WINN-DIXIE STORES, INC. AND SUBSIDIARIES, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 5382-97
UNITED STATES TAX COURT
Filed October 19, 1999
113 T.C. No. 21
Held: P‘s broad-based leveraged COLI program lacked economic substance and business purpose (other than tax reduction) and is therefore a sham for tax purposes. As a result, interest on P‘s COLI policy
Michael J. Henke, Tegan M. Flynn, Cary D. Pugh, Thomas Crichton IV, Robert H. Cox, and Thomas P. Marinis, Jr., for petitioner.
Nancy B. Herbert, Jeffrey L. Bassin, James D. Hill, and Michelle A. Missry, for respondent.
RUWE, Judge: Respondent determined a deficiency of $1,599,176 in petitioner‘s Federal income tax for its tax year ending June 30, 1993. After concessions, the issue is whether deductions petitioner claimed for policy loan interest and administrative fees associated with certain of petitioner‘s corporate-owned life insurance (COLI) policies are deductible.
Unless otherwise indicated, all section references are to the Internal Revenue Code in effect for the year in issue, and all Rule references are to the Tax Court Rules of Practice and Procedure.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found. The stipulations of facts are incorporated herein by this reference. At the time the petition was filed, petitioner was a
Petitioner was founded in the 1920‘s, and its stock is publicly traded on the New York Stock Exchange. Petitioner is a major food retailer made up of self-service food stores which sell groceries, meats, seafood, fresh produce, deli/bakery, pharmaceuticals, and general merchandise items. As of June 30, 1993, petitioner had 1,165 stores in 14 States and the Bahama Islands.
Petitioner is an accrual basis taxpayer, which has adopted a 52-53 week fiscal year ending on the last Wednesday in June. Petitioner filed a consolidated corporate Federal income tax return for its fiscal year ending June 30, 1993.
As of June 30, 1993, petitioner employed approximately 36,000 full-time and 69,000 part-time employees. Since 1988, all full-time employees who completed 3 months of continuous service have been eligible for a flexible benefits program called “Winn-Flex“. Under Winn-Flex, employees were furnished certain benefits that they received automatically and certain optional benefits among which they could choose. Employees automatically received life insurance and accident and sickness coverage. The optional benefits included a medical plan, dental coverage, vision coverage, supplemental associate life insurance, long-term disability and two flexible spending accounts for health care and
The life insurance coverage provided by the company under the core Winn-Flex benefit program was in effect only while a worker was a full-time employee. Petitioner provided no postretirement benefits to its employees under Winn-Flex. Early retirees covered by the Winn-Flex plan had the option of continued coverage under a separate insurance pool not paid for by petitioner.
Since 1980, petitioner has also maintained a program to provide death, disability, and retirement benefits to a limited number of full-time management level employees. This program was known as the “Management Security Program” (MSP). During the fiscal year ending in 1993, 615 of petitioner‘s employees were covered under the MSP. In order to provide funds for specific benefits for each manager, petitioner purchased flexible premium adjustable life insurance policies on each manager (MSP policies) from American Heritage Life Insurance Co. (AHL). The MSP policies are individual policies and not group contracts. The death benefits under the individual MSP policies were tailored to cover petitioner‘s costs for preretirement deaths of the covered individual and to cover costs of postretirement benefits.
During 1992 and early 1993, Wiedemann & Johnson (WJ) and The Coventry Group (Coventry) formed a joint venture (WJ/Coventry) and approached petitioner with a proposal for the purchase by petitioner of individual excess interest life insurance policies on the lives of petitioner‘s employees. AIG Life Insurance Company (AIG) was to be the underwriter for the proposed policies. In a letter dated January 12, 1993, Mr. Alan Buerger, chairman of Coventry, confirmed a meeting on January 14, 1993, with Mr. Richard D. McCook, petitioner‘s financial vice president. Included with the letter was a memorandum from Mr. Buerger and Mr. Bruce Hlavacek, chairman and chief executive officer of WJ, proposing that petitioner purchase a “broad-based COLI pool“.
The memorandum provided an overview section which generally described a broad-based COLI pool as consisting of a group of corporate-owned life insurance (COLI) policies covering a wide cross-section of a corporation‘s employees. Petitioner was the proposed beneficiary of the COLI policies to be written on the lives of petitioner‘s employees. WJ/Coventry‘s proposal focused on two issues raised by petitioner in a prior meeting. These two issues were described as “(i) achieving positive earnings in
The memorandum summarized the tax aspects of leveraged COLI with the following captioned diagram:
1 - Winn-Dixie makes deposits and pays loan interest to insurance carrier.
2 - Winn-Dixie receives withdrawals, loans and death proceeds from the insurance carrier.
3 - Winn-Dixie receives a tax deduction for loan interest paid.
The memorandum next explained the difference between the proposed broad-based COLI pool and petitioner‘s then existing leveraged COLI program being used to fund the MSP. The memorandum stated:
Winn-Dixie is familiar with leveraged COLI and particularly with the tax arbitrage created when deductible policy loan interest is paid to finance non-taxable policy gains. Winn-Dixie‘s existing leveraged COLI policies provide this arbitrage and, having been purchased before passage of the 1986 Tax Reform Act, provide it beyond the $50,000 cap applicable to newer policies.
A broad-based COLI Pool applies the same principle in ways that are effective under current law. But, where each of the existing policies was designed to fund a specific executive‘s benefit under the MSP, the Pool that we have illustrated would cover 38,000 employees at all levels of Winn-Dixie‘s workforce.
With respect to obtaining the employees’ consent to purchase the COLI policies on their lives, the memorandum stated:
We usually recommend that a company adopt or expand employee death benefits when installing a COLI Pool. This provides an immediate and meaningful benefit for employees, and it helps to provide a logic and incentive for obtaining employees’ consent to being insured. The benefit may depend on the size of the pool and the amount of the insurance purchased on each employee. A death benefit in the range of $5,000 to $15,000 is typical for the Pools presented here. After an employee leaves the company, the benefit is normally reduced or discontinued. With normal rates of retirement and attrition, only a small proportion of the participants will receive a benefit. As a result, the cost of providing the benefit is insignificant.
