By Sean Gregory King, JD, CPA, MAcc
Recently, Beckett Cantley and a few other commentators have attacked the idea of captive insurance companies investing into life insurance. Cantley’s recently managed to get his opinions on this topic published in a law review article here.
As I believe both the conclusion and the premises of Cantley’s article to be flawed, and I have expressed that view in various forums, I have been invited by Cantley , Hale Stewart, and others to respond with a “scholarly” article of my own refuting Cantley’s position.
However, as I do have a day job, I don’t have the luxury of a professorship that pays me to create marketing pieces for my side business under the pretext of a law review article, and I don’t have access to cadre of law students to assist in my research and writing efforts, I’m afraid that the below is the best that I can do, less than strictly “scholarly” though it may be. Even so, for the critical reader, one not susceptible to falling for irrational “arguments from authority”, the below should suffice to demonstrate that: (a) I know what I’m talking about, and (2) the Cantley paper is wrong in its conclusion and biased in its approach.
However, before proceeding to address the specific issues raised by Cantley in his paper one-by-one, it’s important that the reader first understand who Cantley is, the purpose of his law review article, as well as the current political landscape of the captive industry.
Who is Beckett Cantley?
The paper notes that Beckett is simply an Associate Professor of Law at Atlanta’s John Marshall Law School in Atlanta, a little-known and sometimes marginalized for-profit law school. His LinkedIn profile also notes only that he is an Associate Professor of Law at John Marshall Law School.
But Beckett is not the disinterested, humble law professor that he would have the average reader of his paper believe. In fact, in addition to being an Associate Professor of Law, he is actually a captive insurance company practitioner, a facilitator/broker of life settlements, and one of the unofficial mouthpieces for the captive insurance industry’s “Old Guard” (defined below).
Whether forming and managing captive insurance companies for his personal clients is his day-job and professoring his night-job, or vice versa, is difficult to know. But Cantley spends significant amounts of his time working with his personal clients in the captive space, and even actively assists at least some of the captive insurance companies with which he is involved as legal counsel to invest in life insurance policies. Much more on this last topic shortly. Reader’s of the Cantley paper, and ideally the “peers” who reviewed the article prior to its publication, should know of these undisclosed conflicts-of-interests. As we shall see shortly, understanding them is the only way to make any real sense of the Cantley paper.
The Purpose of the Cantley Paper
The paper is presented as a scholarly law review article. However, despite its frequent use of flowery legal language and plentitude of legal citations, its general tone and constant use of ad hominem, non sequitur and other logical fallacies reveal it to be anything but. It is, as we shall see, little more than a gratuitous attack by the Old Guard on the New Wave life insurance professionals that are encroaching upon the the Old Gaurd’s turf.
Evidence of the true purpose of the Cantley paper is everywhere, beginning with the very first sentence of the abstract: “The life insurance industry has a long and tortured history of seeking the Holy Grail of insurance schemes: the tax deductible life insurance premium.”
Does this sound like disinterested “scholarly” law review language to you, dear reader?
Or, how about this language from the very next sentence:
“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 as an investor in life insurance…”.
Note that Cantley cites not a single source for his contention that “every year”, life insurance agents seek to “boost sales” by marketing tax deductions. Again, does this sound like detached, “scholarly” language to you? Or…does it sound more like biased a propaganda piece? Do disinterested, scholarly law review articles usually make such liberal use of hyperbole and ad hominem? Not in my experience.
But, the ad hominem attacks just keep coming: For instance, in the first full paragraph of page 4, Cantley attempts to offer an explanation for the (in his mind) inappropriate encroachment of New Wave life insurance agents into the captive space. He insists its just a their attempt “to make up for…reduced life insurance sales” that have resulted from changes in estate tax laws over the years. It’s not that life insurance makes particularly good sense as an investment tool, he impliedly insists, it’s just that life insurance agents are desperate to replace lost revenue. “Beware the desperate shysters”, he doesn’t actually say but clearly implies.
Note that Cantley’s desperate shyster implication is likewise unsupported by even a single citation, and also that it is completely irrelevant to Cantley’s thesis. There is, quite simply, no reason at all to include unsourced, gratuitous attacks in a real “academic” paper. But, as we shall continue to see, this wasn’t intended to be a real academic paper at all, but rather an Old Guard marketing piece written by one of its chief shills.
The reason that Cantley’s desperate shyster contention is unsourced is quite simply that it is demnstrably untrue. There is no reason to believe that estate tax reform has had, or will have, any material impact on life insurance industry sales. Industry analysts who have done actual studies of the impact on life insurance sales of an outright estate tax repeal have indicated for years that such a repeal would be inconsequential to the industry.
Futhermore, look at this chart and note the growth in the estate tax exemption by year. Over the last decade, there was no huge change in the estate tax exemption (in absolute dollar terms) until 2009, when it jumped from $2 million to $3.5 million, and then again in 2010 when it jumped to $5 million. It has increased slightly every year after 2010 for inflation.
Thus, if Cantley’s contention were remotely true, one would expect sales of permanent life insurance products (whole life and universal life), the types used in estate planning scenarios, to decline precipitously (both in absolute dollar terms and as a percentage of policies sold) over the years as the estate tax exemption has increased, especially in 2009 and after. The only problem is…sales don’t decline. Rather, quite the contrary.
As this article from June 2012 notes:
For the past five years, industry researcher LIMRA reports, sales of whole life insurance policies have taken a rising share of all life insurance sales, steadily rising from 22 percent of industry sales in 2007 to 31 percent last year.
And, as this LIMRA article explains:
Total individual life insurance new annualized premium grew six percent in 2012 — resulting in the third consecutive year of growth — according to LIMRA’s fourth quarter 2012 individual life insurance sales survey. In the fourth quarter, total individual life premium grew 12 percent, the largest growth recorded since the [economic] downturn. The number of life insurance policies sold grew by one percent for the year, making 2012 the second consecutive year of positive annual policy growth. The last time individual policy count increased two years in a row was in 1980/1981, when policy count grew three and seven percent, respectively. “We haven’t seen a quarter in which all of the major product lines experienced growth since 2006,” commented Ashley Durham, senior analyst, LIMRA Product Research.
Universal life (UL) new annualized premium had the strongest performance of all the products in the fourth quarter, rising 20 percent. For the year, UL premium rose eight percent compared with 2011. The number of UL policies sold fell eight percent for the quarter and three percent in 2012. In 2012, UL market share was 40 percent of total new individual life insurance premium.
Indexed UL soared 42 percent in the fourth quarter and improved 36 percent for the year. IUL now represents 30 percent of total UL premium, and 12 percent of all individual life insurance premium. While lifetime guaranteed UL premium jumped 27 percent in the fourth quarter, it was primarily a reflection of a fire sale before the new reserving requirements took effect on Jan. 1, 2013.
Whole life sales continued to be strong in the fourth quarter. WL new annualized premium increased six percent in the fourth quarter, resulting in a seven percent uptick for the year. This is the seventh consecutive year of growth for WL. In 2012, WL market share was 32 percent of total premium, which is the highest since 1998. WL policy count was up four percent for the quarter and up five percent in 2012.
In short, Cantley’s contention that life insurance professionals are pursuing captive insurance company business “to make up for reduced life insurance sales” that resulted from estate tax reform is, like so many of his contentions, erroneous and unfounded, and completely irrelevant to his paper’s pretextual thesis, though useful in advancing its ulterior purpose.
The Purpose of the “Gratuitous” Attacks
These attacks on life insurance agents, and the positioning of those attacks within the Cantley paper, are not quite as “gratuitous” as I have so far suggested. They were, in fact, almost certainly included within the paper, right at the beginning, to serve a particular purpose. That is, they are intended to prime the reader right up front to accept Cantley’s negative view of life insurance professionals, making readers less likely to scrutinize his article and especially his conclusions.
In short, the paper wasn’t written for the benefit of academics or subject matter experts. In fact, as I shall show below, none reading it would take its conclusion, or its underlying “reasoning”, seriously. Rather, the paper is meant as an Old Guard marketing piece–an “argument from authority” designed to scare the public away from New Wave practitioners.
Before moving on, I want to make a very important point: I am not arguing that Cantley’s paper is wrong because Cantley is biased. That would simply be ad hominem. Rather, I’m arguing that the paper is so clearly biased (and makes so little sense from a legal perspective) because it is constructed around a foregone conclusion that was clearly erroneous. It’s not wrong because it is biased, it is biased because it is wrong.
To understand why that is so, a little history is in order.
Political History of Captives Part 1—The Old Guard
To make any sense at all of Cantley’s paper, a little historical context is required.
For decades the captive insurance company industry was tiny, exclusive, relatively unknown, and controlled by a handful of specialist attorneys, actuaries and captive managers (the “Old Guard”). This Old Guard was seemingly diverse on the surface but generally had a few important things in common:
First, they were fortunate enough to work in an industry that required highly specialized knowledge and, therefore, had inherent barriers to entry. Captive attorney Jay Adkisson, who is not a tax attorney, famously noted in his 2006 book titled Adkisson’s Captive Insurance Companies that, at the time it was published, there were probably only a half dozen competent captive attorneys in the country. Jay was probably wrong on that count (Jay is renowned for self-serving statements of hyperbole, and there were probably a couple dozen or more competent captive attorneys in the country even then), but his broader point, that the Old Guard was quite small in number, was spot on.
Second, due to these barriers to entry, the cost of forming and managing captives back then was quite high (at least by today’s standards). Consequently, the client businesses of the Old Guard were primarily large, sophisticated, “corporate”, and wealthy. Essentially, captives were niche market product that appealed to a limited clientele, and the Old Guard rather liked it that way.
Third, the combination of high barriers to entry for competing professionals and a sophisticated clientele meant that the Old Guard had to do very little by way of marketing. Essentially, prior to the early to mid 2000’s, anyone wanting to form a captive had to go to, and through, them. They were the “gatekeepers” to the captive industry.
The common business factors noted above caused the Old Guard, even though they competed among themselves, to develop similar ways of doing business (no collusion required) and a certain shared view of the industry.
