The life insurance community has a long and tortured history of seeking the Holy Grail of insurance schemes: the tax-deductible life insurance premium. Nearly every year around tax planning season, life insurance agents attempt to boost year-end sales by offering some kind of tax-deductible premium plan — the newest of which is the small business Captive Insurance Company (“CIC”) as an investor in life insurance. In this transaction, a small business deducts premium payments for business risks to an IRC § 831(b) CIC; the CIC is permitted to receive up to $1.2 million of premium income tax-free; and the CIC uses a substantial amount of the tax-free premium immediately to purchase life insurance on the small business owners who often also own the CIC. The Internal Revenue Service (“IRS”) already loses a substantial amount of otherwise collectible tax revenue due to the existing tax-breaks afforded life insurance policy holders, such as tax-free internal build-up inside life insurance policies and the receipt of policy proceeds tax-free at the death of the insured. Therefore, the IRS has historically staunchly defended the loss of additional life insurance oriented tax revenue that may derive from tax-deductible life insurance premiums. In furtherance of this defense, the IRS has brought cases against individual taxpayers and promoters, designated certain abusive life insurance arrangements as listed transactions, and imposed accuracy-related taxpayer penalties.
The IRS is likely to view an arrangement where a small business owner funds a CIC for the primary purpose of obtaining deductions on owner-insider life insurance premium payments as similarly abusive to prior listed transactions involving I.R.C. § 419 plans, I.R.C. § 412(e)(3) plans, and I.R.C. § 831(b) Producer Owned Reinsurance Companies (“PORCs”). They will also likely view this as a violation of its historical tax enforcement policies against discriminatory insider tax benefits and improper uses of key man life insurance. The IRS should view the use of an entity as a direct conduit for achieving an impermissible tax deductible premium payment in the same manner as it would the taxpayer taking the deduction directly. This article discusses (I) the history of using taxation as a motivation for sales in the life insurance business, (II) the IRS enforcement and tax policy in combating improper tax uses of life insurance, and (III) evaluates the likely success of applying these historical arguments to establish that insider life insurance premiums are not deductible, nor should any tax-deducted funds be used to purchase such policies.