Some transactions must be reported to the IRS as potential corporate tax shelters.
The IRS requires reporting any transaction that has one of five features. One of the five is that the transaction is a “listed transaction” that the IRS has said it does not believe works or is “substantially similar” to such a transaction. The IRS has identified 36 listed transactions to date. Reporting makes an audit more likely.
A US appeals court said in late June that a purchase of a cash value life insurance policy by a corporation for its sole shareholder and employee was “substantially similar” to one of the 36 listed transactions and should have been reported. The corporation had asked the court to waive the fines for not reporting.
A cash value life insurance policy differs from term life insurance. A term insurance policy is in effect for a definite term. There is a payout if the policy holder dies during the term.
With a cash value policy, a portion of the premium goes into an investment account. The policy holder controls how the funds are invested. When the plan terminates, the policy holder can withdraw the funds that have accumulated.
Interior Glass Systems, Inc. paid the premiums each year for a cash value policy for its sole shareholder and deducted the amounts as a business expense.
After the IRS made any transaction involving such a policy a listed transaction in 2007, the company made changes in how the policy was structured, but continued putting money into it.
The 2007 IRS notice described cash value life insurance policies that have four elements.
The modified policy still had three of the four element. The one missing element was the cash value policy was arranged through a tax-exempt business trade group rather than a trust or welfare benefit fund. The revamped policy also provided some group term life insurance benefits as well as a cash value life policy.
IRS regulations say a transaction is “substantially similar” if it is “expected to obtain the same or similar types of tax consequences and . . . is either factually similar or based on the same or similar tax strategy.”
Interior Glass argued that this standard is too vague.
The court said the differences between the revamped policy and what the IRS said does not work were immaterial. Both policies have the effect of shifting pre-tax earnings of the business into the shareholder’s personal investment account. The amounts put into the cash value policy should have been reported as dividends to the shareholder or as compensation in his role as the sole employee.
The case is Interior Glass Systems, Inc. v. United States.