For instance, because they had little need to actively market their services to the public on a wide scale, they never became great communicators or evangelists for captives. In fact, rather than trying to help the public and other professionals really understand how captives work, and how simple they are to own and operate (no more difficult than, say, a defined benefit pension plan in many cases), they were motivated to do just the opposite–that is, to make doing a captive sound as complex and technical as possible, sometimes even scary, thereby reaffirming the importance of their role as gatekeepers and making the barriers to entry for any prospective competition seem impenetrable.
Partly for this reason, the Old Guard came to look with disdain upon anyone actively marketing captives to the general public, especially anyone who effectively communicated just how approachable captives really are, or at least can be.
Additionally, because of their common backgrounds (law, actuarial studies, and P&C insurance primarily), they tended to focus upon the “liability” side of the captive equation rather than the “asset” side. That is, their work focused almost exclusively upon risk management aspects of a captive—that is, pricing the policies issued by the captive, calculating the captive’s reserves and potential liabilities, paying claims, etc., and they almost completely ignored the other side of the balance sheet—that is, how given captive might manage its assets so as to best support it’s long-term claims-paying ability and support its profitability. This is some what strange since “real” independent insurance companies give asset management at least as much attention as liability management and underwriting.
Political History of Captives Part 2—The New Wave
Then, starting in the early to mid-2000’s, the captive industry began to experience rapid changes that, over time, tended to undermine the gatekeeper role of the Old Guard. First, inspired by the success of Vermont in attracting captive business to the state in the 1990’s, other states and some foreign jurisdictions started to compete heavily for captive business. Whereas only a dozen or so states and a limited number of foreign jurisdictions actively licensed small captive insurance companies prior to the mid-2000’s, and even fewer were truly “captive friendly”, today at least twenty-six states, the District of Columbia, and a great many foreign jurisdictions compete to be the most accommodating for licensing and regulating captives. As a result, lawyers, CPA’s and other professionals in each of these jurisdictions have become increasingly familiar and competent at forming and managing captives, expanding greatly the public’s access to them, and thereby diminishing the influence of the Old Guard.
Second, due to this new competition among licensing jurisdictions and their respective professionals, the cost of setting up and operating captives dropped precipitously beginning in the early to mid 2000’s. Whereas as recently as the mid to late 1990’s setting up a captive required a prospective client to make an initial capital contribution of as much as $1 million cash just to get licensed, and also to incur set-up costs of as much as a $225 thousand dollars or more, and ongoing operating costs in excess of $100 thousand per year, today’s captive can be established and licensed with capital and costs of only a fraction of these amounts. This too greatly expanded the public’s access to captives, and made captives economical and appealing to smaller and smaller businesses. Much to the chagrin of some in the Old Guard, doing a captive was on the cusp of becoming “turnkey”, just like doing a qualified plan had been for decades.
As the assets inside of captives began to grow exponentially during the 2000’s, captive insurance companies finally started gaining the attention of financial professionals–people who manage assets. For the first time, the asset side of the captive equation—that is, how the captive manages its assets—began to get specialized attention. These financial professionals, the “New Wave” as I call them, had a few things in common:
First, they realized that how the captive deploys its assets is at least as important to its long-term profitability as how it manages its liabilities, and maybe more so. Prior to the New Wave’s involvement, captive assets were often just kept in simple interest-bearing bank accounts (back when one could actually earn some interest on such accounts), loaned back to the insured operating business (where they could theoretically be deployed at a higher expected ROI), otherwise used to purchase assets (often illiquid ones) that benefited (or could be leased back to) the insured operating business, or plopped into some managed account with little regard to matching assets and liabilities. These arrangements often resulted in the captive sitting on “lazy money” or investing in illiquid assets without sufficient regard to the claims-paying ability of the captive or to the tax implications of the investment activity.
Second, the New Wave, unlike the Old Guard, was accustomed to working with the retail public, primarily small businesses and their owners who made up a significant portion of their pre-existing client base. As such, they were generally excellent communicators—experts at describing complex arrangements (like qualified retirement plans, for example) in ways that their clients could understand and easily act upon. And, they were often expert marketers and salespersons, having come from an industry (financial services) where sales and marketing skills are paramount. These communication and marketing talents, combined with an existing base of prospective captive clients, proved particularly beneficial to the New Wave. Where the Old Guard had often previously engaged in intentional obfuscation and delighted in complexity, the New Wave promoted illumination and demonstrated simplicity, therefore accounting for an increasing percentage of captive “sales”.
Third, some in the New Wave, or at least many of the more successful ones, had significant experience managing assets for highly regulated entities such as pension plans, banks, non-qualified deferred compensation plans, and the like. Captives, likewise being regulated, were therefore a natural fit for their expertise, and an untapped market, for their services.
Fourth, due to their significant experience with these highly-regulated industries, many in the New Wave understood the benefits of using certain types of life insurance contracts as an asset management tool. For instance, banks regularly invest billions and billions of their Tier 1 capital into BOLI (bank-owned life insurance), nearly seventy percent of Fortune 1000 companies invest their non-qualified deferred compensation plan (the retirement plan for their most senior executives) assets into COLI (corporate-owned life insurance), and some large defined benefit plans (even some governmental ones) have invested heavily into POLI (pension-owned life insurance). As even its Old Guard detractors often admit, except for potential and perhaps overrated IRS considerations, life insurance is often an ideal asset management tool for captives for many of the same reasons that banks do BOLI, corporations do COLI, and pension do POLI.
Thus, the most successful of the New Wave often had significant life insurance experience. Successful life insurance professionals, a subset of financial professionals in general, have excellent marketing and networking skills, are highly effective communicators, understand the asset side of the captive equation, appreciate the risk management benefits of a captive (since life insurance is, after all, primarily a risk management tool), have experience with similar industries, and are highly compensated for the work they do.
In short, top life insurance professionals represent one of the most well trained and highest paid sales forces in the country, and they and their allies quickly began to take captive market share from the Old Guard starting in the mid-2000’s for the reasons noted above.
Political History of Captives Part 3—The Old Guard Reacts
The reaction of the Old Guard has been predictable.
Any business model losing market share to competitors generally typically resorts to four defenses: First, it tries to differentiate itself from the up-and-comers, usually based upon its “superior” knowledge and experience. Ideally, this is a positive differentiation; with the defensive business model touting it’s superior market share and years of service. From a marketing strategy perspective, the idea is to differentiate itself from its up-and-comer competitors without actually acknowledging their existence. “Let’s not give them anymore attention than they deserve”, is the general theme of the defensive strategy. One is reminded of Microsoft’s refusal to mind Apple for years.
But, when the business model under attack has inferior communication and marketing skills, as the Old Guard does, positive differentiation often fails. When it does, the failing business model usually resorts to “negative differentiation”, also known as ridicule. Rather than highlighting its superior experience and market share in a positive way, the failing model begins to attack the relative “inexperience” of the “small-time” up-and-comers. Just Google “Steve Balmer Apple quotes” to see what this looks like first hand.
And, when negative differentiation fails to stem the tide, the failing model resorts to intimidation and scare tactics. Specifically, it tries to scare the public away from working with the up-and-comers by implying, or in some cases outright stating, that the “newbies” don’t know what they are doing and, at best, will sell you an inferior product or, at worst, will subject to you fines, penalties, and maybe even prison! Witness, for example, this article by Jay Adkisson.
And finally, if scare tactics fail to break the approaching tidal wave, the worst of them appeal for regulation. Specifically, they attempt to position themselves with regulators as the “good guys” and their competitors as “rouges” or “promoters” whose “schemes” endanger the public, or even the republic, and who must therefore be brought to heel via increased oversight, scrutiny and regulation. In short, in a last desperate attempt to defend their falling barriers to entry, they invite regulation of their industry believing, often incorrectly, that such regulation will protect them from their new competitors (think Atlas Shrugged).
And, inviting IRS regulation of the captive industry is the second purpose of the Cantley paper.
The Old Guard’s attacks on “promoters” of life insurance follows perfectly the time-tested defensive pattern of the dying business model outlined above. When both positive and negative differentiation failed to stem the tide, the likes of Old Guard attorney Jay Adkisson began resorting to blatant intimidation and fear tactics. His writings on the subject of life insurance are now often vitriolic, filled with hyperbole, and frankly over-the-top. Read some of them for yourself and decide whether they seem to represent the conclusions of a disinterested lawyer or a biased self-promoter. For instance, in this famous attack by Adkisson on life insurance producers, the word “shady” appears twice, “bogus” appears four times, “sham” appears five times, “scheme” appears ten times, “tax shelter” appears seventeen times, and “promoter” appears twenty-one times.
What makes the Old Guard’s attacks on this subject so shameless is that they once actively promoted combining life insurance with captive insurance companies (and some, like Cantley, secretly still do). But today, despite once giving an extensive talk to the Association for Advanced Life Underwriting (an industry group of the nation’s top life insurance producers) on the benefits of combining life insurance and captives, and despite the fact that his captive management company once actively promoted combining life insurance and captives, Jay Adkisson, who is not a tax attorney, now warns the public that:
If someone ever uses the terms “captive” and “life insurance” in the same sentence, run! Unless you have a burning desire for the IRS to act as your proctologist, that is.
Methinks he doth protest too much. Jay’s about-face on the subject of life insurance and captives is just a little too convenient, and hostile, to be taken seriously.
Although not nearly as prone to hyperbole as Jay, Jay is sometimes joined in his attacks on life insurance by the likes of Old Guard mouthpieces Hale Stewart and Beckett Cantley, both of whom seem to go out of their way to target life insurance “promoters” whenever possible, despite the fact that Cantley (at least) is privately known to sell life insurance policies to captives with some regularity (via his participation in life settlement transactions in which captives that he serves are the purchasers).
The attacks by Stewart and Cantley are in some ways far more troubling than Jay’s because, unlike Adkisson, who is obviously over-the-top biased (the hyperbole gives him away), the former two strive to convey an illusion that their opinions are anchored in objectiveness and sound, even “professorial”, legal reasoning (witness, the Cantley paper). Say what you want about Jay Adkisson, at least he’s not a shill.
