COLI program lacked economic substance.

• Author: Morrissey, John
• Position: Corporate-owned life insurance

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...