The memorandum also expressed an opinion on the tax issues raised by the proposed COLI pool, the legislative status of leveraged COLI, and exit strategies available to petitioner in the event that the tax laws change:
What tax issues are raised by the COLI Pool?
Deductibility of Interest. Because the COLI Pool involves systematic borrowing of increases in the policies’ cash value, a deduction for interest to carry policy loans is allowed only if at least four of the first seven annual premiums are paid in cash. In addition, a deduction is allowed for interest on only the first $50,000 debt to carry policies on any one employee. The COLI Pool proposed here is designed to satisfy the 4-out-of-7 rule, and the financial illustrations take into account the $50,000 cap on loans for which interest deductions are allowed.
What is the legislative status of leveraged COLI?
In the past few years, Rep. Barbara Kennelly (D-Conn.) and Senator David Pryor (D-Ark.) have introduced bills that would impose new restrictions on the deductibility of interest paid on loans from COLI policies. No bill is now pending, but it is possible that one will be introduced in the future. Kennelly/Pryor, as the last such bill was generally known, was written with the participation and support of the National Association of Life Underwriters, and, if a similar bill does become law, we do not believe the financial advantages of Winn-Dixie‘s COLI Pool would be seriously compromised.
History suggests that specific changes in the law that would address leveraged COLI would also allow grandfathering of existing policies. Past changes, for example, imposition of the $50,000 loan cap, have grandfathered existing policies, and the large number of major corporations that have created COLI pools is a significant political constituency. Of course, grandfathering cannot be assumed, and we have, therefore, kept the consequences of exit very much in mind in developing strategies for Winn-Dixie.
What exit strategies are available if the tax laws or Winn-Dixie‘s tax position changes?
A COLI Pool can become a financial burden if the tax arbitrage in the program loses its attractiveness. This can occur, for example, if Winn-Dixie‘s marginal tax rate on interest deductions becomes low and remains low, if Winn-Dixie becomes an alternative minimum taxpayer, or if the intended premium payment strategy becomes invalid through regulation. Likewise, Winn-Dixie‘s appetite for interest expense may be satisfied for reasons unrelated to deductibility.
* * * * * * *
If it becomes necessary or useful to terminate the COLI Pool, or to discontinue further borrowing, Winn-Dixie will be able to do so without significant adverse effect. The policies can be put on a “paid-up” basis,
either with the original carrier or with another carrier via a “1035” exchange, without incurring a tax liability, a negative effect on earnings, or a significant cash payment.
The memorandum outlined two proposed financial strategies for structuring the purchase by petitioner of the pool of COLI policies. The first strategy was labeled “cash management“. The second strategy was labeled the “zero-cash strategy” and was described as follows:
Under Strategy 2, Winn-Dixie would maximize its tax arbitrage by borrowing the first three premiums and would minimize its cash investment by withdrawing accumulated policy values to pay the next four premiums. The policies used in this zero cash strategy are specially designed to minimize cash outflows and to maximize the rate of return on investment. Thus, loads are minimal, the interest rate is high, and the loan spread is limited to 40 basis points. Because little cash is required, a higher premium can be used. We have illustrated an average premium of $3,000 per employee.
Petitioner elected strategy 2, the zero-cash strategy.
On January 25 and 27, 1993, Mr. Buerger sent revised copies1 of the 1993 COLI proposal materials to Mr. McCook and Mr. Hlavacek. The revised 1993 COLI proposals outlined two scenarios for the amount of interest petitioner was to be charged for policy loans. Both interest scenarios were based upon the zero-
Scenario 1 - Constant Loan Interest Scenario. In this scenario, it is assumed that Winn-Dixie‘s appetite for interest deductions remains large, and policy interest is charged at 11.06% throughout the life of the COLI Pool. This scenario results in the largest amount of earnings possible.
Scenario 2 - Reducing Loan Interest Scenario. In this scenario, Winn-Dixie‘s appetite for interest deductions is assumed to reduce over time. To adjust to the change in circumstances, the interest rate under the COLI Pool policies is reduced to 8% after the fifteenth year. This scenario generates a somewhat smaller tax arbitrage, but the resulting earnings are nevertheless significant.
Included in the revised proposal memorandum dated January 27, 1993, were projections of petitioner‘s profit and loss, cash-flow, and balance sheet balances under scenario 1, the constant loan interest rate scenario, for the years 1993 through 2052. The projections were based on the assumption that premiums paid by petitioner would be financed by policy loans in all years except years 4 through 7. In the years 4 through 7, inclusive, premiums were to be paid using funds from policy withdrawals. The constant loan interest rate (scenario 1) projections included in the January 27, 1993, memorandum are attached as appendix A.
Corporate tax bracket: 38%
Population (number of insured employees): 38,000
Premium: $3,000 per life
Mortality assumption: 100% of 1983 GAM1
Fee: $8 per participant annually
With respect to the estimated 1993 premiums of $114 million, the projection indicated that petitioner would, in part, satisfy the premiums by borrowing $107,684,000 against cash surrender
The projection indicated that petitioner would sustain a negative “pretax earnings effect” on the COLI plan for every year the plan remained in effect. Thus, the projection for the years
The projection of profit and loss also included an analysis of the effect of the COLI plan on petitioner‘s income tax liability in each of the years 1993 through 2052. Assuming a 38-percent corporate tax bracket,11 the projected $11,902,000 loan interest accrued and deducted by petitioner in the first policy
The projected total after-tax earnings of more than $2.2 billion were the result of total projected income tax savings of more than $3 billion less projected pretax net losses. The projected tax savings were attributable to the anticipated tax deductions for policy loan interest and fees.16 The effect on Winn-Dixie‘s after-tax earnings and cash-flow was projected to be positive in each year only because of tax benefits from interest and fee deductions. Absent such tax benefits, the effect on
In February 1993, Mr. McCook decided to have petitioner engage in the proposed broad-based COLI plan. On March 25, 1993, Mr. Hlavacek sent Mr. McCook another projection under the constant loan interest rate scenario estimating the effect of the proposed COLI plan. The projection estimated, among other things, the effect over 60 years beginning in 1993 of the proposed COLI purchase on petitioner‘s effective tax rate. The projection assumed an effective tax rate of 40 percent and predicted that the proposed COLI purchase would reduce petitioner‘s effective tax rate each year, reaching its lowest point of 26.54 percent in 2007.