Making Sense of the Cantley Paper, and My Bias
The Cantley’s paper must be understood in the context of the above history. With this history in mind, we can understand why it is so riddled with slights-of-hand, non-sequiturs, and other logical fallacies. It’s great shill-based marketing, but as a work of legal analysis, it fails miserably, as we shall see.
However, before moving to the next section, let me make a few disclosures:
First, I am, at least tangentially, part of the New Wave. My credentials, background and experience are easily ascertained by anyone so interested (not that they should necessarily mean anything to you—beware the opinions of “experts”, including mine.).
Second, my office sells obscene amounts of life insurance—for COLI, estate liquidity, personal planning, buy-sell, and innumerable other purposes. Contrary to Cantley’s implications, I (and others like me) don’t need captives to “replace” any “lost” life insurance sales.
Third, I’ve never participated in any 419 or 412(e)(3) transactions. And, I’ve never sold life insurance to a captive insurance company per se (not that there’s anything wrong with that).
I mention the above to make this point: Don’t accept (or reject) anything that I say at face value. Do your homework. Test my words, and Cantley’s, against your own knowledge and experience and decide for yourself what is true and who is right.
Fortunately, the target audience of this post will have sufficient industry experience to know, without a need for me to cite too many sources, that the political history noted above, and my other points below, are fundamentally accurate and correct.
Cantley’s Real View of Life Insurance
Nobody reading the Cantley paper could reasonably conclude that Cantley would actually favor the use of life insurance as an investment tool for captives. To the extent that he believes that using life insurance within captives is ever acceptable, he fails to make public note of it in the paper or, as best as I can tell, anywhere else.
And that is one of the reasons that his paper struck me as so deceitful when I first read it. You see, unlike his average reader, I know for a fact that Cantley facilitates the purchase of life insurance by at least some of the captives that he oversees, and that he makes quite a bit of money from his life settlement side business. OCTOBER 31, 2013 UPDATE:> In one of Cantley’s life settlement deals, Cantley stood to personally earn more than $400,000. That’s four hundred thousand and no/100’s.
In those captive cases about which I am personally aware, the portion of the captive’s asset invested into life insurance is substantial, and the life insurance policies were purchased very shortly after the captive was formed (or, perhaps originally by Cantley, even before they were formed).
So, how does one explain Cantley’s apparent disingenuousness on the subject of life insurance and captives? Why does he privately facilitate the combination of life insurance with captives while publicly ridiculing the idea?
When I raised the issued in a LinkedIn forum, Cantley responded, in part, as follows:
The reason that I have not taken a similar [adverse] position with the purchase of third party old and cold life insurance policies (i.e., not on the CIC owners and too old to have conceivably been taken out for this purpose) [by a captive], is that such life settlements are really just another asset class now held widely by hedge funds, banks, and other wealthy investors. Thus, there is no circular money flow issue, and no issue that the CIC owner has structured the CIC for the purpose of deducting life insurance on his own life.
“Third party old and cold life insurance policies” is just a roundabout way of saying “life settlements.” You can learn more about life settlements here.
Cantley’s efforts to distinguish his “life settlement” transactions from more traditional “owner-insider” life insurance arrangements is misplaced and unconvincing, especially when one remembers his biases. First of all, it’s not a distinction that he made particularly clear in the Cantley paper, or anywhere else for that matter. Given his apparent position on the subject, it’s odd that a Google search for “Beckett Cantley life settlements” turns up nothing of consequence. As best as I can tell, Cantley’s private involvement with life settlements wasn’t publicly known until I called him out in a LinkedIn forum. And, something tells me that Cantley preferred it that way and would rather not have this area of his life scrutinized.
Second, as we shall see, virtually every single legal argument that he makes against traditional life insurance arrangements and captives applies equally to captives using life settlements, and in some cases more so. Thus, by attempting to differentiate life settlements from other types of life insurance arrangements, he disingenuously offers up a self-serving distinction without a difference. A captive could just as easily be formed “for the purpose” of investing in tax deductible life settlements as easily as for “owner-insider” policies, and the tax avoidance benefits would be essentially identical, at least during the life of the captive’s owner. And, the “circular flow of money issues” remains the same in either scenario, it’s just a matter of whose death (the captive owner’s, or some stranger’s) triggers the so-called circular flow.
Given Cantley’s “distinction without a difference”, what is the real explanation for Cantey’s deceit on this subject?
I believe there to be two. First, by keeping his life settlement activities quiet, Cantley attempts to “fly below the radar” as he sicks regulators, the IRS, upon his competitors. By never mentioning life settlements, and how he distinguishes them (or fails to do so) from “owner-insider” life insurance, Cantley is free to form captives, and help his client’s purchase life insurance within them, while appearing to the IRS, and the New Wave, to be life insurance adverse.
Second, if one simply remembers that “life insurance” is an Old Guard euphemism for the New Wave, everything falls into place and makes perfect sense. When the Old Guard attacks life insurance, they are simply attacking their most successful competitors. Their issue really isn’t with the life insurance product in general (as evidenced by the fact that many of them, including Jay Adkisson and Becket Cantley have historically combined life insurance with captives in their own practices), but rather upon the life insurance producers who have successfully invaded “their” industry in recent years.
By publicly attacking “owner-insider” life insurance (Cantley’s word for traditional life insurance placed on the life a captive business owner) while privately excepting life settlement transactions from scrutiny, the Old Guard conveniently seeks to undermine the appeal of the captive industry to the New Wave, and invite IRS attack upon the New Wave, while preserving for their own clients all of the undeniable benefits of combing captive insurance companies and life insurance. Cantley would have the public believe that it’s perfectly acceptable to sell “old and cold” life insurance policies on strangers to a captive, but selling a newly commissionable policy on the life of an “owner-insider” is somehow taboo. Cantley seeks to have his cake and eat it too. How convenient. And…unscholarly.
Breaking Down The Cantley Paper
The second paragraph of the paper begins rather weakly by successfully slaying a “straw man”. After introducing the reader in the first paragraph to the existence of those pesky “life insurance agents” who every year seek to “boost year end sales” with some new fangled “tax-deductible premium plan” that represents the “Holy Grail of insurance schemes”, the second paragraph states baldly that “[t]he 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…abusive…”.
But, the IRS isn’t just as “likely” to object to sham captives created for the purpose of purchasing tax-deductible life insurance, they are absolutely certain to do so. But…who claims the contrary? Virtually nobody as far as I can tell. With the exception of one very unfortunate marketing piece circulated by Pacific Life many years ago (which has been subsequently revoked and disavowed completely), I’m not aware of anyone in the New Wave making such claims.
But Cantley wants his reader to believe otherwise. Note how Cantley engages in intentional priming by juxtaposing the slanders on life insurance agents in paragraph 1 with the straw man of paragraph 2. His purpose is, among other things, to create via priming the false impression in the reader’s mind that: (1) the New Wave is marketing captives as a way to purchase tax-deductible life insurance, and (2) anyone who talks of captives and life insurance together secretly has this nefarious purpose in mind.
The second paragraph of the paper then continues by cherry-picking a few specific instances where the IRS was successful in attacking certain tax-favored life insurance transactions. The implication is that the IRS has been completely or mostly successful in its efforts. Unfortunately, it takes a very knowledgeable reader to know just how misleading Cantley’s implication on this point really is.
For example, the non-expert reader doesn’t know, because Cantley doesn’t tell, that the IRS has no apparent issues with the use of life insurance in many arrangements that are explicitly tax-favored. Examples include but are not limited to traditional defined benefit pension plans, profit sharing plans, and split dollar (including non-profit split dollar) plans. Additionally, tax-exempt not-for-profit organizations regularly invest in life insurance (with little to no trouble from the IRS), and family foundations are even free to own or purchase life insurance on the lives of their insider-grantors. Why doesn’t Cantley raise issues with the use of any tax-favored life insurance in these instances, just as he does with captives? The history that I note above explains his disparate treatment.
Nor does the non-expert reader know, because Cantley doesn’t tell, that the IRS’s “success” in even the limited areas he specifically cites was, on several occasions, a qualified success rather than a complete one. For instance, the IRS has conceded the legitimacy of many 419 plans, 412(e)(3) plans, and COLI arrangements that involve the use of life insurance. Why does the Cantley paper therefore leave the definite impression that most every 412(e)(3) arrangement involving life insurance, just to pick one example, is improper when that is certainly not the case?
In short, the instances that Cantley harps upon in his paper involved the use of specific types of life insurance in very particular ways for very narrow and abusive purposes. As we shall see, in nearly every single instance cited by Cantley where life insurance was successfully challenged (e.g., 419 plans, 412(e)(3) plans, and COLI financing), the explicit objective of the arrangement was the purchase of tax-deductible life insurance, and in most cases the transaction made use of “trick” life insurance policies, kinds not available to the general public, that were specifically designed to achieve a certain tax objective and otherwise lacked true economic substance.
This is simply not the case in most every instance (that I’m aware of) where captives are involved with life insurance. In captive cases, the explicit intention is the purchase of property and casualty insurance. The captives have real risk shifting and risk distribution, and therefore clearly have economic substance. The life insurance policies sold are ordinary policies offered to the general public in innumerable other contexts, not “trick” policies designed for a particular tax-avoidance purpose. In fairness, the examples cited by Cantley don’t even apply by analogy, as we shall see.
The IRS “Goes to War” Over Tax-favored Life Insurance?
After slaying his straw man, Cantley continues in the first full paragraph on page 8 by citing a number of specific examples that are supposed to support the proposition that “[t]he IRS has a long history of going to war with promoters and taxpayer participants of vehicles that result in tax-deductible or tax-advantaged life insurance premium payments.” But, before I refute his examples one by one, let me first make a few broader points.
