Vol 10 No 3		April 2008

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Legal Opinion Letters

"Most of my involvement with springing cash value policies is now in the context of litigation. In that arena plaintiff attorneys are perplexed about the existence of such impressive appearing legal opinion letters."

Life insurance has been a preferred funding vehicle for various tax avoidance schemes because it is extraordinarily complex, and the commissions are huge and hidden. The favorite trick has been using springing cash values (SCV). The policy's value is claimed to be very low when measured for taxation purposes and then it dramatically increases. For example, a springing cash value policy funded with $100,000 premiums for five years has a claimed value of $98,000 that grows to $498,000 in another five years. This represents a compounding return of 38% from the sixth to the 10th year. That insurance companies and agents peddle this concept isn't particularly surprising, but distinguished law firms have provided opinion letters in support of such valuations. The purpose of this Perspective is to look inside such logic - or illogic if you prefer.

SCV policies have funded welfare benefit plans with claimed tax deductible contributions (why they are not really tax deductible is for another time), 412(i) qualified defined benefit plans and to soak up retained earnings in a closely held C corporation. The tax avoidance occurs at the time the SCV policy is transferred out of the owning entity. In the example above the claimed value for tax purposes is $98,000 when in reality its value is closer to $390,000 (discussed below).

The selling of tax avoidance schemes using SCV policies has, I think, slowed considerably with the Internal Revenue Service's attention to policy valuations - notable with the relatively new regulations under Section 402(a). Most of my involvement with this issue is now in the context of litigation. In that arena plaintiff attorneys are perplexed about the existence of such impressive appearing legal opinion letters. The opinion letters make defendants' arguments that these tax avoidance schemes were perfectly legal when sold appear legitimate. However, my position is that the Service didn't change the rules they just tightened interpretations because of the games that were being played with policy valuations. SCV policies have never been permitted to avoid taxes.

Review of a legal opinion letter is instructive. A particular letter includes the insurance company's explanation of its SCV policy's design. In order to drive down the fifth year value the insurance companies admits the commissions are very high with first year selling expenses 140% of the target premium, then claims that "aggregate costs are estimated to be…60 - 70% of each year's premium" for years two through five. Costs in years two through five are no where near this high. They are closer to 10%. Such claims are intended to justify very low fifth year reserves and the law firm accepted them "without independent investigation."

The letter opines that: "IRS guidance generally supports valuing a policy…at its surrender value."; taxpayers must "…include in income the difference between the fair market value of the property and the amount paid for the property…": "reserve accumulation constituting the source of the cash value"; and "there is no definitive statement" by the Service as to policy value. This confusing trail, I think, may intentionally avoid the absolute validity that fair market value is the true test for an asset's value for tax purposes.

The attorneys' wordsmith abilities run head long into the math and the point where the Service always tears these things apart. Returning to the example above about a policy with $100,000 annual premiums for five years. This is the example provided with this particular opinion letter. The accompanying policy information shows: a fifth year cash surrender value of $67,761; an accumulation value of $441,692; and a reserve of $98,257. The cash surrender value grows to $497,615 by the 10th policy year. That the opinion letter supports the thesis that the value of the policy at the fifth year is its reserve value of $98,257 is extraordinary. As noted above the growth of the cash surrender value from the sixth to the 10th year is 38% annually. Given the safety of the life insurance policy, in this fixed rate environment, a 6% IRR might be satisfactory to a buyer of this asset. In that case the true fair market value for tax purposes at the end of the fifth year is around $390,000 not $98,257.

Although the legal opinion letter boldly states that this isn't a SCV policy I suspect that the letter is written cleverly enough to allow for a substantial defense if the law firm gets dragged into litigation.

My experience with fancy claims made about various life insurance issues is that the true perspective is almost always found in the math.