AIG participated in the development of information for projections regarding petitioner‘s proposed COLI plan. A preliminary census reflecting the ages of the approximately 36,000 employees to be insured was prepared on May 28, 1993.18 Mr. Buerger sent two more sets of revised projections to Mr. McCook. The first set of revised projections was sent on May 28,
Using the same basic analysis that had been used in the January projections, the June 4, 1993, projections again indicated that petitioner would sustain a pretax loss and a posttax profit on the COLI policies for every year the plan remained in effect. See appendix B. Thus, for the years 1993 through 2052, the June 4, 1993, projections indicated the broad-based COLI plan would affect petitioner‘s profit and loss as follows:
Petitioner prepared a list of “Company Expense Reduction Opportunities” for fiscal year 1993 that listed 23 items of savings that totaled $329,093,000. The largest item of expense reduction on the list is “Proposed Corporate Life Insurance (COLI)“. The list shows that this item (COLI) was estimated to be implemented on June 30, 1993, and that petitioner‘s estimated savings from COLI was $300 million. Mr. McCook testified that he thought this figure was derived from the “After-Tax Earnings Effect” shown in column J of appendix A.21
AIG is a major underwriter of COLI policies. AIG had been working with WJ/Coventry in preparing the COLI plan. Mr. Qureshi
- * * *[Petitioner] reviews and verifies the accuracy of the information contained on the Client Master Information Form, attached as Exhibit A.22 * * *
- * * *[Petitioner] completes and certifies the information contained on the Certification of Employee Census form, attached as Exhibit B.23
- * * *[Petitioner] completes at least one Individual Life Insurance Application for each defined class of covered employees.
- The aggregate number of employees within each defined class of covered employees, on the effective date of coverage, totals at least 2,000 lives.
- The minimum annual premium for each covered employee is $3,000 and the maximum annual premium for each covered employee is $16,667.
- AIG Life determines that each defined class of covered employees identified on the attached Client Master Information Form and each employee identified on the Certification of Employee Census are acceptable for underwriting purposes and that the amounts of coverage applied for are acceptable.
In addition, the Letter of Understanding required that petitioner acknowledge and agree with the following:
- This Letter of Understanding and attached Exhibits A and B contain the entire agreement between the parties and supersedes all previous agreements entered into between Client and AIG Life, or promises made with regard to the subject matter of this letter.
- * * * [Petitioner] has reviewed with its own legal and tax advisors all present and future implications of its ownership of the Policies, including, but not limited to, the tax consequences of loans and/or withdrawals from the Policies and the deductibility thereof, and that it has not relied upon any representations of AIG
Life or any employee, broker, or agent of AIG Life in that regard. - The premiums specified in the Policies are intended to meet the requirements of Section 7702 and Section 7702A of the Internal Revenue Code as in effect on the date of this letter so that the Policies will qualify as life insurance and will not be treated as modified endowment contracts. AIG Life does not warrant or represent that the Policies will not be treated as modified endowment contracts.
- The statements contained in the attached Exhibits A and B shall be considered as binding representations by the * * * [petitioner] and that such Exhibits shall be deemed attached to and made a part of the Policies.
The Letter of Understanding provided that if, within 90 days of June 4, 1993, all the above conditions had been met and AIG received the total first-year premium, then AIG would agree to issue to petitioner, in the State of Florida, the life insurance policies effective as of March 1, 1993.
By invoice dated June 9, 1993, Coventry requested payment of a balance due on the 1993 COLI policies of $7,245,000 from petitioner. The invoice reflected a total premium of $108,573,000, covering 36,191 total lives at $3,000 of premium each, less a policy loan of $101,328,000 to arrive at the net amount due.
On June 15, 1993, in accordance with the Letter of Understanding, AIG sent the “Policy Terms Overview” (PTO) to petitioner. The PTO provided for an effective date of March 1,
The PTO generally provided that AIG would establish on behalf of petitioner a claims stabilization reserve (CSR) for the policies. Petitioner could not withdraw or borrow against the amounts credited to the CSR. The maximum level of the CSR at the end of each year was generally determined to be the higher of the annualized “cost of insurance”24 (COI) charges actually collected in any one of 3 preceding policy years or the highest amount of death benefits actually incurred in any one of 3 policy years. COI charges were deducted from the premium that was paid and used to fund the CSR. The CSR was generally held available by AIG to pay death claims under the COLI policies.
Petitioner was to be charged 11.06 percent interest on amounts that it borrowed against the cash value of the policies. Pursuant to the PTO, the portion of the policy account value that was borrowed would earn interest at a rate not to exceed 40 basis points25 or four-tenths of 1 percent below the amount charged on
The policies provided for expense charges which would not exceed 23 percent of the premiums paid. The expense charges were comprised of premium expense charges of 17.8 percent and annual expense charges of 5.2 percent. The negotiated PTO reduced maximum expense charges from 23 percent to 8.934 percent of premiums paid.
Mr. McCook approved the purchase of the 1993 COLI policies, and on June 17, 1993, Mr. McCook, on behalf of petitioner, executed the June 4, 1993, Letter of Understanding. On the same day, petitioner remitted the net amount of $7,245,000 to AIG as payment for the policies.
The 1993 COLI policy forms were registered and approved in form and for sale by the insurance commissioner of the State of Florida. Initially, the total number of lives included, subject to eligibility, under the 1993 COLI policies was 36,191 as of June 17, 1993.
On July 19, 1993, Mr. McCook executed the PTO.27 Also on July 19, 1993, Mr. McCook accepted receipt of the COLI policy contract documents from AIG and authorized Coventry to retain possession of the policies on petitioner‘s behalf.28 The type of coverage provided was listed as “excess interest life“. The person whose life was insured under each policy was one of petitioner‘s employees. Petitioner was listed as the owner and beneficiary of each policy.
The rights and liabilities of AIG and petitioner were governed by insurance policy forms (Policy Form), riders to the policies, the Letter of Understanding, and the PTO. The Letter of Understanding and the PTO set forth essential elements of the
Policy face amounts varied with the age of each insured. Generally, petitioner‘s death benefits were governed by policy Option A, which provided for benefits based on the larger of the face amount plus the account value on the date of death, or the account value on the date of death multiplied by a specified percentage based on the age of the insured.29 The applicable mortality table was the 1980 Commissioners Standard Ordinary Mortality Table B, Age Last Birthday, referred to as the CSO-B table. Under the terms of the policies, death benefits from a policy would first be used to reduce any outstanding loan.