My first broader point is this: Cantley’s states that the IRS’s concern is with “tax-deductible or tax-advantaged life insurance premium payments”. He repeats this mantra, and others nearly identical to it, time and again throughout the paper. Only occasionally does he limit the IRS’s potential concern to policies written on “owner-insiders”. This is important because life settlement policies purchased by a captive insurance company are, most definitely, “tax-advantaged life insurance premium payments”, at least if ordinary life insurance on “owner-insiders” is. And, if tax-advantaged life insurance is truly the root of the IRS’s supposed issue, then Cantley’s attempt to distinguish his involvement with life settlements from life insurance on owner-insiders is disingenuous. For all intents and purposes, they offer virtually the same tax-avoidance benefits. It just so happens that the latter helps pay Cantley’s competitors to compete with him while the former, by and large, does not.
My second broader point is…so what? Even if his assertion is true that the IRS goes to war every time they sniff out tax-advantaged life insurance (and it’s not, as evidenced by Cantley’s involvement with life settlements, among many other things), the IRS also has a long history of “going to war” with captive insurance companies in general, regardless of their use of life insurance. Cantley doesn’t suggest that one should therefore avoid captives altogether, does he? Of course not. He gets paid for helping his clients set up and run captives.
The Service also has a long and successful history of attacking 403(b) plans, a subject about which I am quite familiar. Cantley doesn’t suggest that non-profits should avoid adopting such plans as a result, does he?
In short, simply because the IRS might enjoy attacking or scrutinizing a particular tax structure at any given moment doesn’t mean that the Service is right or is likely to win and that the transaction should therefore be avoided. And, even when they do win some cases against scrutinized transactions (as they did, for example, against some captive arrangements and 403(b) arrangements), that doesn’t mean that all such arrangements by the same name are tainted or at risk, right?
But, when it comes to captives and life insurance, and only with respect to captives and life insurance, the Old Guard is intentionally trying blur the lines between IRS scrutiny and illegality. In fact, that’s the entire point of Cantley’s article: To try to equate potential IRS scrutiny of a transaction with the near certainty of a tax evasion conviction, or at least major civil penalties.
If someone leapt to such an over-the-top conclusion with, say, captives in general, or qualified plans (both of which have historically been subject to great audit scrutiny), or even ordinary 412(e)(3) plans that make use of “normal” life insurance policies, they’d be dismissed out of hand. And, Cantley should be too.
My third broader point is that the examples of the “war” he cites generally suffer from extreme sampling, selection, and confirmation biases. As for sampling bias, he mainly cites court cases. The problem with that is that the IRS doesn’t risk losing in court (and setting and adverse precedent) except in cases where the conduct of the taxpayer was so egregious that the IRS is confident it will win. Thus, the examples cited by Cantley (a certain particular variety of 419 plans, a certain particular variety of 412(e)(3) plans, certain particular varieties of COLI arrangements, and certain PORCs), are by definition extreme. Unfortunately, he doesn’t make it clear in his paper that it was only “certain particular varieties” of the arrangements that the IRS successfully attacked. And, as for selection bias, he doesn’t analyze and distinguish even a single case regarding life insurance where the IRS lost.
By highlighting only examples of IRS victories in court, Cantley completely ignores the hundreds if not thousands of IRS audits involving life insurance (even some where captives are involved), where the IRS either: (a) didn’t challenge the structure, (b) challenged it but settled at the appeals level (usually for pennies on the dollar), or (c) went to court and lost. Cantley is almost certainly aware of at least some of these audits. He nonetheless disregards them because the only way that one can arrive at Cantley’s sweeping conclusion that “[t]he IRS has a long history of going to war with promoters and taxpayer participants of vehicles that result in tax-deductible or tax-advantaged life insurance premium payments” is to conveniently ignore all evidence contradicting the assertion.
Anyone attempting to discern the IRS’s position on captives and life insurance, or the strength and validity of the IRS’s position on this subject (as Cantley is want to do), must admit that the audits noted above are directly on point. Far more so than the court cases cited by Cantley that apply, if at all, only by tortured analogy. And, anyone failing to take account of such audits in developing their opinion on this subject is very likely to reach an inaccurate conclusion.
Deconstructing Cantley’s Specific Arguments
Even when we analyze Cantley’s cherry-picked sampling of cases, the instances he cites don’t support his general contention that the IRS will “go to war” over any arrangement involving tax-favored life insurance of the ordinary variety. Let’s review them one-by-one, just as he did, so that I can explain why.
He begins his cherry-picked survey of the IRS’s position on page 8 with a discussion of 419 plans. One page 10 he begins a discussion of the famous Neonatology case. To his credit, he does point out that the type of life insurance used in this case wasn’t the ordinary type that the reader would be familiar with, but rather an “innovative life insurance product” that was “designed to masquerade as a policy that provided only term life benefits…”. In other words, this was a specially designed life insurance contract designed specifically to achieve a certain tax result. It was marketed and sold only to 419 plans.
Also to his credit, Cantley acknowledges that “premiums in the Neonatology 419(e) plans were found to be four to six times higher than…under a conventional group term life plan”. In other words, the plan was overcharging for the life insurance coverage in order to enlarge the desired tax deduction and generate excess revenue that could be used to fund the cash value portion of the trick life insurance policies.
Not surprisingly, the Tax Court held that the inflated premiums paid to the plan were a constructive (taxable) dividend to the beneficiaries of the plan rather than legitimate contributions to the plan deductible as ordinary and necessary business expenses. By definition, if you’re overpaying for something, especially to a related party, that’s probably not an “ordinary and necessary” business expense, right?
In short, despite Cantley’s implications to the contrary, the court’s issue in Neonatology wasn’t with real, normal life insurance policies of the variety used with captives, but with contracts specially designed to achieve a certain tax result and that were funded with artificially inflated premiums. Also, the explicit objective of the arrangement was the purchase of tax-deductible life insurance, something that the Code generally forbids. For him to assert that this case in any way stands for the general proposition that the IRS will “go to war” over any combination of tax-advantages and life insurance is simply a non sequitur that he hopes the reader will accept ipsa dixit.
Cantley then continues with a discussion of the Benistar 419 cases. Without going into detail here, suffice it to say that the Benistar case was very complex and had some similarities to the Neonatology case (after all, both were 419 plans and involved specially-crafted life insurance policies). As in Neonatology, the court found that contributions to the Benistar trust were not “ordinary and necessary business expenses” but rather were a distribution of profits. If one reads the cases (and the reader should do so), it’s not too hard to see how the court came to that conclusion. Or how that same conclusion, using the same logic, would be completely inapplicable to captives that invest in life insurance.
Here’s the main problem with Cantley’s citation of these 419 cases: If one were to read Cantley’s paper uncritically, one might believe that the Neonatology and the Benistar cases stand for the proposition that businesses can’t deduct contributions to 419 plans where life insurance is involved. But, that would be a complete and total misreading of the cases, as Cantley himself would admit if pressed. Even to this day, it is perfectly acceptable to deduct contributions to 419 plans for the purpose of life insurance protection, but only for term life insurance protection for the benefit of many and not just the owners of the company. Only if premiums are inflated above market rates to afford the employer a larger deduction, or if those premiums are then diverted to specially-designed life insurance policies to achieve a certain tax result for owner-insiders, or if the arrangement represents a “thinly disguised distribution of corporate profits” to a select group of owners, does one need to worry about deducting contributions to such plans today.
Despite this, Cantley actually invites the reader to go much, much further in interpreting the holding of the case. Even though the 419 rulings don’t even stand for the proposition that “owner-insider” life insurance within 419 plans is taboo, Cantley would have the reader believe that it is an example of “the IRS…successful[ly]… defending the non-deductibility of…investment oriented life insurance arrangements” in general. Such a conclusion is not even warranted by parsing the dicta of these cases!
Certain 412 Plans
Cantley then continues at the top of page 13 with a discussion of some cases and rulings under 412(e)(3), which describes certain types of defined benefit retirement plans (aka, 412(i) plans). To his credit, he accurately describes the types of cases that the IRS believed to be abusive–specifically, those cases where, once again, specially designed life insurance contracts were designed and used to achieve a desirable tax outcome. The abusive arrangements worked as follows:
The employer, usually a closely-held business, would make tax-deductible contributions to the 412(e)(3) retirement plan. The plan would then invest contributions it received each year into specially-designed life insurance policies (which were really not sold for any other purpose but to fund these plans). The life insurance policies were designed specifically so that they would have essentially no cash surrender value for, say, five years, and then suddenly increase in value tremendously in the next year, with the cash surrender value in the sixth year approaching or exceeding the cumulative premiums paid into the policy up till that point. These became knows as “springing cash value policies”.
Now, here’s the really abusive part (there were a couple of other abusive features, but this is the key one): The plan would distribute the life insurance policy “in kind” to the participant (usually the business owner), or else permit the participant to purchase the policy for it’s cash surrender value, at the end of the fifth year, just before the cash value “sprang” to life. And, to make matters worse, the plan and participant tried to claim that the participant owed little or no tax on the distribution or purchase from the retirement plan since the policy was worthless or worth little (i.e., had no or little cash surrender value) at the time it was distributed.
I mean, what a deal, right? My retirement plan distributes something to me that’s supposedly worthless, so that I owe no tax, but it suddenly becomes extremely valuable shortly after its handed over to me (thanks to the miraculous machinations of some insurance company actuary). And, thanks to the peculiarities of life insurance law, I’m then able to access that now very valuable cash surrender value tax-free (via policy loans).
But, that’s just too cute by half, no? As any reasonable person should know, the policy was not “worthless” when distributed to or purchased by the participant. A policy that has no cash surrender value today but is guaranteed by a highly-rated life insurance company to have substantial cash surrender value tomorrow, or next year, is definitely worth something—a fair amount actually. And, as the IRS asserted reasonably, the fair market value of the property should be taxed to the participant upon distribution from the plan.
Needless to say, the IRS won these cases and won them big.
So, given this victory, and given Cantley’s write-up, the reader could be forgiven for believing that 412(e)(3) plans are “dead” today, and that certainly nobody would ever use life insurance in them, right? Wrong! These plans are alive and well and funded with “normal” life insurance policies every single day, and the IRS mostly leaves them alone. It’s only the highly-abusive ones that made use of “trick” life insurance policies that are dead and improper.
