IRS denies COLI deductions.

• Author: Vernaglia, Anthony
• Position: Corporate-owned life insurance

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...