Under the terms of the policies, petitioner could withdraw part of the cash value of each COLI policy. However, a withdrawal could not exceed the “net cash value”30 of the policy.
The policies also permitted petitioner to borrow an amount that, with interest to the next policy anniversary, would not
The policies were modified by a Renewable Level Term Insurance Rider. The rider provided death benefits equal to the amount of death benefits lost as a result of a withdrawal from the account value. Under the provisions of the rider, petitioner had the option on any policy anniversary date to elect to change from the 11.06-percent policy loan interest rate to a fixed rate of 10 percent in arrears or 9.1 percent in advance which would apply to both old and new policy loans. For the 1993 COLI policy year March 1, 1993 to 1994, petitioner elected the variable loan interest rate of 11.06 percent.
The final provisions governing the COLI policies purchased by petitioner in June 1993 were devised to produce results in accord with those set forth in the June 4, 1993, projections contained in appendix B.
On July 19, 1993, petitioner entered into an Administrative Services Agreement with Coventry in which petitioner appointed Coventry as the administrator of the COLI pool. Under the
- On the basis of census information supplied by petitioner
- Identify which of the petitioner‘s employees may become insured;
- Calculate the face amounts of the policies and the first year premiums for the covered employees;
- Determine and process new insureds and process any change in the status of any insured;
- Make the necessary calculations with respect to premiums, loans, withdrawals, loan interest, death claims and/or any other periodic payments;
- Provide consolidated invoice and itemization to petitioner and AIG;
- Receive and inspect the insurance policies from AIG and forward them to petitioner;
- Search government databases and other sources for covered deceased employees and obtain death certificates for deceased insureds;
- Provide petitioner with ongoing advice with respect to financial options and strategies related to 1993 COLI polices; and
- Provide petitioner with various reports including insurance value reports, year-end summaries, accounting reports and custom-designed decision-support reports.
Westport Management, an organization that performs administrative services for life insurance companies, was engaged by AIG and WJ/Coventry to administer petitioner‘s COLI policies. In order to ascertain deaths of former employees, Coventry would ask Westport to perform “Social Security sweeps“, by checking data base files to determine whether any covered former employee had died. After the purchase of the policies and input of the COLI policy data on its computer system, Westport began its administrative duties, regularly preparing performance and accounting reports, which were provided to Coventry and AIG. On every policy anniversary, Westport calculated all values on a monthly basis for all policies for the coming year. On petitioner‘s behalf, Coventry administered the COLI plan, acted as an intermediary with AIG, and checked reports and other information provided by AIG and Westport to ensure correctness. Every month and on request, Coventry received reports from Westport on past and expected performance of the policies and policy loans. From these reports, Coventry generated annual and
From 1993 through 1996, petitioner kept the employee COLI policies in force. AIG billed petitioner for premiums and interest annually on a net basis, as set forth below:
June 1993, Policy year beginning March 1, 1993:
Premium $108,573,000
Loan (101,328,000)
Net premium 17,245,000
A revised invoice was sent on Sept. 21, 1993, which reflected a reduction in insureds from 36,191 to 35,983 due to a recision of 208 policies. Thus, the calculation was as follows:
Premium $107,949,000.00
Loan (100,770,140.06)
Net premium 7,178,859.94
Less amount paid (7,245,000.00)
Balance owed petitioner 66,140.06
Policy year beginning March 1, 1994:
Premium $107,862,000.00
Loan (108,877,159.95)
Interest 11,136,375.63
Balance due 10,121,215.68
Premium $107,685,000.00
Loan (112,165,202.89)
Withdrawal (4,080,660.74)
Net premium due (8,560,863.63)
Interest 23,140,858.57
Balance due 14,579,994.94
Policy year beginning Mar. 1, 1995, was revised at least twice. The final revision resulted in the following:
Premium $107,685,000.00
Loan (112,112,913.04)
Withdrawal (4,134,020.12)
Net premium due (8,561,933.16)
Interest 23,140,858.57
Balance 14,578,925.41
Amount paid 14,579,994.94
Net refund due 1,069.53
Policy year beginning March 1, 1996:
Premium $107,553,000.00
Withdrawal (129,934,414.41)
Net premium due (22,381,414.41)
Interest 35,497,690.97
Balance due 13,116,276.56
COI and policy expense charges (DAC tax, State premium tax, commission and loading charges) under petitioner‘s COLI policies were as follows:
| Policy Year | Cost of Insurance | Expense Charges | Total |
|---|---|---|---|
| 1993 | $3,354,561 | $3,412,447 | $6,767,008 |
| 1994 | 4,641,249 | 4,721,130 | 9,362,379 |
| 1995 | 4,890,649 | 8,516,817 | 13,407,466 |
| 1996 | 5,173,414 | 8,990,642 | 14,164,056 |
The annual amounts of cash paid by petitioner to AIG for the COLI policies, compared with the total of COI and policy expense charges for corresponding years, were as follows:
| Policy Year | Cash Paid By Petitioner | COI Plus Expense Charges |
|---|---|---|
| 1993 | $7,178,860 | $6,767,008 |
| 1994 | 10,121,216 | 9,362,379 |
| 1995 | 14,578,925 | 13,407,466 |
| 1996 | 13,116,277 | 14,164,056 |
| Total | 44,995,278 | 43,700,909 |
For the first 4 COLI policy years, beginning March 1, 1993, AIG billed petitioner $431,049,000 in gross premiums and $69,774,925 in interest charges. Gross premiums and interest charges totaled $500,823,925. Of this total amount, petitioner remitted the above-calculated $44,995,27832 in cash.
