Blogging Employee Benefits

January 23, 2006

6th Circuit Sides With IRS on COLI

Filed under: IRS, Litigation — Fuguerre @ 3:16 pm

Courts may consider future profits contingent on some future taxpayer action, but only when that action is consistent with the taxpayer’s actual past conduct.

Arrangements involving corporate-owned life insurance (COLI) were “economic shams,” so tax deductions were properly disallowed by the IRS, according to a ruling by the Court of Appeals for the Sixth Circuit reversing a district court decision. [Dow Chemical v. U.S., CA6, No. 03-2360, 1/23/06]

Dow had purchased COLI policies on the lives of some of its employees from two life insurance companies. Dow was both owner and beneficiary of the policies. Premiums were paid through two primary funding mechanisms: (1) Dow borrowed funds from the insurers via policy loans, using the cash values of the COLI policies as collateral; and (2) Dow made partial withdrawals from unencumbered cash values of the COLI policies.

Dow claimed deductions for interest paid on loans used to pay COLI premiums, plus fees relating to administrative costs. The IRS disallowed the deductions and assessed tax deficiencies plus interest. Dow paid the amount assessed by the IRS, then filed administrative protests that the IRS then denied. Dow next filed suit in district court, which ruled that the IRS had improperly disallowed the deductions. The IRS appealed.

Dow’s COLI arrangements were projected to generate negative pre-deduction cash flows for a long period, a feature identified in previous COLI cases as a “hallmark of an economic sham.” However, since Dow’s COLI arrangements were projected to have both positive cash flow years and negative cash flow years, the district court had applied a present value analysis to determine overall cash flow as being positive. That analysis, however, was contingent on Dow’s intended infusion of large amounts of cash into the arrangements during middle years. The appellate court sided with the IRS in judging that “considering that Dow had heretofore made no similar cash infusions, such additional spending would be a drastic departure from the taxpayer’s past conduct.” Removing the dubious future infusions of cash from the present value analysis left only negative cash flows for the arrangements.

Moreover, no significant inside build-up was projected for Dow’s COLI arrangements, largely on account of the policy loans and partial withdrawals. Again the district court looked to future expected cash infusions to cure the absence of inside build-up; and again the appellate court found those expectations unpersuasive, given Dow’s “actual conduct of maintaining little or no net equity” under the arrangements.

Finally, both insurer’s COLI products limited Dow’s potential mortality gain under the arrangements. The district court distinguished this aspect from previous adverse COLI rulings, arguing that neither arrangement here had “a 100% retrospective [mortality] adjustment mechanism.” Here, the appellate court has ruled that the district court erred in “imposing such a high hurdle as a prerequisite to finding that Dow’s plans were designed to neutralize mortality gains.” Finding no significant benefit from mortality gains in Dow’s COLI arrangements, the appellate court saw additional evidence that that arrangements were economic shams.

Finding none of the three key non-tax benefits relevant to an appraisal of COLI plans — positive cash flow, inside build-up, and benefit from mortality gains — the 6th Circuit reversed the district court’s ruling, agreeing with the IRS in disallowing Dow’s deductions with respect to the arrangements.

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