Relearning the Lesson : IRS Judicial Doctrine Attacks on the Captive Insurance Company Pre-Planned Tax Deductible Life Insurance Tax Shelter

There are certain members of the life insurance industry that are in perpetual pursuit of the ultimate potential driver of life insurance sales-tax-deductible life insurance premiums. Some in this industry have previously used aggressive retirement plan funding, and numerous other tax vehicles for these purposes, but in the end the IRS has always succeeded in defeating such strategies through administrative enforcement and litigation. The latest attempt to achieve tax-deductible premiums is the formation of a small business captive insurance company (“CIC”) for the pre-planned purpose of using the CIC funds to invest in life insurance. The owner of a small business forms an IRC § 831(b) CIC, and pays a presumably tax- deductible premium to the CIC for business risk insurance issued by the CIC. Subsequently, the CIC uses a significant part of the tax-free premium immediately to purchase life insurance on the common owner of the small business and CIC. In general, life insurance premiums are not deductible as ordinary and necessary business expenses, and tax-deducted funds should not be used to purchase life insurance. The IRS is likely to view the CIC created and funded for the primary purpose of purchasing personal life insurance for its owner, as an abusive tax shelter. The IRS would see this transaction as the CIC serving as a conduit for the life insurance premiums to follow a circuitous route to achieve the tax deduction. The IRS often argues that judicial tax doctrines should be applied to disallow claimed deductions on what the IRS perceives to be Congressionally unintended life insurance oriented abusive tax shelters. In attacking the CIC pre-planned life insurance transaction, the IRS would likely utilize the following judicial doctrines: (1) the sham transaction doctrine (specifically, as a sham in substance); (2) the economic substance doctrine; (3) the doctrine of substance over form; and (4) the step transaction doctrine. This article discusses (a) the history of these judicial doctrines in general and specifically in life insurance cases; (b) a distillation of the rules derived from these cases that may apply to prospective life insurance tax shelters; and (c) the likelihood of IRS being successful in applying these judicial doctrines to defeat this latest attempt by some in the life insurance industry at creating tax-deductible insider personal life insurance premiums