Following the enactment of tax law changes in 1996, petitioner commenced discussions with AIG, Coventry, and WJ concerning the phaseout or discontinuance (unwind) of the COLI policies. These discussions concerned the approximately 36,000 policies purchased by petitioner in 1993 plus approximately 11,000 and 9,000 COLI policies purchased in 1994 and 1995, respectively. On October 22, 1996, Mr. McCook sent a letter to Mr. Qureshi, vice president of AIG, which stated:
Winn-Dixie has used AIG policies on three corporate owned life insurance (COLI) programs over the last several years. Because of the recent tax law changes, we have been working with Alan Buerger of the Coventry Group and Bruce Hlavacek of Wiedemann and Johnson, to try to minimize the financial impact on Winn-Dixie for the phase out of COLI.
Mr. Qureshi responded to Mr. McCook‘s October 22, 1996, letter
Coventry prepared a draft booklet dated October 30, 1996, which contained, among other things, an overview of the current status of petitioner‘s COLI pool, an opinion of the financial effect of the 1996 tax law change, and explanations of several exit and unwind strategies. The draft booklet indicated that petitioner had three separate enrollments covering approximately 55,740 lives. The first enrollment “WD1” was in relation to the policies written in 1993 covering 35,810 employees. The second enrollment “WD2” was in relation to the policies written on November 30, 1994, covering 10,704 employees. The third enrollment “WD3” was written on June 30, 1995, and covered 9,226 employees. With respect to the effect of the 1996 tax law changes on petitioner‘s COLI policies, the booklet stated in pertinent part:
In August of 1996, Congress amended the Internal Revenue Code was [sic] to deny deductions for any interest on policy loans on the lives of employees, officers, and persons financially interested in a trade or business maintained by the taxpayer. The disallowance was retroactive to January 1, 1996, except that deductions may be continued through 1998 on up to 20,000 policies. The deduction on those policies, however, must be based on an interest rate no higher than Moody‘s average corporate bond rate, and only 90%
* * * * * * *
In the aggregate, the three enrollments cover 55,740 lives with aggregate outstanding loans of about $500 million at interest rates averaging 11%. At a 39% tax bracket, these policies would produce tax deductions worth $21,450,000 per year.
Under the amended law, assuming aggregate indebtedness of $195 million on the “best” 20,000 policies and a Moody‘s rate of 8% per annum, the following savings will be available:
Calendar 1996 $6,084,000
Calendar 1997 5,475,600
Calendar 1998 4,867,200
The booklet next identified three basic exit strategies for petitioner. The three strategies were listed as the policy surrender, policy unwind, and aggressive tax strategy. The policy surrender strategy generally entailed the cancellation or surrender of the policy and the receipt by petitioner of the net cash value of the policy. The booklet recommended under this strategy that petitioner maintain the policies on 20,000 lives in fiscal years 1996 and 1997.
With respect to the policy unwind strategy, in lieu of surrendering the policies, petitioner was informed that it could keep the policies in force and allow the unrealized gains related to the policies to be paid out eventually as tax-free death benefits. The booklet further stated that in order to unwind a policy, petitioner “would withdraw a portion of the cash value
The third strategy, the aggressive tax strategy, suggested that under the revised statute, deductions were disallowed only with respect to policies on the life of an individual who was an officer or employee or was financially interested in petitioner‘s trade or business. The booklet further indicated that counsel for Coventry believed that a strong argument could be made that the disallowance described by the statute did not apply where the insured was a former officer or employee or was not financially interested. Based on this argument, the booklet gave an example which assumed an additional $200 million of aggregate indebtedness could be attributed to petitioner‘s former employees upon whom policies were still maintained. As a result of the additional $200 million of aggregate indebtedness, the booklet concluded that the tax savings in each year would be equal to 39 percent of 11 percent of $200 million or $8,580,000, for as long as the loans remained in force.
In a letter to Mr. Qureshi dated September 8, 1997, Mr. McCook indicated that in light of the passage of the legislation pertaining to leveraged COLI, petitioner was working toward a
OPINION
On its return for the fiscal year ending June 30, 1993, petitioner claimed a deduction of $3,735,544 for accrued interest on loans from COLI policies that petitioner purchased in 1993.33 Petitioner also claimed a $100,000 deduction for administrative fees related to these COLI policies.34 Respondent disallowed the deductions after determining that the 1993 COLI Plan was tax motivated, unsupported by any independent business purpose, and
The starting point for determining whether the form of a particular transaction will be recognized for tax purposes is the Supreme Court‘s decision in Gregory v. Helvering, 293 U.S. 465, 469 (1935), wherein the Court stated:
The legal right of a taxpayer to decrease the amount of what otherwise would be his taxes, or altogether avoid them, by means which the law permits, cannot be doubted. * * * But the question for determination is whether what was done, apart from the tax motive, was the thing which the statute intended.
In Gregory, the Court denied reorganization treatment with respect to a stock distribution even though the taxpayers had followed each step required by the Code for a reorganization. In deciding that the distribution was taxable as a dividend, the Court held that the structure of the transaction was a “mere device” for the “consummation of a preconceived plan” and not a reorganization within the intent of the Code as it then existed. Id. Because the transaction lacked economic substance, as opposed to formal reality, it was not “the thing which the statute intended.” Id.; see Kirchman v. Commissioner, 862 F.2d 1486, 1490-1491 (11th Cir. 1989), affg. Glass v. Commissioner, 87 T.C. 1087 (1986).
A transaction that lacks substance is not recognized for Federal tax purposes. See ACM Partnership v. Commissioner, 157 F.3d 231, 247 (3d Cir. 1998), affg. in part and revg. in part T.C. Memo. 1997-115; United States v. Wexler, 31 F.3d 117, 122 (3d Cir. 1994). Denial of recognition means that such a transaction cannot be the basis for a deductible expense. See United States v. Wexler, supra at 122. Citing the Supreme Court‘s decision in Gregory, the Court of Appeals for the Eleventh Circuit in Kirchman v. Commissioner, supra, stated the doctrine as follows:
The sham transaction doctrine requires courts and the Commissioner to look beyond the form of a transaction and to determine whether its substance is of such a nature that expenses or losses incurred in connection with it are deductible under an applicable section of the Internal Revenue Code. If a transaction‘s form complies with the Code‘s requirements for deductibility, but the transaction lacks the factual or economic substance that form represents, then expenses or losses incurred in connection with the transaction are not deductible. [Id. at 1490.]