But, yet again, Cantley goes much further: He concludes based upon this result in these limited 412(e)(3) cases, and invites the reader to do the same, that most every tax-advantaged life insurance arrangement is at risk.
At the bottom of page 16, Cantley then offers up his third grand example of the IRS’s supposed hatred for all things life insurance and success in attacking it—tax advantaged financing of corporate-owned life insurance, or COLI. In doing so, Cantley (purposefully?) conflates a number of separate issues. The issue in question involved the financing of COLI policies, the deductibility of interest associated with that financing, and whether or not certain (once again) specially-designed life insurance contracts (once used to fund such arrangements) were legitimate.
In the end, the IRS was partially successful in eliminating the tax-advantaged financing of COLI policies, and the specially-designed policies that courts found had no “economic substance”, but contrary to Cantley’s repeated contentions, not COLI policies in general. COLI is still much used today (it is just no longer financed improperly and the policies used are standard life insurance policies like those used with captives today).
Query: Would any reader of the Cantley paper walk away with the understanding that nearly 70% of Fortune 1000 companies use COLI for investment purposes today and receive little or no attention from the IRS? Not after reading highly misleading statements like these:
Enactment of the Health Insurance Portability & Accountability Act of 1996 (“HIPPA”) ended the use of broad-based COLI plans by eliminating the interest deduction on policy loans for employees that were not key persons.
In 2002, after a series of victories, the IRS issued Announcement 2002-96 stating that all future COLI litigation would be “vigorously” prosecuted or defended.
However, COLI used for investment purposes is no longer allowed based upon application of the economic substance doctrine.
The first and last quotes immediately above are unforgivable. Cantley must know, or at least should know (if he’s going to publish papers on the subject), that it is totally and demonstrably false.
By stating that “COLI is no longer allowed”, Cantley not only tells the readers explicitly to draw a bogus conclusion regarding the cited cases, but he yet again invites the reader to go much further: He asks the reader to conclude, as he has, that these few highly abusive COLI cases are evidence of a much broader IRS stance against tax-advantaged funding of life insurance in general:
The multi-faceted attack represented by legislation, an IRS settlement initiative, IRS announcements of policy, and court challenges against COLI all act as another indication of the IRS’ determination to not permit aggressive tax-advantaged funding of life insurance premiums.
Once again, that conclusion is not even supported by the dicta of these cases, but that doesn’t matter to Cantley.
Finally, toward the top of page 19, Cantley gets to his fourth and final example of IRS attacks against tax-favored life insurance “schemes”: PORCs, a specific type of captive insurance company. And, this final example is perhaps his weakest of all. Perhaps he assumed his readers wouldn’t’ read so far, or would skip to the end for his big conclusion?
Anyway, he apparently cites the PORC example for the primary purpose of demonstrating two things: (1) That the IRS has seen fit to scrutinize certain types of captive insurance company arrangements in the past, and may do so again in the future; and (2) that the IRS is highly skeptical of arrangements, such as PORCs, that “divert income properly attributable to the taxpayer to a wholly owned company that [is] subject to little or no federal income tax” (IRS Notice 2002-170).
But, are PORC’s really the best example of these issues that he can find? After all, he notes that in 2002 the IRS made PORCs a “listed transaction”, but reversed that decision two years later after finding “fewer abusive PORC transactions than anticipated.”
Despite this, Cantley once again steadfastly assures the reader that the PORC non-event is evidence of “a continued IRS policy of disallowing aggressive tax-deductions in the context of insurance.”
Conclusion Regarding Cantley’s Cited Cases
To conclude this section, Cantley only offers up four examples, spanning decades, of the IRS supposed “war” against all tax-favored life insurance arrangements. But the examples he cites don’t support his contention. They are the product of selection, sampling and confirmation biases, and thereby omit every case and situation (the majority, in fact) that contradicts his thesis. The examples he cites are extreme cases of obvious taxpayer abuse, with such abuse being evidenced certain badges of fraud such as artificially inflated premiums, specially-crafted “trick” life insurance policies designed to game the system, arrangements that lack any demonstrable economic substance, and arrangements where deducting permanent life insurance premiums was explicitly the motivation of the taxpayer.
So, it’s not that the examples cited by Cantley, or his analysis of them, are wrong, it’s just that the conclusions he wrangles from them are totally unjustifiable. Cantley’s deceit is that he repeatedly invites the reader, in fact directs the reader on occasion, to assume that these limited and extreme, cherry-picked examples, which most readers will have never analyze in any detail, are obvious evidence of some broader IRS vendetta against tax-favored life insurance in general.
More Forgone Conclusions
Cantley’s disingenuousness on this subject continues in earnest on page 22 when he attempts to “synthesize and summarize” IRS supposed policy regarding tax-favored life insurance arrangements for us. He explains there that “the IRS has considered the following circumstances as indicative of potential abuse in the life insurance area: (a) tax-advantaged payment of life insurance premiums to accumulate assets; (b) circular cash flows used to pay policy premiums; and (c) discriminatory life insurance benefits.” He then analyzes each of these separately.
His analysis of these conclusions is such a rambling, strung-together recitation of non-sequiturs and irrelevant citations that one struggles to make much sense of it. His point (I think), which is really kind of hard to dispute despite his weak attempts to support it, is that the IRS doesn’t just love it when taxpayers shift income to tax-favored investments (like life insurance) or entities (like captive insurance companies), and that they therefore might really not just love it if one does both of these things together.
Well, that’s fair enough. If I were the IRS, I probably wouldn’t love it either. As Upton Sinclair famously said, “it’s difficult to get a man to understand something, when his salary depends upon him not understanding it.”
But not liking or not understanding something and being willing and able to do something about it are two very different things. Cantley constantly and intentionally conflates these two things in an attempt to instill fear, uncertainty and doubt (FUD) in the minds of his readers, and provide ammunition for the Old Guard. One again, it is important to Cantley that the reader improperly equate potential IRS skepticism or scrutiny of an issue with its illegality.
Additionally, it is important to note that most of the criticisms Cantley offers in this section of his “analysis” either: (a) don’t apply to captives investing into life insurance, or (b) apply equally to his preferred life settlement methodology. That he fails to turn his own weapons against himself, and in fact never even discloses to the reader that he sells life settlements to his captive clients and views doing so as acceptable (and why), cinches the case against him and his conclusion.
Tax-favored Life Insurance
Consider, for example, his analysis on page 22 of the IRS’s supposed policy against arrangements that permit the tax-advantaged payment of life insurance premiums to accumulate assets. He begins by citing the universally accepted rule that life insurance premiums are not deductible, and that this rule has almost “no exceptions”, including (he doesn’t say) life settlements.
Fair enough. But, this is another straw man. No captive that chooses to invest into life insurance, whether life settlements or “owner-insider” policies, takes a deduction for doing so. I challenge Cantley to cite even a single known instance otherwise. The premiums paid by the insured to the captive are not for “key man” insurance, but rather for various types property and casualty risks. Assuming these property and casualty policies are real, then such premiums are clearly deductible as such. And, the life policies subsequently purchased by the captive are not for “key man” insurance, but rather to act as a reserve into which the captive invests its own assets for its own easily-documented and self-evidently justifiable reasons.
In short, Cantley’s analysis of this issue on pages 22 and 23 is completely irrelevant to captives unless, of course, one disregards the economic substance of the captive altogether and pretends that the primary insured of the captive is directly investing into life insurance on a tax deductible basis. For that to be true, the policies issued by the captive (for which the deduction was ostensibly taken by the insured) would have to be sham policies. But, assuming that they are not—that is, assuming that the captive has real economic substance (real and fairly priced policies, risk shifting and risk distribution, independent profitability, etc.)–disregarding the substance of the captive under one or more anti-abuse theories should be all but impossible, almost regardless of how the captive invests its assets. And, if the captive is substantive, then no party to the transaction ever takes a deduction for life insurance, and Cantley’s analysis in this section is therefore inapplicable and irrelevant.
But, if the captive is not substantive, then Cantley is correct and the deduction would be denied. But not because the premiums went into life insurance, thereby violating some statutory ban on deducting life insurance premiums (which would apply equally to life settlements), but because businesses don’t get a deductions for making ordinary investments, whether they be into life insurance, real estate, or most anything else. Thus, the deduction would be denied whether the captive invested in real estate, a managed portfolio, life settlements, or…fill in the blank.
At the bottom of page 23, Cantley then discusses “circular flows”, another area of supposed grave concern for the IRS. He proceeds by citing a number of rules, laws and cases that have absolutely nothing to do with how captives invest into life insurance. However, to the extent that the citations have any relevance at all, they are equally relevant to life-settlement transaction.
Finally, at page 24, he discusses the IRS supposed concerns over any arrangements that “discriminate” in favor of business owners or highly compensated employees. As regards qualified plans and certain welfare benefit plans, which are basically the only examples he cites, Cantley is right. Under the Internal Revenue Code, qualified plans cannot offer benefits, rights or features that discriminate in favor of owners or highly compensated employees. And welfare benefit plans generally cannot either. These provisions are unique to the qualified plan and welfare benefit plan rules and generally do not apply in other areas of tax law (for example, companies are free to pay, and deduct, compensation to their most senior executives that is many times greater than that earned by their average worker). Cantley fails to cite even a single example of these rules being applied outside of a qualified plan or welfare benefit plan context.
With these unique rules, relevant again only to qualified and welfare benefit plans, the IRS was perfectly justified in challenging 419 and 412(e)(3) plans, a welfare benefit plan and a qualified plan respectively, on discrimination grounds. However, the rules he cites would have application to captives, if at all, only if a given captive is simply a welfare benefit plan or qualified in disguise. Thus, IRS wouldn’t be justified in using these limited rules to attack arrangements that are not qualified plans or welfare benefit plans, such as, for example, properly established captives or private placement life insurance. If there is any legal precedent for such a nondiscrimination attack outside the realm of qualified and welfare benefit plans, I’d like Cantley to cite it (and…I’m sure that he would have).
