Employer Has Insurable Interest in Employees

Prior to 1980, A established a group life insurance program for its employees, which allowed a participating employee, including retired employees, a death benefit. A later realized that its liability to its employees under these plans was greater than it could fund. It then decided to purchase insurance (P policies) that would cover the projected liability and allow for premium payments that A could sustain. Thus, A purchased whole life policies on its employees’ lives, naming A as the beneficiary. Undisputedly, all of the employees insured under the new plans consented in writing to be part of the plans.

Because the P policies were whole life insurance policies, A was allowed to borrow up to the amount of a policy’s cash value during the insured employee’s life. If the insured employee died before the loan was repaid, the loan amount and any accrued interest was deducted from the death benefits paid to A. The projected interest expense deductions on the loans would reduce A’s taxes by approximately $1.72 billion.

Insurable Interest Requirement

The Service asserts that A lacked an insurable interest in the lives of the 2,435 employees insured under the P policies. As a result, it contends that the policies were void as against public policy and did not create genuine indebtedness and, thus, A is not entitled to an interest deduction under Sec. 163.

State law: The parties agree that Colorado law governs the question whether A has an insurable interest in the employees covered by the P policies. Although Colorado courts have not had the occasion to decide precisely this question, the government urges this court to apply other jurisdictions’ decisions that have prohibited employers from obtaining life insurance on their employees, citing Mayo v. Hartford Life Ins. Co., 354 F3d 400 (5th Cir. 2004); Tillman v. Camelot Music, Inc., 408 F3d 1300 (10th Cir. 2005); and distinguishing Dow Chem. Co., 250 FSupp2d 748 (DC MI 2003).

Purpose: The purpose of the insurable interest requirement is to ensure that a policy does not fall into the forbidden class of “wager contracts,” taken out by people who are wholly unrelated to the insured and thus who have a “direct interest in [the insured’s] early termination” (Warnock v. Davis, 104 US 775 (1881)). In Warnock, the Supreme Court further defined an insurable interest as “arising from the relations of the party obtaining the insurance, either as creditor of or surety for the assured, or from the ties of blood or marriage to him, as will justify a reasonable expectation of advantage or benefit from the continuance of his life.” The Colorado Court of Appeals, in a different context, further defined this interest to exist “when, from personal relations between parties, one has a reasonable right to expect some pecuniary advantage from a continuance of the life of the other, or to fear the loss from his death” (Lampkin v. Travelers’ Ins. Co., 52 P 1040 (CO Ct. App. 1898)).

Holding: This court finds that the Colorado Supreme Court would reasonably decide, based on existing case law, that A has an insurable interest in the employees insured under the P policies. In addition, each employee was informed of the purpose of the P policies, consented to be insured and designated P as the policy’s beneficiary. Such consent is persuasive, “further vindicat[ing] the public policy designed to prevent wagering contracts on which the insurable interest rule is grounded” (Dow Chem. Co.). For these reasons, A has an insurable interest in its employees’ lives.

Interest Deduction

Sec. 163 states that “[t]here shall be allowed as a deduction all interest paid or accrued within the taxable year on indebtedness.” A corporation may deduct the interest expense that accrues annually on loans obtained from an insurer, as long as various tax rules are met. The IRS contends that these policies were substantive shams, the sole purpose of which was to reduce A’s tax liabilities. Thus, it asserts that the interest paid on the loans taken from these policies is not deductible.

The Eighth Circuit’s analysis of whether a sham exists consists of two prongs: (1) under the business-purpose test, “a transaction will be characterized as a sham if ‘it is not motivated by any economic purpose outside of tax considerations’”; and (2) under the economic-substance test, if it “is without economic substance because no real potential for profit exists” (5 IES Indus., Inc., 253 F3d 350 (8th Cir. 2001) (quoting Shriver, 899 F2d 724 (8th Cir. 1990) and citing Rice’s Toyota World, Inc., 752 F2d 89 (4th Cir. 1985))).

This court finds that genuine fact issues remain as to whether the P policies were substantive shams as a matter of law. Four cases—Dow Chem. Co.; Winn-Dixie Stores, Inc., 254 F3d 1313 (11th Cir. 2001); In re: CM Holdings, Inc., 301 F3d 96 (3d Cir. 2002); and American Elec. Power Co., Inc., 326 F3d 737 (6th Cir. 2003)—were all decided after the courts held lengthy bench trials with extensive expert testimony and complex actuarial analyses of the plans at issue. Here, expert discovery has not been completed. Fact questions remain as to whether the P policies presented a real opportunity for a risk-based gain or loss based on the insured employee’s actual mortality. In addition, genuine issues of material fact exist as to whether, absent the interest deductions, the plan could generate a pre-tax profit for A.

Because questions of fact remain as to the economic substance of the P investments, A has not met its burden of proving the validity of the P policy loan deductions. As a result, summary judgment on this issue is inappropriate.

Xcel Energy, Inc., DC MN, 10/12/05