Because the transactional events at issue in this case actually occurred, we limit our inquiry to the question of whether the substance of the COLI transaction corresponds with its form.35
The fact that an enforceable debt exists between the substance their form represents. * * *
In determining whether a transaction or series of related transactions constitute a substantive sham, both this Court and a majority of the Courts of Appeals have utilized a flexible analysis that focuses on two related factors, economic substance apart from tax consequences, and business purpose. See ACM Partnership v. Commissioner, supra; Karr v. Commissioner, 924 F.2d 1018, 1023 (11th Cir. 1991); accord Casebeer v. Commissioner, 909 F.2d 1360 (9th Cir. 1990), affg. in part and revg. in part on another ground Larsen v. Commissioner, 89 T.C. 1229 (1987); James v. Commissioner, 899 F.2d 905, 908-909 (10th Cir. 1990), affg. 87 T.C. 905 (1986); Shriver v. Commissioner, 899 F.2d 724, 727 (8th Cir. 1990), affg. T.C. Memo. 1987-627;
Economic substance, in this context, is determined by objective evaluation of changes in economic position of the taxpayer (economic effects) aside from tax benefits. See Kirchman v. Commissioner, supra at 1492; accord Knetsch v. United States, supra at 366 (“nothing of substance to be realized * * * from this transaction beyond a tax deduction“); ACM Partnership v. Commissioner, supra at 248; Sheldon v. Commissioner, supra. The inquiry into whether there was a legitimate business purpose involves a subjective analysis of the taxpayer‘s intent. See ACM Partnership v. Commissioner, supra at 247; Kirchman v. Commissioner, supra at 1492.
We will begin with an examination of the economic substance of petitioner‘s 1993 COLI plan. In doing so, we focus on the COLI transaction in its entirety rather than any single step. See Kirchman v. Commissioner, supra at 1493-1494.
Petitioner‘s 1993 purchase of COLI on the lives of approximately 36,000 of its employees was done pursuant to an
Shortly after having been approached by WJ/Coventry regarding proposals for COLI to be purchased from AIG, petitioner decided that it was interested in what was described as a “zero-cash strategy“. This strategy was based on an elaborate plan involving the purchase of life insurance on the lives of over 36,000 of petitioner‘s then current employees. The plan was complex and depended upon relationships between many factors, including number of lives insured, premium levels, policy expenses, rates of interest to be charged and credited, policy loans, cash surrender values, withdrawals from cash surrender
The profit and loss statements in the projections illustrate the pretax effect and the after-tax effect that the COLI plan would have on petitioner. The difference between pretax and after-tax effects was based on the income tax savings that would result from deducting policy loan interest and administrative fees. Policy loan interest was clearly the dominant element. All the various projections prepared before the actual purchase of the policies in June 1993 show that the pretax effect on
The projections submitted to petitioner on June 4, 1993, were prepared just before petitioner‘s purchase of the COLI policies in June 1993. These projections are attached as appendix B. We shall use figures from the projections in appendix B to illustrate the COLI plan‘s lack of economic substance.
The elements of the COLI plan and their projected impact on petitioner at the completion of the first policy year were as follows. Petitioner would make a premium payment of $108,573,000 and simultaneously borrow $101,328,000 against the policy. This required petitioner to pay the balance of $7,245,000 to AIG to satisfy the premium. At the end of the policy year, interest accrued on petitioner‘s policy loans would be $11,191,000, and petitioner would also have incurred administrative fees of $290,000. What benefit was petitioner to get for these costs? At the end of the first policy year, the COLI policies would have net cash surrender value of $11,287,000. In addition, based on actuarial determinations, petitioner expected death benefits from the COLI policies in the first year to be $3,250,000.39 Based on the combination of these first-year costs and benefits, the net
| Net premium payment | $7,245,000 |
| Interest on policy loan | 11,191,000 |
| Administrative fees | 290,000 |
| 18,726,000 | |
| Less: Net cash surrender value | 11,287,000 |
| Death benefits | 3,250,000 |
| 14,537,000 | |
| Loss | 14,189,000 |
1The June 1993 projection shows $4,188,000. This is apparently due to rounding or a math error.
Following the same approach, the June 1993 projections show the COLI plan producing pretax losses in the next 2 policy years of $7,885,000 and $10,869,000, respectively. Thereafter, the pretax losses over the next 57 years range from $6,244,000 in the last year to $16,447,000 in year 2021. The total of pretax losses for the projected 60 years was $681,922,000. In each and every year, the combined yearly pretax benefits from the policies; i.e., the expected death benefits from the 36,000 policies plus the year-end net equity value of the policies, were substantially less than petitioner‘s cost of maintaining the policies.
The next part of the June 1993 profit and loss projections illustrates the “tax effect” of the COLI plan. The profit and loss statement contained in the June 1993 projections shows
The June 1993 projections contain a cash-flow analysis for each policy year from 1993 to 2052. The structure of the zero-cash strategy was intended to produce a positive after-tax cash-flow for each policy year. Thus for the first year, the plan was to produce a positive cash-flow of $196,000 after factoring in tax savings from deducting policy loan interest and fees.43 Without the savings from these deductions, there would have been a negative cash-flow of over $4 million. The projections show increasing positive after-tax cash-flows for each of the following 59 years. Projected after-tax cumulative cash-flow for the entire 60-year period was more than $2 billion. Cumulative net equity at the end of each year varied, rising in some years and falling in others but, because of the policy loans and withdrawals, remained relatively small in relationship to the numbers in the overall plan. For example, cumulative net equity
We recognize that one of the normal benefits of life insurance is the death benefit to be received if the insured dies before the insured‘s actuarially determined life expectancy. Thus, the predictable cost of maintaining life insurance might be greater than predictable death benefits and still be justified by the financial protection that insurance provides against the financial consequences of the unexpected death of the insured. But as we discuss later, petitioner had no such reason or purpose for engaging in the 1993 COLI program. Petitioner suggests that the policies could conceivably produce tax-independent benefits if some catastrophe were to occur that would produce large, unexpected death benefits. We are convinced that this was so improbable as to be unrealistic and therefore had no economic significance. Indeed, petitioner makes no pretense that it purchased these policies in anticipation of, or to protect itself against, a catastrophic event. The policies were on the lives of 36,000 individual employees of various ages who lived in diverse
Economic substance depends on whether, from an objective standpoint, the transaction was likely to produce economic benefits aside from tax deductions. See Kirchman v. Commissioner, 862 F.2d at 1492; Bail Bonds by Marvin Nelson, Inc. v. Commissioner, 820 F.2d 1543, 1549 (9th Cir. 1987), affg. T.C. Memo. 1986-23. Viewing the COLI plan as a whole, we find that the only function of the plan was to produce tax deductions in order to reduce petitioner‘s income tax liabilities. Without the tax deductions, the plan as designed would produce a negative cash-flow and a negative earnings effect for petitioner in each and every year the plan was in effect. Consequently, the COLI transactions lacked economic substance apart from producing tax deductions.