Bringing it Home–Cantley’s PORC Attack
Finally, after discussing for several more pages the tax-advantage nature of life insurance (virtually all of which apply to life settlement transactions too), Cantley finally attempts to wrap all of his prior ramblings up into a nice little bow at page 29. This is where he attempts to explain how captives combined with life insurance can skirt IRS policy and therefore should be viciously attacked by the Service. Essentially, this section of the paper is Cantley’s attempt to sick the IRS upon the New Wave, and provide the Service with a legal road map for doing so. Fortunately, the road map is flawed and full of holes.
For instance, he begins by inviting the IRS to argue that, whenever life insurance is involved, the principal purpose of the captive should be deemed to be tax avoidance rather than true insurance. He calls this the “PORC attack”. He concludes on page 30 (without citing evidence or explaining why) that “the conduit nature of the CIC insurance premiums into personal life insurance on a common owner is likely to make it difficult to prove that the CIC was created for proper non-tax business purposes.”
Well, let’s assume that he’s right for a minute (and he’s not). Let’s assume, for the sake of argument, that a given captive was formed primarily for tax-avoidance purposes.
So what? The transaction is only in jeopardy under the various anti-abuse rules if it lacks economic substance and a profit motive. Provided that the transaction changes the taxpayer’s economic position in a meaningful way, that the transaction has a substantial (though not necessarily a primary) non-tax purpose, and provided that the transaction has a profit-making motive (apart from any tax consequences), then it cannot be disregarded by the tax authorities.
Applying this well-known law to captives, it’s difficult to conceive of how a properly-formed and operating captive—one issuing real policies priced by independent third parties in exchange for real premiums, and where real risk shifting and risk distribution are involved—doesn’t pass these tests. It’s nearly undebatable that risk shifting and risk distribution alone change the taxpayer’s economic position in a real and meaningful way (after all, that’s the whole point!). And, given the popularity of captive insurance companies in general as a risk management tool, it would seem easy enough in most every case to show that there was at least some substantial non-tax reason to form and operate the captive, and very likely more than one. Again, risk shifting and risk distribution are very strong evidence of just one such non-tax motive. And finally, captives are generally known to be highly profitable entities—so the expectation of substantial profit is very real.
This is perhaps one reason why the last time the IRS launched Cantley’s “PORC attack”, it failed. PORC’s were “de-listed” just two short years after being originally designated as listed transactions as a result of a failure to find substantial abuse.
But regardless, Cantley’s contention that the “conduit nature” of life insurance makes it difficult to prove a non-tax purpose for the captive and/or life insurance is simply wrong. There are innumerable ways to prove that a given captive was not formed simply a conduit for the purchase of tax-deductible life insurance. Here are just a few:
1) The business should have, and document, the need for captive insurance, including its many risk management and cost savings benefits.
2) The decision to establish the captive should be the result of the process noted in 1 above, and should be made without regard to how the captive may invest its assets.
3) Conversations about how the captive might invest its assets, including the possibility of life insurance, should be delayed until after the decision to form the captive is made. If life insurance is ultimately used, it should only be applied for after the captive’s formation.
4) Any decision to invest in life insurance should be made after considering the pros and cons primarily from the captive’s perspective, not simply or even primarily the shareholders, and should ideally be based upon a formal, written “investment policy statement” adopted by the captive. The basis of the captive’s decision (a formal asset/liability study, comparison and consideration of alternatives, etc.) should be documented and retained.
5) Life insurance premiums should, perhaps, be limited to a reasonable percentage of the captive’s assets.
6) The insured should, by shareholder’s agreement or otherwise, be prohibited from directly exercising control over the life insurance policy.
In short, proving the legitimacy of a captive that invests in owner-insider life insurance is only “difficult” if, indeed, the captive is a sham, but it should not be difficult in any other instance. The existence of life insurance doesn’t, ispo facto, make it a sham, nor does it even increase the odds of it being a sham. In the absence of significant other aggravating factors, it difficult to see how the IRS could successfully challenge an otherwise legitimate captive as a sham conduit simply because it invested some of its assets in life insurance, especially when the decision to purchase the life insurance was made in a manner consistent with the above six parameters, or similar ones.
Lastly, I would point out that, many of the “conduit” issues that seem to concern Cantley have already been resolved with respect to other tax-favored entities that often invest in life insurance—for instance, family foundations. The private inurement laws that govern such entities can be viewed, in part, as very strict anti-conduit rules. And yet, even there, life insurance on “insiders” is employed regularly, albeit with reasonable precautions that should inform those who make use of such insurance with captives. In short, if one wants to argue by analogy as to how life insurance inside captives should be viewed by the IRS, tax-exempt family foundations are a far more apt analogy than 419 plans, 412(e)(3) plans, or tax-favored financing of COLI.
Not “Arm’s Length”?
Next, Cantley argues that somehow the use of life insurance makes it less likely that a given captive transaction is “arm’s length”. By “arm’s length”, he means that the property and casualty premiums paid to the captive were independently priced, market comparable, reasonable, relevant, etc. In other words, the premiums can’t simply be invented or inflated to suit the purposes of the insured or its owners, or for the primary purpose of obtaining tax benefits. Everyone, as far as I can tell, agrees with that.
But, as usual, Cantley goes further and invites the reader to do the same. He suggests that decisions about how the captive invests its assets must also be “arms length” and therefore be independent of the consideration of the captive’s insured’s and their owners. In doing so he invents a legal standard that does not exist in statute, case law, IRS rulings, state regulations, or anywhere else. He argues:
It is unlikely that an independent insurance company would choose in an arm’s length deal to make use of its reserves to purchase life insurance on the life of its owner, especially before the insurance company has even proven to be a consistently profitable venture. Aside from the “insider” nature of such an investment, the investment of a significant portion of the reserves in one concentrated vehicle may result in the CIC investment portfolio failing to be diversified in a manner consistent with how an independent insurance company would operate. Newly written life insurance contracts inherently possess significant illiquidity compared to more traditional CIC investments, such as public stocks and bond. Overall, the unlikely nature of this choice of investment on an arm’s length basis makes it subject to heightened scrutiny by the IRS.
Note that this entire quoted paragraph contains not a single citation. It is purely speculative and conclusory. And, more importantly, it is completely at odds with how business has been done in the captive industry for decades, with little to no interference from the IRS (at least on this particular point). No captive that I’m aware of (and I doubt many that Cantley is aware of), whether investing in life insurance or not, strives to invest its assets as an “independent insurance company” would. Nor do they usually seek to diversify their investment portfolio as an “independent insurance company” would. That is not, and never has been, the IRS’s standard for an “arm’s length” captive transaction, nor it is the standard of the state regulators who supervise and regulate the asset management activities of captive insurance companies. The NAIC Investment of Insurer’s Model Act has no such requirement.
It’s no wonder that Cantley fails to cite a single source in support of this proposition.
And, it is no surprise that it is therefore nearly universally disregarded by the captive industry. Captives commonly invest in assets that can then be leased back to the related operating business, something an “independent insurance company” would never do. Captives commonly engage in “loan-backs” to the related operating entity, which is nearly universally recognized as acceptable within certain debated limits, something that an “independent insurance company” would never do. Captives often invest significant percentages of their assets in relatively illiquid investments, such as timberland or, in the case of some of Cantley’s clients, life settlements. This is something that no “independent insurance company” would do.
Captives often invest virtually all their assets in a single brokerage account or managed account with a single broker or advisor, something “independent insurance companies” never do.
Additionally, there is great doubt about whether the IRS even has jurisdiction to challenge captives on the grounds that Cantley alleges. As one of the South’s top tax litigators, David Aughtry, noted to the Kentucky Captive Association earlier this year in a talk conveniently (for my purposes) titled “Defending Captives Against the Guards”:
Some of the…challenges asserted by the Service may be outside of its realm of regulation. For example, the administrative and operational requirements of a captive are prescribed by the Insurance Commissioner of the jurisdiction in which the captive is formed. Accordingly, in an attack by the Service administrative or investment issues may be largely irrelevant since the Code provides no requirements for issues of the sort. If the Service raises administrative or investment arguments, it is imperative to delineate the Service’s actual authority and distinguish that authority from issues over which they have no jurisdiction. [emphasis added]
Respectfully, deciding whether a captive has invested its assets in a manner consistent with the practices of “independent insurance companies” is almost certainly a matter over which the Service lacks jurisdiction (as well as competence). Commentators like Adkisson, Cantley, and Stewart should join Aughtry in emphasizing this point, and add their voices to those who would reign in the Service’s overreach into these areas. But, instead, for selfish, personal reasons, they instead invite (nearly beg) the Service to chasen their competition (the New Wave asset managers) by regulating in an area where the Service has no authority and even less competence.
Cantley Argues “Regulation for Thee, but Not for Me”
Knowing Cantley’s history with life settlements, some of his statements in the last quoted paragraph above are so disingenuous that they can only be characterized as shameless. Let me just point out a few:
Aside from the “insider” nature of such an investment, the investment of a significant portion of the reserves in one concentrated vehicle may result in the CIC investment portfolio failing to be diversified in a manner consistent with how an independent insurance company would operate.
In other words, Cantley makes it clear here and in multiple places throughout the paper that his supposed issues are not “just” with life insurance on “owner-insiders”, but with life insurance in general, which by any fair definition would include life settlements (remember, the reader isn’t supposed to know about those pesky life settlement arrangements that Cantley’s so fond of promoting).
Individual life settlement policies of the type that Cantley is fond of using are every bit as “concentrated” as “owner-insider” arrangements. This is especially true where, as I know to be the case in at least some instances, Cantley’s captives invest in life settlement contracts on only one or two lives and issued by only one or two different companies. If diversification were truly a concern for Cantley when life insurance is involved, that concern would apply equally to his preferred structure. And, if diversification were the real issue, there are a thousand ways to skin the diversification cat (as Cantley almost certainly knows): Simply invest in multiple polices from multiple companies on multiple insureds, for example. Or…only invest a reasonable portion of the captive assets into life insurance. Or…. (fill in the blank).
