLI settlement allows taxpayers to waive 20% of the tax attributable to disallowed COLI deductions. For example, based on a 35% corporate tax rate, a corporation would save $7,000 in taxes if it had deducted $100,000 in COLI interest.

Appeals will continue to accommodate taxpayers that wish to surrender their COLI policies by entering into closing agreements that finalize the tax consequences of such surrenders.

FROM ANTHONY VERNAGLIA, MST, CPA, GRAY, GRAY & GRAY LLP, BOSTON, MA