Before entering into the COLI transaction, there were numerous versions of profit and loss and cash-flow projections, which were consistently formatted so that petitioner could compare the pretax earnings effect to the post-tax earnings effect. Petitioner requested multiple versions of the projections at various estimated combined Federal and State marginal tax rates in order to see what effect a change in rates would have on the proposed COLI transaction. On the other hand, petitioner produced no contemporaneously prepared documents indicating that it purchased the 1993 COLI policies in order to provide a source for funding its Winn-Flex obligations. Unlike
On brief, petitioner argues that death benefits and policy loans and withdrawals from the net cash value of COLI policies could be used to help fund Winn-Flex. However, the projections, which embody petitioner‘s broad-based COLI plan, show that anticipated death benefits and net cash values were going to be exhausted in order to satisfy petitioner‘s premiums and policy loan interest obligations. According to petitioner‘s COLI plan, there would be no death benefits and cash value left over to provide the necessary funding for Winn-Flex. Indeed, the COLI plan anticipated that after using available death benefits, policy loan proceeds, and withdrawals, petitioner would still be required to make annual cash payments in order to satisfy its annual premium and policy loan interest obligations. We do not
In his testimony, Mr. McCook made it clear that his focus was on the bottom line, after-tax earnings impact, of the COLI plan and the resulting positive cash-flow that the tax deductions were expected to generate. Referring to the January 27, 1993, projections of profit and loss prepared by Coventry (appendix A), Mr. McCook testified that he expected that by the 15th year the annual financial benefit of the COLI transaction would offset the annual costs of petitioner‘s Winn-Flex obligations. According to the January 27, 1993, projection of profit and loss (appendix A), there was a pretax loss in each year of the 60 years in the projection. The pretax loss for the 15th year (2007) was $14,178,000, and the cumulative pretax loss for the first 15 years was $148,483,000. The January 27, 1993, projection of profit and loss showed a profit for the year 2007 only after considering the tax savings from the policy loan interest and fee deductions. The projected after-tax profit from the COLI plan for 2007 was $64,479,000. When Mr. McCook identified the amount he believed would be available to fund the annual costs of Winn-Flex, he referred to the $64,479,000 amount of projected after-tax earnings from the COLI program for the year 2007. This amount was produced by loan interest and fee deductions. A tax savings generated by the COLI plan was the only reason the plan
Even if we were to accept Mr. McCook‘s testimony that he intended to use tax savings to fund Winn-Flex, that would not cause the COLI plan to have economic substance.45 If this were sufficient to breathe substance into a transaction whose only purpose was to reduce taxes, every sham tax-shelter device might succeed. Petitioner‘s benefit from the COLI plan was dependent on the projected interest and fee deductions that would offset income from petitioner‘s normal operations. The possibility that such tax benefits could have been used as a general source of funds for petitioner‘s Winn-Flex obligations (or any other business purpose) does not alter the fact that the COLI plan
Petitioner also argues that the purchase of the COLI policies permitted it to increase group life benefits offered to Winn-Flex participants. It is true that petitioner offered an additional $5,000 in life insurance benefits to employees who agreed to allow petitioner to purchase COLI policies on their lives. However, this was done at the suggestion of Coventry in order to obtain the employees’ consent to have their lives insured. There was no relationship between death benefits under the COLI policies and the relatively small $5,000 employee death benefit. All policies bore a $3,000 annual premium, and death benefits under the policies were based on that premium amount and the age of the employee. Also, petitioner had a high turnover among its employees, and the $5,000 death benefit expired when the insured‘s employment with petitioner ended. As a result, Coventry advised petitioner that the additional $5,000 in coverage could be provided at an insignificant cost. Based on the record, we do not believe that the purpose of the COLI plan was to fund employee benefits.
Petitioner‘s COLI plan required a relatively small amount of cash investment by petitioner and charged a high rate of interest
Following the enactment of tax law changes in August 1996, which greatly restricted employers’ deductions for interest on loans from company-owned life insurance policies on the lives of employees, petitioner terminated its COLI program. See
Petitioner cites Campbell v. Cen-Tex, Inc., 377 F.2d 688 (5th Cir. 1967), as controlling precedent in this case.46 Petitioner‘s reliance on this case is misplaced. Cen-Tex was a family-owned corporation that had entered into deferred compensation arrangements, which obligated it to provide payments to the surviving spouse or lineal descendants of employee stockholders and to purchase and redeem stock of deceased stockholders. Cen-Tex decided to meet these obligations by purchasing insurance on the lives of the employee stockholders. Cen-Tex paid the first annual premium on each policy and prepaid the next four annual premiums, discounted at 3 percent, and then borrowed against the value on each of the policies at a 4-percent rate. See id. at 689. The court allowed deductions for interest on the policy loans.
Cen-Tex, Inc. is clearly distinguishable from petitioner‘s case. The parties in Cen-Tex, Inc. stipulated that the insurance policies at issue were procured to assist in meeting the obligations of the taxpayer under its deferred compensation plan and its obligations under the stock option and redemption
In contrast to Campbell v. Cen-Tex, Inc., supra, we have found that no nontax purpose was served by the COLI transactions. The projections for the COLI policies contemplated a substantial pretax loss in each year, even after considering the projected death benefits and net cash surrender value of the policies. Only by deducting the policy loan interest and fees and reducing its income tax could petitioner anticipate any benefit from its COLI transactions. Without the tax benefits of the policy loan interest and fee deductions being generated by the COLI plan, petitioner‘s plan would have generated a predictable negative cash-flow and pretax loss in each of the 60 years projected. This predictable result precludes any economic value, economic
Based upon all the aforementioned considerations, we find that petitioner purchased the COLI policies in 1993 pursuant to a plan the only function of which was to generate interest and fee deductions in order to offset income from other sources and thereby significantly reduce its income tax liability. We hold that petitioner‘s 1993 broad-based COLI program lacked substance and was a sham.
