Hard-to-Spot Differences in Tax Loopholes vs. Tax Scams

    by Peter Katt

    July 28 was like any other mid-summer Sunday that found me checking E-mails around the middle of the day. But it was unusual for so many E-mails to be flowing into my inbox from clients and tax attorneys—all about a New York Times front-page article appearing that morning with the headline “IRS Loophole Allows Wealthy to Avoid Taxes.”

    It was no surprise to me that the loophole claimed in the article had life insurance as its cornerstone. As I have written about many times in the past, permanent life insurance is often associated with various promised tax loopholes because it is very complicated and the commissions earned from its sale are hidden and grossly high.

    Although it may never be possible to know precisely the planning blueprint hinted at in the article (due to confidentiality agreements signed by those who participated), it is an open question as to whether it is a “loophole,” as the headline screamed, or only a “catch-us-if-you-can scheme.”

    What does appear to be a common trait with the developers and promoters of tax avoidance schemes is that they sell better if tagged with the “tax loophole” label, because this gives them more apparent legitimacy.

    I understand “tax loophole” to refer to transactions or steps that result in tax benefits that are permitted by law, but were not intended or foreseen by Congress or the IRS. That is, creative tax advisers and financial asset marketers weave together disparate steps into a single plan whose components are all perfectly legitimate and provide unforeseen specified tax benefits. Over time, a loophole’s legitimacy increases due to its common usage. If the IRS wishes to eliminate an unintended tax advantage, they can ask Congress to change the law and close the specific tax loophole. Usually, this affects tax loopholes prospectively.

    For example, a common life insurance tax loophole is the use of permanent insurance cash values to fund retirement income via policy loans that are never included in the policy owner’s income. Tax law provides that withdrawals of cash values are taxable when they exceed cost basis, but not when these withdrawals are policy loans. In order to take advantage of this loophole, insurance companies have designed policies that have net-zero loan interest to make policy loans for retirement income attractive for insurance salespersons to sell and consumers to buy.

    Net-zero loans refer to crediting the loaned funds with the same loan interest rate so that there is no net cost to borrow. (This strategy is not without risk, and I am not promoting it by using this example.) The IRS and Congress know about this very widespread strategy of accumulating and receiving retirement income free of income taxes via life insurance cash values. They can eliminate it only by passing a law that might treat cash value loans having less than market levels of loan interest as withdrawals to be taxed when cost basis is exceeded.

    But some so-called cutting-edge tax planning that uses life insurance doesn’t use tax loopholes at all. It involves a critical step that has no authority in tax law, but that isn’t explicitly prevented either. This critical step, without whose presence the planning device being promoted would not have its promised tax advantages, usually resides within the shadows. Meanwhile, the many other steps or issues that are perfectly legitimate are paraded around with great attention and are used to defend the tax plan’s legitimacy. However, the IRS doesn’t accept the theory that something not specifically denied must be legal until prohibited, and the IRS has teams of experts looking for various tax avoidance schemes that use this “catch-us-if-you-can” approach.

    As various tax avoidance schemes lay in ruin in their rearview mirrors, clever planning developers will continue to find new ways to package tax-deductible permanent life insurance premiums. They will manipulate policy values that promise very low valuation at the precise moment valuation is measured for tax purposes, followed by dramatically increasing policy values without reference to future premiums. The fact that neither of these two life insurance attributes exist is not going to stop the peddling of these “catch-us-if-you-can” schemes dressed up as cleverly designed and legitimate tax loopholes.

    A recent example will give you a better understanding of how “catch-us-if-you-can” planning operates, and the havoc it can create in the lives of its customers because of the large sums of money involved.

    In a recent Tax Court case [Neonatology v. Commissioner], New Jersey doctors were promised a specified amount of tax-free retirement income and paid-up life insurance for specified tax-deductible contributions to a particular type of employee benefit plan. The trick (or tax evasion) was the attempted disguise of permanent life insurance as term insurance with a conversion right. The overpaid term insurance premiums were fully expensed as a benefit plan death-only contribution. These excessive premiums fully funded the cash values that appear only after the policy has been converted and is then owned by the doctor personally and therefore no longer within the plan. Tax Court Judge Laro ruled there was only one policy with two components and the excessive premiums were not entitled to be expensed.

    The doctors have had their lives turned inside out from the moment the IRS denied their deductions until Judge Laro’s ruling was upheld by the United States Court of Appeals for the Third Circuit in July 2002. They not only were denied their deductions, but the excess contributions were deemed constructive dividends so the doctors were hit with double taxation. In addition, they were assessed interest and negligence penalties. Combined, these costs and their legal expenses in many cases exceeded the original contributions.

    Both courts put heavy blame on the doctors and denied their defense that they merely relied on the advice of professional advisers.

    All through this process, the benefit plan developers and promoters constantly encouraged the doctors to continue their tax fight because the plan was a legitimate loophole. None of this was true and these doctors were victimized a second time as they wasted more money, time and false expectations on a cause that was lost from the day they signed up for the retirement plan.

    In the scheme outlined in the July 28 New York Times, the article claimed that the planning referred to was legal, blessed by the IRS in 1996. Then, in a follow-up front-page story dated August 17, they reported that the IRS banned the technique “thousands of the wealthiest Americans have used to escape billions of dollars in gift and estate taxes.” But the next paragraph declares “The department said the technique was not valid and never had been….”

    The official action taken by the IRS was the publication of a notice that states “The use of such techniques…does not conform to, and is not permitted by, any published guidance.” In other words, what the New York Times described as a loophole, blessed by the IRS and then banned, never was permitted.

    The problem in this loose use of our language is that it permits developers and promoters of “catch-us-if-you-can” tax avoidance schemes to claim loophole legitimacy when they sell these plans, and then to claim innocence when their schemes implode—causing enormous grief to the buyers by blaming the IRS for changing the rules after the fact.

    Individuals need to understand more precisely which type of “scheme” they are buying into.

    And when it is clear that the developers of such scams knew exactly what they were getting buyers into, we need the Justice Department to take action against these developers.

    Peter Katt, CFP, LIC, is sole proprietor of Katt & Co., a fee-only life insurance advisor located in Kalamazoo, Michigan (269/372-3497; www.peterkatt.com). His book, “The Life Insurance Fiasco: How to Avoid It,” is available through the author.

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