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EDDIE HASKELL: A POOR ROLE MODEL FOR TAXPAYERS

August 21, 2002

Eddie Haskell figured prominently in the old �Leave it to Beaver� show as an oily character who took advantage of adult cluelessness to charm his way out of trouble. Several recent cases and IRS rulings illustrate some of the shortcomings of the Eddie Haskell approach to tax problems. These examples show that while the IRS may do stupid things, it is not required to be stupid as a matter of law.

The lack of required stupidity is bad news for taxpayers who have used certain heavily marketed tax sheltering techniques. The techniques are varied, but they have two things in common:

They require the IRS to accept an illogical (but taxpayer-friendly) result from a skein of plausible, but shaky, premises. Stated bluntly, they require the IRS to be stupid.
They require life insurance.

JANITOR INSURANCE: The holding company for now-defunct Camelot Music took out whole life policies on 1,430 employees in 1990. The policy was set up to take advantage of the tax-free build-up of values in whole life policies. Premiums of about $14,000,000 per year were funded with policy loans, withdrawals and dividends of about $13,000,000.

Disregarding tax deductions, the plan generated a loss each year. This would achieve a lucrative after-tax irrational result: interest deductions with no net economic outlay. By offsetting tax-free policy build-up against nearly-identical interest payments, the arrangement became profitable after taxes.

The court ruled that the tax law didn�t have to stupidly pretend that the offsetting expenses had economic reality just because actual checks were used to make the offsetting payments. The court disallowed the deductions and imposed 20% penalties for understating taxable income.

DOCTOR INSURANCE: In Neonatology Associates, life insurance sellers persuaded a doctor group to join a Voluntary Employees Beneficiary Association (VEBA) in order to achieve life insurance miracles. VEBAs were originally designed as a tax-exempt vehicle to hold deductible pre-payments of employee benefits. Because VEBA contributions used to purchase term life coverage can be deductible, insurance agents look for creative ways to use VEBAs.

The Neonatology VEBA was used to buy very expensive term coverage. The term policies were outrageously expensive (500% over the normal cost of similar policies) because the overpriced amount was treated as �conversion credits,� convertible into Universal Life policies that could be almost fully withdrawn as tax-free policy loans. The scheme sought the irrational result of tax deductible VEBA contributions that could be withdrawn as tax-free policy loans.

The third circuit ruled that the IRS was not required to be stupid and pretend that the VEBA contributions really were buying overpriced group-term coverage, rather than disguised universal life coverage. No deduction for the excess contributions were allowed, and the doctors were taxed on the excess as dividends. To show that the IRS should not be assumed stupid, the court also imposed negligence penalties.

OVERPRICED OR PREPAID SPLIT-DOLLAR LIFE INSURANCE has been marketed as an estate planning panacea. Under this type of plan taxpayers establish a life insurance trust with the donor�s children as beneficiaries. The trust buys a very large (or very expensive) life insurance policy. The insurance policy proceeds received by the trust are excluded from the donor�s taxable estate. The policy is typically funded with large prepayments or very expensive premium rates, all paid by the donor establishing the policy.

The irrational result claimed by promoters of this setup is that the amount subject to gift or estate tax is much less than value of the benefit passed to the next generation. In some versions, the policy premiums are purposely overpriced -- by as much as tenfold. The value used to value the gift to the younger generation is the lowest premium cost available for a similar policy, or in some variants, a term life premium from an IRS table. The �excess� amount of the price increases the policy�s cash value in favor of the next generation. Such a scheme got front page treatment in the New York Times (the Times requires you to register to see the linked article).

The IRS last week said it would decline to be stupid in this area. Notice 2002-59 states that the cost of the cost of the bargain-priced policy, or the bargain costs from IRS tables, are not -- and never were -- the appropriate measure of the taxable gift to the successor generation. The Times reports that some families have paid as much as $40,000,000 in premiums under such schemes, so there will be some interesting discussions between promoters of these plans and their clients.

What�s more, the Treasury made clear in their announcement that they will attack all schemes where the actual benefit of a policy payment for income or gift tax purposes is understated by the use of published premium tables or overpriced policy premiums.

ARE THE INSURANCE PROMOTERS OUT OF BUSINESS? Not likely. As long as bears variable annuity in the woods, there will be folks looking for new and creative ways to unlock your inner commission-generating potential.

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