Petitioner argues that lack of economic substance does not warrant disallowing the interest deduction in question because deductions for interest on life insurance policy loans were condoned by Congress as indicated by the safe harbor test of
Section 264(a)(3) generally provides that no deduction is allowed for amounts paid or accrued on indebtedness incurred to purchase a life insurance contract if such debt was incurred pursuant to a plan of purchase which contemplates the systematic borrowing of increases in the cash value of the insurance contract. Section 264(c)(1) provides an exception to the general rule under section 264(a)(3). Section 264(c)(1) provides that if no part of any four annual premiums due in the first 7-year period of an insurance contract is financed by means of indebtedness, then the general rule of section 264(a)(3) will not apply.47
* * * * * * * (c) Exceptions.--Subsection (a)(3) shall not apply to any amount paid or accrued by a person during a taxable year on indebtedness incurred or continued as part of a plan referred to in subsection (a)(3)-- (1) if no part of 4 of the annual premiums due during the 7-year period (beginning with the date the first premium on the contract to which such plan relates was paid) is paid under such plan by means of indebtedness, (2) if the total of the amounts paid or accrued by such person during such taxable year for which (without regard to this paragraph) no deduction would be allowable by reason of subsection (a)(3) does not exceed $100, (3) if such amount was paid or accrued on indebtedness incurred because of an unforeseen substantial loss of income or unforeseen substantial increase in his financial obligations, or (4) if such indebtedness was incurred in connection with his trade or business. For purposes of applying paragraph (1), if there is a substantial increase in the premiums on a contract, a new 7-year period described in such paragraph with respect to such contract shall commence on the date the first such increased premium is paid.
An argument similar to petitioner‘s was made in Knetsch v. United States, 364 U.S. 361 (1960). In Knetsch, the Court found that the taxpayer‘s purchase of annuity contracts and simultaneous loans from an insurance company was a sham that did not give rise to deductible interest. Nevertheless, like petitioner, the taxpayer in Knetsch contended that by enacting section 264 as part of the 1954 Code, Congress “authorized” the interest deductions for transactions prior to the effective date of the 1954 Code. See id. at 367. Section 264(a)(2), as enacted in 1954, denied a deduction for amounts paid on indebtedness incurred to purchase or carry a single premium annuity contract, but only as to contracts purchased after March 1, 1954, the date of enactment. See id. From this the taxpayers reasoned that Congress intended to allow interest deductions for such transactions occurring prior to March 1, 1954, regardless of their substance. The Supreme Court disagreed, concluding that unless such meaning plainly appeared from the statute and its legislative history, the Court would not attribute such an intent to Congress, for “‘To hold otherwise would be to exalt artifice above reality and to deprive the statutory provision in question
A taxpayer‘s right to a deduction for interest on an insurance policy loan is based on section 163, not section 264. Golsen v. Commissioner, 54 T.C. 742, 755 (1970), affd. 445 F.2d 985 (10th Cir. 1971). Section 264 does not confer the right to a deduction but simply denies, disallows, or prohibits deductions that might otherwise be allowable under some other provision. See id. at 756. Thus, while the parties agree that petitioner‘s COLI plan meets the “four-of-seven test” of section 264(c)(1) and would be excepted from the general disallowance rule of section 264(a)(3), section 264 does not confer a right upon petitioner to take the deduction that would not otherwise be allowable under section 163.
Petitioner cites the Senate Finance Committee‘s report discussing the scope of section 264 prior to the 1964 amendment. The report states that “under present law, no interest deductions are denied where the taxpayer purchases an insurance contract with the intention of borrowing the maximum amount on the contract each year“. S. Rept. 830, 88th Cong., 2d Sess. (1964), 1964-1 C.B. (Part 2) 505, 581. Based on this, petitioner argues that Congress did not view the Supreme Court‘s decision in Knetsch as foreclosing interest deductions based on the type of
Based upon the foregoing, petitioner by a tour de force concludes that: (a) The 1958 transaction herein is the type of abuse meant to be curbed by subsection (a)(3), but only prospectively; (b) the legislative history expressly confirms his assertion that the deduction flowing from this abuse was allowable under prior law; and (c) the ‘interest’ involved herein is therefore deductible.
We agree with petitioners that the 1958 transaction in form fell within the class of transactions at which subsection (a)(3) was aimed. But we do not agree with his assertion that the legislative history should be turned into an open-ended license applicable without regard to the substance of the transaction. Nor do we agree with the assertion that, if Knetsch and Pierce, were controlling with respect to post-1958 multiple-premium annuities, there would have been no need for further legislation in 1964. Knetsch and Pierce involved transactions without substance. Congress, in enacting section 264(a)(3), struck at transactions with substance. It is a reductio ad absurdum to reason, as petitioner does, that Congress simultaneously struck down a warm body and breathed
Petitioner attempts to supplement its argument by citing additional legislative materials related to changes or proposed changes to section 264 in 1984, 1986, 1987, 1988, 1990, 1991, and 1996. We need not address each of the changes and proposals regarding interest deductions on life insurance policy loans. It is clear that Congress and the Treasury Department were aware of the problems associated with interest deductions on life insurance loans. However, we are not persuaded that Congress, by enacting and amending section 264 or other related provisions that restrict the deductibility of interest, intended to allow interest deductions under section 163 based on transactions that lacked either economic substance or business purpose. In Knetsch, the Supreme Court noted that nothing in the legislative history of section 264 suggests that Congress intended to protect sham transactions. Similarly, we find nothing in the more recent legislative history of section 264 suggesting that Congress intended to allow deductions arising from sham transactions that lacked economic substance and business purpose.
The transactions associated with petitioner‘s COLI program lacked economic substance and business purpose (other than tax reduction). As a result, the interest on petitioner‘s COLI loans was not deductible interest on indebtedness within the meaning of
Decision will be entered under Rule 155.