There is an insurance type that I have never worked with professionally: tax liability insurance.
It is what
it sounds like: you are purchasing an insurance policy for unwanted tax
liabilities.
It makes
sense in the area of Fortune 500 mergers and acquisitions. Those deals are
enormous, involving earth-shaking money and a potentially disastrous tax
riptide if something goes awry. What if one the parties is undergoing a
substantial and potentially expensive tax examination? What if the IRS refuses
to provide advance guidance on the transaction? There is a key feature to this
type of insurance: one is generally insuring a specific transaction or limited
number of transactions. It is less common to insure an entire tax return.
My practice,
on the other hand, has involved entrepreneurial wealth – not institutional money
- for almost my entire career. On occasion we have seen an entrepreneur take
his/her company public, but that has been the exception. Tax liability
insurance is not a common arrow in my quiver. For my clients, representation
and warranty insurance can be sufficient for any mergers and acquisitions,
especially if combined with an escrow.
Treasury has
been concerned about these tax liability policies, and at one time thought of
requiring their mandatory disclosure as “reportable” transactions. Treasury was
understandably concerned about their use with tax shelter activities. The
problem is that many routine and legitimate business transactions are also
insured, and requiring mandatory disclosure could have a chilling effect on the
pricing of the policies, if not their very existence. For those reasons
Treasury never imposed mandatory disclosure.
I am looking
at an IRS Chief Counsel Memorandum involving tax liability insurance.
What is a
Memorandum?
Think of
them as legal position papers for internal IRS use. They explain high-level IRS
thinking on selected issues.
The IRS was
looking at the deductibility by a partnership of tax insurance premiums. The
partnership was insuring a charitable contribution.
I
immediately considered this odd. Who insures a charitable contribution?
Except …
We have
talked about a type of contribution that has gathered recent IRS attention: the
conservation easement.
The
conservation easement started-off with good intentions. Think of someone owning
land on the outskirts of an ever-expanding city. Perhaps that person would like
to see that land preserved – for their grandkids, great-grandkids and so on –
and not bulldozed, paved and developed for the next interchangeable strip of
gourmet hamburger or burrito restaurants. That person might donate development
rights to a charitable organization which will outlive him and never permit
such development. That right is referred to as an easement, and the transfer of
the easement (if properly structured) generates a charitable tax deduction.
There are
folks out there who have taken this idea and stretched it beyond recognition.
Someone buys land in Tennessee for $10 million, donates a development and
scenic easement and deducts $40 million as a charitable deduction. Promoters
then ratcheted this strategy by forming partnerships, having the partners
contribute $10 million to purchase land, and then allocating $40 million among
them as a charitable deduction. The partners probably never even saw the land.
Their sole interest was getting a four-for-one tax deduction.
The IRS
considers many of these deals to be tax shelters.
I agree with
the IRS.
Back to the Memorandum.
The IRS began
its analysis with Section 162, which is the Code section for the vast majority
of business deductions on a tax return. Section 162 allows a deduction for ordinary
and necessary expenses directly connected with or pertaining to a taxpayer’s
trade or business.
Lots of buzz
words in there to trip one up.
You my
recall that a partnership does not pay federal tax. Instead, its numbers are
chopped up and allocated to the partners who pay tax on their personal returns.
To a tax
nerd, that beggars the question of whether the Section 162 buzz words apply at
the partnership level (as it does not pay federal tax) or the partner level
(who do pay federal tax).
There is a
tax case on this point (Brannen). The test is at the partnership level.
The IRS
reasoned:
· The tax insurance premiums must be
related to the trade or business, tested at the partnership level.
· The insurance reimburses for federal
income tax.
· Federal income tax itself is not
deductible.
· Deducting a premium for insurance on
something which itself is not deductible does not make sense.
There was also
an alternate (but related argument) which we will not go into here.
I follow the
reasoning, but I am unpersuaded by it.
· I see a partnership transaction: a
contribution.
· The partnership purchased a policy for
possible consequences from that transaction.
· That – to me - is the tie-in to the
partnership’s trade or business.
· The premium would be deductible under
Section 162.
I would
continue the reasoning further.
· What if the partnership collected on
the policy? Would the insurance proceeds be taxable or nontaxable?
o
I
would say that if the premiums were deductible on the way out then the proceeds
would be taxable on the way in.
o
The
effect – if one collected – would be income far in excess of the deductible
premium. There would be no further offset, as the federal tax paid with the
insurance proceeds is not deductible.
o
Considering
that premiums normally run 10 to 20 cents-on-the-dollar for this insurance, I
anticipate that the net tax effect of actually collecting on a policy would
have a discouraging impact on purchasing a policy in the first place.
The IRS
however went in a different direction.
Which is why
I am thinking that – albeit uncommented on in the Memorandum – the IRS was
reviewing a conservation easement that had reached too far. The IRS was
hammering because it has lost patience with these transactions.
