Corporate-owned life insurance policies remain an area of controversy with the IRS.

Public Service of Colorado — which is now part of Xcel Energy — bought 2,435 life insurance policies on its employees in 1984 and 1985 — it said to help fund a benefits plan for workers that promised death benefits and life insurance coverage, but that was in danger of being underfunded.  The holder of a whole life insurance policy can ordinarily borrow against it.  The utility borrowed the cash value of the policies and paid interest.  It had a choice of two interest rates.  It chose the rate that was higher, and the insurance company credited part of the interest paid back to the cash value of the policies. The utility used at least some of the borrowed money to pay the premiums on the insurance policies.

Companies can deduct the interest they pay on borrowed money.

However, the IRS denied the interest deductions that the utility claimed in this case, charging that the insurance arrangements were a sham.

The case is now before a federal district court in Minnesota.  Both sides asked the judge to decide the case for them on the basis of legal briefs without the need for a trial.  In November, the judge rejected the government’s argument that there were no real insurance contracts, but said he wants to hear the evidence at trial about whether the utility was entitled to an interest deduction.

Section 264 of the US tax code makes it difficult for corporations to deduct interest payments on loans under corporate-owned life insurance policies, but the interest is deductible on policies purchased before June 20, 1986 as long as the corporation paid the premiums using unborrowed funds in at least four of seven years and the arrangement is not purely a tax play.

The court said the issue is whether there was economic substance to the arrangements.  In particular, it is interested in whether the utility expected a profit — apart from tax benefits — from its investment in the life insurance policies.

Keith Martin