For many years, folks in the insurance industry have been conjuring ways to make life insurance premiums tax deductible. Over the years we have seen many schemes that have failed IRS scrutiny. Welfare benefit plans set up under I.R.C. section 419, 412(e) plans and Producer Owned Reinsurance Companies (PORCs) are all common examples.
When one scheme fails it isn’t long before a resourceful promoter comes up with a different product. Inevitably promoters find some lawyer or accountant to draft a favorable opinion letter and a new industry is born. In a few years, however, the IRS catches up and declares the arrangement to be a listed transaction and abusive tax shelter.
The latest entries seeking to find a way to make life insurance premiums deductible is a small business captive insurance company or CIC.
How do they work and what will the IRS do? Great questions.
Congress has long given special tax considerations to life insurance. IRC section 101(a) provides that life insurance death benefits can be paid to the beneficiaries tax free. The IRS also allows the investment gains of the policy to grow tax free on whole life policies until retirement. If a whole life policy is held until death, the gains are completely tax free.
Clearly Congress ‘ legislative intent is to provide tax breaks on the back end. For some promoters, however, that isn’t enough. Unfortunately the IRS has been very diligent in shutting down life insurance products that provide tax benefits on both ends.
The newest product under scrutiny is a small business captive insurance company. The theory behind these CICs is that the business will form a captive to insure against some type of business risk. The CIC then invests its money by purchasing life insurance on the owner’s life. Even though the money is being invested in personal life insurance policies, promoters suggest that the funding of the captive is an ordinary and reasonable business expense (26 USC sec 162).
On paper, the transaction seems legitimate. The business is insuring itself against some type of risk. The CIC is using life insurance as an investment. While each component may be acceptable under the Internal Revenue Code, the practical reality is that the IRS still views them as a subterfuge and therefore void.
IRC sec. 264(a)(1) states the general proposition that life insurance premiums are not deductible if the taxpayer is a direct or indirect beneficiary under the policy. Notwithstanding the recent popularity of these and similar plans, the IRS has been quite assertive in rebuffing these attempts. To date, the courts usually side with the Service as well.
On paper, CICs are the perfect tax shelter. The business can set up a captive insurance company to insure against a legitimate business risk. That means the premiums are a valid business expense and thus deductible. The captive can exclude over a million dollars a year of premiums. And the captive has the ability to invest its premium money to earn a return.
Where things can dicey is when the captive invests in life insurance on the business owner’s life. Remember, those dollars are still pre-tax.
It all sounds perfect and there are some promoters out there ready to tell you exactly how perfect and legitimate it really is.
If you think this post ends here, it doesn’t. Before going the captive route – and there are legitimate captives – speak to a good CPA or tax attorney. If created for legitimate insurance purposes, a captive insurance company offers many benefits; including tax minimization, lower insurance costs and even the unavailability of certain types of coverage. Use premiums to purchase life insurance on the owner’s life and trouble will follow.
Why? Here are some reasons.
The IRS looks to see if a transaction is arms length, if the purpose is tax avoidance and if there is a legitimate business purpose for the transactions.
Second, the IRS strongly holds on to its policy of no deductions for life insurance premiums. We have seen several 419 welfare benefit plans fail despite great sounding legal opinion letters.
For many years, promoters have marched out slick new products designed to allow individuals to deduct life insurance premiums. Since at least 1995, the IRS has warned that these devices are potential abusive tax shelters and listed transactions. A captive insurance company can be an important and legitimate money saving tool for business. Extreme caution must be used if the captive and its owners decide to invest in certain life insurance contracts, however.
Although deducting life insurance premiums for business owners is still doubtful, a very recent U.S. Tax Court opinion suggests that the courts are willing to be open minded if a captive is properly structured.
In the 2014 Rent-A-Center, Inc case, a majority of the court ruled that payments by a parent company’s wholly owned subsidiaries to a wholly owned captive were deductible insurance expenses. Previously the Tax Court upheld the IRS’ determination that such expenses were not deductible in “brother sister” captive insurance arrangements.
If you are planning to create a captive for the sole purpose of investing in life insurance, contact a good CPA or tax lawyer first. The same also holds true if you already have such a plan.
Failure to report a listed transaction can involve huge civil penalties. These penalties can be as high as $100,000 or $200,000 per year and are in addition to any other tax, interest and penalties attributable to disallowed deductions and accuracy penalties.
The law firm of Mahany & Ertl is a full service, national boutique law firm concentrating in tax matters. For additional information, contact us at or by telephone at (414) 223-0464.
Post by Brian Mahany, Esq. For other posts related to this topic, see Captives and Life Insurance, A Deadly Combination, IRS Cracks Down on Captive Insurance Arrangements, and Cell Captive Insurance, Legitimate Insurance or Abusive Tax Shelter?