And anyway, if Cantley is honest in applying his own made-up test, he should ask himself this: How many “independent insurance companies” are going to invest any meaningful percentage of their assets directly into individual life settlement policies on complete strangers? Exactly none, I’d bet. If Cantley can cite even a single instance of this, I’m all ears.
Life Insurance is Illiquid?
And then there’s this zinger of a shameless quote: “Newly written life insurance contracts inherently possess significant illiquidity compared to more traditional CIC investments, such as public stocks and bond.”
Cantley is either stunningly ignorant on a topic on which he professes to be an expert, or else he is intentionally deceiving the reader. The fact is that legitimate COLI type policies, policies that are used for investment purposes every day by Fortune 1000 companies with no complaints from the IRS, and the type that would often be used with captives, have cash surrender values in even the first year of as much as 90 percent or more of the premiums paid, and with none of the risk of the stock or bond market. That’s significantly higher liquidity than many “traditional” captive investments (which are not all that often the simple stock and bond portfolios that Cantley suggests). COLI is certainly more liquid than some real estate ventures, limited partnerships or hedge funds arrangements that “independent insurance companies” often get involved with.
And, maybe most importantly for our purposes, COLI is for more liquid than the life settlement policies that Cantley privately promotes. Even before the financial crisis, life settlements were viewed as relatively illiquid investments, and they still are today. And, during the financial crisis, the life settlements industry famously seized up. The secondary life insurance market became almost completely illiquid. Even today, prices for life settlements are significantly lower than just a few years ago, meaning that anyone wanting to “flip” policies purchased back then is likely to suffer a meaningful loss. And, the industry could disappear completely if regulators decide to crack down on “stranger-owned life insurance” (“STOLI”), as many have been hinting they might. Many Canadian provinces ban life settlements already, and it’s not too hard to foresee at least some US states doing the same.
Some of the life settlement policies in Cantley’s captives have almost no cash surrender value. Should the secondary market dry up again or even disappear, they would be nearly completely illiquid. Furthermore, unlike “old and cold” owner-insider policies, they require continued, ongoing premiums to keep them in force.
Compare this to COLI-type owner-insider insurance. As we have seen already, they usually have first year cash surrender values equal to 90 percent or even 100 percent of premiums paid. And this money is completely accessible to the captive, thanks in part to life insurance’s built-in borrowing feature. Unlike a stock and bond portfolio (which might have to be liquidated at a loss to pay claims), or a life settlement policy (which would usually have to be sold in an “iffy” secondary market to raise cash), stable life insurance cash surrender values can be borrowed against at anytime without recourse. Life insurance is the only asset that I’m aware of that: (1) comes with a guaranteed right to borrow against it, (2) on a non-recourse basis, (3) regardless of one’s credit worthiness, (4) at little or no net interest cost (I think Cantley later calls these “wash loans”, but they don’t have to be), (5) with all principal and accrued interest due only upon the death of the insured (or lapse of the policy, which can be avoided more easily today than ever).
Honesty, it’s hard to get more “liquid” investment for a CIC than a high early cash value COLI policy. For Cantley to state otherwise represents either unforgivable ignorance or a shameful lie.
Risk Shifting and Risk Distribution
Next, Cantley turns to the issues of risk shifting and risk distribution, but this is mostly a variation of his already very weak “arms length transaction” analysis. Cantley states, “If the funding of the CIC is not truly at arms-length (as described above), the IRS could also argue that risk shifting and distribution has not occurred since a lack of arms length dealing indicates mutual ownership and control.”
But…is that really the test for risk shifting and risk distribution, Cantley? A lack of “mutual ownership and control”? By that definition, captives would not exist. As Cantley must know, there is not, and never has been, a requirement that a captive have “independent” ownership and control in order for risk shifting and risk distribution to occur. Quite the contrary, actually, since even properly structured parent-subsidiary captives are respected these days (thanks to IRS losses in court over the “economic family doctrine”).
Perhaps understanding the weakness of his initial argument on this subject, Cantley follows with this zinger: “Of course, even if the CIC establishes that it has met the definition of an ‘insurance company’ [by virtue of meeting the risk shifting and risk distribution requirements], the IRS may still attack the CIC by asserting the IRS general policy against the deductibility of life insurance premiums.”
Well…the IRS can attack any transaction at any time for any or no reason. But, if that attack is to be successful, it certainly won’t a result of asserting its “general policy” on anything. Fortunately, the IRS is still bound by laws passed by Congress and interpreted by courts and doesn’t get to act by “general policy” fiat. Regardless, as we have already demonstrated time and again, no such “general policy” even exists. Tax-exempt entities (qualified plans, family foundations, charities, etc.) invest in life insurance contracts everyday with little or no interference from the IRS.
At page 32, Cantley then proceeds to try to describe this “general policy” in more detail, and in doing so makes even more of a mess of things. Of course taxpayers can’t take a deduction for life insurance premiums. Point conceded, Cantley. That’s not “general policy”, that’s just the law. Another straw man successfully slayed.
The Perfect Tax Shelter?
He then argues that permitting a captive to invest into life insurance should be against IRS policy because it represents “the perfect tax shelter”. Well, it doesn’t, for reason’s I’ll explain in a minute, but let’s take him at his word for now and then ask, once again…so what? As Cantley reluctantly concedes, “there is no specific statutory prohibition against a CIC investing in life insurance…” In fact, not only is there no statutory prohibition, but there’s not a single court case, regulation, Revenue Ruling, Letter Ruling, or any other federal law that prohibits it. Nor do any state laws. The IRS has offered absolutely no formal or informal guidance on this subject. In fact, were the captive insurance company an ordinary C-corporation—say a bank or an “independent insurance company”–Cantley would have absolutely no objection to such an entity investing into life insurance. It’s done every day and is clearly permissible. So…what exactly is Cantley’s concern with captives doing the same thing their peers do?
Well, his primary concern is to frighten the reader away from the New Wave, but beyond that, his concern is simply this: Section 831 (b) Captives don’t pay any tax on underwriting profits (by statute). And life insurance has lots of tax advantages too (by statute). If we allow captives to invest their underwriting profits into ordinary COLI-type life insurance that any other corporation is free to purchase, the result is potentially “the perfect tax shelter”. And, the scary IRS doesn’t like perfect tax shelters, even when they are explicitly grounded in statute. So, the Service might use their police state bullying power, combined with ethereal and subjective “anti-abuse” doctrines like “economic substance” and “step transaction”, to viciously attack them. In fact, Cantley argues that they should viciously attack them (“Please!”, you can almost hear him cry.) Shameful.
The fact is, if Congress doesn’t want life insurance to be purchased by captives, and or if its concerned about its potential abuse as “the perfect tax shelter”, there’s a really easy fix. Just pass a law banning the combination, or taxing the inside build-up of life insurance, or…whatever. No need for police state intimidation tactics and scary law review articles written by a half-professor-half-Old-Guard-captive-practitioner shill.
But…apparently, despite Beckett’s histrionics on the subject, that’s not Congress’s concern at all because the only recent bills introduced in Congress over the last few years that would modify Code Section 831(b) have sought to expand, rather than limit, its availability and usefulness, and they make no mention at all of life insurance.
Further, although Beckett of course never says as much (since his reader isn’t supposed to know about his life settlements), his use of life settlements is every bit the same “perfect tax shelter” that “owner-insider” life insurance supposedly is. Money goes into the captive on a tax-deductible basis. The captive pays no tax on its underwriting profits. Those profits are invested into life insurance policies on old or sick strangers (i.e., life settlements), despite the IRS’s supposed anxiety regarding tax-favored life insurance arrangements. Those policies have the same tax attributes and benefits as any other life insurance policy. And, when those strangers die, the tax-free death benefit is paid to its owner (subject potentially to alternative minimum tax), since surely Cantley is smart enough to work his way around the “transfer for value” rules.
In fact, I’d be willing to bet a fair sum that if we asked ten highly successful small business owners whether they’d be more interested in investing into life insurance on their own life, or on the life of old and sick strangers, most would choose the latter (assuming that the latter were equally as “liquid” as the former, which they almost never are as noted above). Most every business owner I know, and I work with a great many in varying capacities, would rather get paid tax-free money when some sick stranger dies than to leave tax-free money to his/her heirs when he/she dies. Wouldn’t you, dear reader?
Once again, Cantley is impliedly calling out “regulation for thee, but not for me.” Convenient.
But, in any event, the “tax shelter” isn’t nearly as “perfect” as Cantley alleges, regardless of whether one uses life settlements, as Cantley prefers, or “owner-insider” life insurance (which is often preferred by captives over life settlements thanks to its superior liquidity, among other reasons). As Cantley reluctantly admits, the assets of the captive, including any life insurance policy, will be taxed as a dividend distribution someday. After all, the owners of the captive will presumably, someday, want to spend the money, and to do that they will have to pay the piper. Cantley asserts that the tax will be 15%, but the 2013 rate on qualified dividend for anyone in the 39.6% tax bracket, which most all owners of captives would be in, is actually 20%. And, then there’s the new 3.8% Medicare tax that’s likely to apply to anyone with sufficient income to own a captive insurance company. And, then there is the state taxes on dividends which will approximate 7% or more.
That brings the total tax rate upon distribution closer to 30% based on current law, but who is to say that current law will hold? Who knows what the tax rate on dividends will be two, five or ten years from now? They could easily return to ordinary income levels, which in turn could be significantly higher than today’s ordinary income rates. In fact, most economists expect that rates on all forms of income will have to increase given the current level of our debt/deficits.
That’s hardly the “perfect tax shelter”.
Favoring the Wealthy
Cantley later asserts that permitting a captive to invest into life insurance will violate IRS “policy” against discriminating in favor of the wealthy. Seriously? Such a policy exists? Has Cantley never heard of private foundations, qualified dividends, the mortgage interest deduction, carried interest, qualified plan contributions, capital gains tax, captive insurance companies, or any number of other provisions of the tax code that explicitly or implicitly discriminate in favor of the wealthy? Heck, when it comes to the tax code, discriminating in favor of the wealthy isn’t a “bug”. It’s a feature (IRS “policy” notwithstanding).
Regardless, let’s be clear about one point: Common sense should tell us that any recent IRS’s interest in captive insurance companies isn’t the result of captives remaining a “niche” tax-dodge for the ultra-wealthy, as they have been for decades. Rather, it’s because captives are on the cusp of becoming turn-key and going mainstream (as qualified plans did in the 1970’s and 1980’s) that the IRS is suddenly interested.
No Benefit for the Middle Class?
Failing to see this, Cantley continues with a series of baseless assertions that once again demonstrate either his complete ignorance or absolute disingenuousness on the subject. For instance, he asserts at the top of page 35 that middle class taxpayer can’t benefit from a captive arrangement because they can’t afford to pay the tax on the dividend distribution from the captive someday. What? Seriously?! The middle class can’t afford to do captives to begin with, Cantley! So, there’s no need for them to worry about dividend taxes.
But, even if there were, the dividend distribution itself provides the source of funds to pay the tax! (Oh, unless it’s a distribution of one of Cantley’s life settlement policies, in which case it likely has significant taxable value but virtually zero internal liquidity to draw on to pay the tax).
Any legitimate life insurance policy of any significant value must, almost by definition, have either significant cash surrender value or significant market value, certainly more than enough to pay any taxes due were it to be distributed as a dividend (though, in the case of a life settlement policy, it might need to be sold first to raise case, assuming a market for it still exists).
Come on, Beckett. Get serious. Dividend taxes don’t prevent the middle class from benefiting from the captive transaction. What a canard.
He then makes a similarly absurd argument concerning certain “discriminatory” attributes of cash value life insurance policies:
[W]ealthy small business owners would be the most likely party to have enough discretionary ordinary income that they could leave the tax-deducted premiums locked up in the insurance policy for the life of the insured. Most middle class people will eventually need to access their prior discretionary income as replacement income in retirement. Thus, if middle class taxpayers attempted to make use of the Insurance Transaction, they would likely end up taking distributions out during life that may (i) defund the policy to the point of being unable to sustain internal payment of premiums, or (ii) eventually trigger gains where distributions exceed basis in the policy. In either of these instances, a middle class taxpayer would be unable to take advantage of the tax-free death benefit feature of the Insurance Transaction. As such, the Insurance Transaction likely results in a discriminatory tax benefit to wealthy taxpayer insiders to the exclusion of rank and file middle class employees.
Oh boy. Where to start? So many non-sequiturs built upon so many false or unsupported premises that it’s difficult to begin.
Well, first, note that there is a third alternative that Cantley fails to mention: The middle class taxpayer could sell his/her policy in a life settlement transaction to raise potentially significant money to fund retirement. Maybe one of the Cantley-managed captives would even purchase the policy?
But, regardless, it is important to point out once again that there is not a single citation in the whole quoted paragraph above. Nothing is offered to support his premise that “middle class” taxpayers borrow against, surrender, or lapse their permanent life insurance policies at a greater rate than the wealthy. Are we just supposed to accept the premise ipsa dixit? I’m too tired to do the research tonight, but something tells me that he’s likely wrong on this point too, just like he was wrong on the supposed reasons that life insurance agents were chasing captive business so as to replace lost sales resulting from estate tax reform.,
In any event, most modern policies come with “overloan protection features” and other options that permit policy owners to access the cash in the policy without fear of inadvertent lapse. Or, said another way, modern policies permit their owners (yes, even “middle class” owners) to “spend down” the vast majority of the cash surrender value during life without fear of losing the death benefit protection. So, as usual, the premise upon which Cantley constructs his argument is just…wrong. Laughably so.
But, even if Cantley were right on this point, so what? I’m sure the middle class gets their cars repossessed at a greater rate than the wealthy. Yet we allow wealthy business owners to depreciate their cars and deduct the interest to purchase them. And I’m sure that the middle class has their homes foreclosed upon more often than the wealthy, and yet we permit the wealthy to take a mortgage interest deduction. And the middle class takes loans and distributions from their 401(k) plans and IRA’s (thus jeopardizing their own retirement) at a much greater weight than the wealthy. Yet we permit the wealthy to deduct 401(k) contributions and enjoy tax-deferred accumulations within retirement plans. It’s not the middle class that sets up private family foundations. Yet we permit the wealthy to do so.
Outside the realm of qualified plans and welfare benefit plans, the idea that the IRS uses “benefit to the wealthy” as some measuring stick for determining the acceptableness of transactions under the Internal Revenue Code is simply unsupported and unfounded. The authorities cited by Cantley for these propositions elsewhere are not on point as they concern qualified retirement plans and welfare benefit plans only, where non-discrimination rules are specifically incorporated into the Code. Nor does the cited authority apply by fair analogy, unless one assumes that the captive insurance is a total sham invented for the specific purpose of avoiding such nondiscrimination rules, in which case Cantley is right on. But it’s quite a stretch to claim, as Cantley does, that combining life insurance with a captive is, ispo facto, evidence of such a sham and should therefore be banned. But…that’s exactly what he would have you believe, and what he’d have the IRS argue.
And finally, to further illustrate the disengenuiness of Cantley’s assertions on this topic, I have re-written Cantley’s last quoted paragraph above substituting “life settlements” for “life insurance” and “Insurance Transaction” [bracketed items represent my edits/comments]:
[W]ealthy small business owners would be the most likely party to have enough discretionary ordinary income that they could leave the tax-deducted premiums locked up in the [life settlement] policy for the life of the insured. [This is especially true since life settlement generally have little or no internal liquidity to begin with and require ongoing premiums to sustain them!] Most middle class people will eventually need to access their prior discretionary income as replacement income in retirement. Thus, if middle class taxpayers attempted to make use of the [life settlement transaction], they would likely end up taking distributions out during life that may (i) defund the policy to the point of being unable to sustain internal payment of premiums, or (ii) [they may be unable to sustain during retirement the ongoing premiums necessary to keep the policy in force]. In either of these instances, a middle class taxpayer would be unable to take advantage of the tax-free death benefit feature of the [life settlement policy, and may even lose the benefit of all prior premiums paid if the policy lapse and can’t be resold to a third party]. As such, the [life settlement transaction] likely results in a discriminatory tax benefit to wealthy taxpayer[s] to the exclusion of rank and file middle class employees.
Thus, once again, even if Cantley’s proposed “benefit to the wealthy” test were actually, you know, real and all, it applies equally to his life settlement transactions. Actually, even more so since policies that require ongoing premiums to sustain themselves are more likely to lapse than those that have high cash surrender value or are “paid up”.
Cantley’s Erroneous Conclusion
Given everything I’ve said above, it’s sufficient to say here that the conclusion to Cantley’s paper is itself conclusory. It is not founded upon any reasonable interpretation of the law but represents a cherry-picked selection of extreme cases from when Cantley attempts to extort generalized conclusions, conclusions that serve his personal purposes and biases. The entire paper is a complete non sequitur built upon innumerable false and unsupported premises. As such, it is a shameless attempt by a practicing member of the Old Guard (and not some disinterested, humble law professor as he would have his readers believe) to intimidate and scare the public away from the New Wave practitioners. And, most disturbingly, it’s bald-faced attempt to protect turf by sicking regulators upon his competitors.
Final Thoughts on the IRS
To a far greater extent that any of us would like and most would suppose, the ultimate tax risk of any sufficiently complex transaction today hinges upon the risk of getting audited combined with the largely arbitrary whims of individual auditors and their supervisors. I wish I could say that a properly established and operated captive, regardless of whether or not it invests in life insurance, needn’t worry about being challenged if audited. But, in our current political and budgetary environment, this is no longer necessarily the case. Our recent experience with audits of some 401(k) plans, some captives and even other transactions indicates that governmental auditors are not necessarily seeking compliance via audits these days so much as revenue. And, occasionally, as 2013 news reports of IRS abuse suggest, their judgment or reasonableness may be influenced by political or personal motivations rather than objective legal/compliance considerations.
Consequently, all clients considering a captive insurance company, or any other complex transaction like a 401(k), should not assume that proper legal or accounting opinions or diligent operation of the arrangement in compliance with all known laws will keep it from being challenged in an audit (and beware the advisor who suggests otherwise). Rather, an auditor may challenge the transaction for some perceived legal justification, or even with little or no justification (perhaps in a bald-faced attempt to extort revenue via a settlement. Such is the power of governmental auditors these days.
As a result, the IRS’s view of tax treatment of any sufficiently complex transaction simply cannot be known with certainty in advance. The idea that captives are “safe” so long as one doesn’t combine them with life insurance is absurd. Nothing is safe these days, not even “simple” qualified plans.
Even so, theoretical tax uncertainties should not dissuade the typical business owner or decision maker from engaging in transactions that they deem likely to produce beneficial economic results. After all, few business decisions are ever made with the benefit of certain knowledge of outcomes. This is why we call businesses “entrepreneurial” (meaning “risk-taking”) enterprises. Clients who choose to pursue the multiple advantages of captives, or even 401(k)’s, realize that tax risk is simply one of many risks that they assume by doing so, and that the desired outcome is likely but not certain. They have surmised that the expected advantages of the arrangement, like the expected advantages of any business enterprise worth pursuing, outweigh the risks.
Weighing risk, weighing reward and making decisions are what separate successful business owners and managers from their peers. They do these things everyday. They don’t fear this process, they thrive upon it. Captives and life insurance should be approached with the same diligence.
In the end, the benefits of combing a captive with life insurance are almost indescribably huge, which is why this subject gets so much attention. Knowing that, consider the offsetting costs, including any realistic “downside” from audit risk or other factors, and then make a decision. But don’t let Old Guard captive practitioners lead to you believe, based on biased non sequiturs hidden in marketing papers disguised as law review articles, that such downside risk includes the possibility of “eating with a spork” in prison on Christmas, or even the likely possibility of substantial civil penalties.
CIRCULAR 230 NOTICE: This post is not intended to be used (and cannot be used) for the purposes of avoiding penalties that may be imposed with regard to the tax consequences of arising from matters discussed herein or for the purpose of promoting, marketing or recommending to another party any transaction or matter addressed herein.