In re CM Holdings, Inc.

• Decision Date: 16 October 2000
• Docket Number: No. CIV.A. 97-695 MMS.,CIV.A. 97-695 MMS.
• Citation: 254 BR 578
• Parties: In re CM HOLDINGS, INC., Camelot Music, Inc., G.M.G., Advertising, and Grapevine Records and Tape, Inc., Debtors. Internal Revenue Service, Petitioner, v. CM Holdings, Inc., Respondent.
• Court: U.S. District Court — District of Delaware

254 B.R. 578 (2000)

In re CM HOLDINGS, INC., Camelot Music, Inc., G.M.G., Advertising, and Grapevine Records and Tape, Inc., Debtors.

Internal Revenue Service, Petitioner, v. CM Holdings, Inc., Respondent.

No. CIV.A. 97-695 MMS.

United States District Court, D. Delaware.

October 16, 2000.

COPYRIGHT MATERIAL OMITTED

Carl Schnee, United States Attorney, and Ellen W. Slights, Assistant United States Attorney, United States Department of Justice, Wilmington, Delaware; Of Counsel: Paula M. Junghans, Acting Assistant Attorney General; Dennis M. Donohue, Special Litigation Counsel; James D. Hill, Special Counsel to the U.S. Department of Justice; Charles M. Ruchelman, Alex E. Sadler, and Joseph A. Sergi, United States Department of Justice, Washington, D.C., for plaintiff.

Pauline K. Morgan, of Young Conaway Stargatt & Taylor, LLP, Wilmington, Delaware; Of Counsel: Michael I. Saltzman, Lawrence M. Hill, and Richard A. Nessler, White & Case LLP, New York City; Francis A. Vasquez, Jr., Jennifer L. Chapin, Charles C. Doumar, and Michael D. Levin, White & Case LLP, Washington, D.C., for defendant.

OPINION

SCHWARTZ, Senior District Judge.

TABLE OF CONTENTS

                  I. INTRODUCTION .....................................................................................581
                  II. BACKGROUND ......................................................................................583
                      A. General Background of Life Insurance .........................................................583
                          1. Whole Life Insurance .....................................................................584
                          2. Universal Life Policy ....................................................................585
                      B. Development of the MBL COLI VIII Policy and Plan .............................................586
                      C. Camelot's Decision to Purchase the MBL COLI VII Plan .........................................588
                      D. Features of Camelot's COLI VIII Policies and Plan ............................................591
                          1. Amounts Due Each Policy Year (Columns (2), (3), and (4)) .................................592
                          2. Sources of Funds to Pay Amounts Due (Columns (5), (6), (7), and (8)) .....................592
                             a. Policy Years One through Three ........................................................592
                             b. Policy Years Four through Seven .......................................................593
                          3. Loan Interest Rate and Differential Crediting Rates ......................................594
                          4. Net Equity (Column (9)) ..................................................................595
                          5. Death Benefit (Columns (10)) .............................................................595
                          6. Net Pre-Interest Deduction Cash Flow (Column (11)) .......................................596
                          7. Interest Deduction Tax Benefit (Column (12)) .............................................596
                          8. Net After Interest Deduction Cash Flow (Columns (13)) ....................................596
                III. DISCUSSION .......................................................................................597
                      A. Deductibility of Interest Under ? 163 and the Sham Transaction Doctrine .................597
                          1. General Principles .......................................................................597
                          2. Sham in Fact .............................................................................600
                             a. Policy Loans ..........................................................................600
                                (1) Policy Loans Made on First Day of Policy Year .....................................601
                                (2) Risk Characteristics of Loans .....................................................602
                                    (a) Market, Interest Rates, and Reinvestment Risk .................................603
                                    (b) Marketability or Liquidity Risk ...............................................604
                                    (c) Volatility, Timing, or Call Risk ..............................................604
                                    (d) Sector Risk ...................................................................604
                                    (e) Credit or Default Risk ........................................................604
                                    (f) Maturity Risk .................................................................604
                                    (g) Legal or Operational Risk .....................................................604
                                (3) Artificially High Interest Rates ..................................................605
                                (4) Backdating of Loans ...............................................................606
                                (5) MBL's Failure to Restrict Policy Loans During Rehabilitation ......................606
                                (6) Only 40% of Interest Paid in Cash .................................................607
                             b. Loading Dividends .....................................................................607
                                (1) Magnitude of Loading Charges ......................................................609
                                (2) Dividends Not Paid From Surplus ...................................................612
                                (3) Dividends Paid At the Beginning of the Policy Year ................................613
                

                                (4) Sources of Dividends .................................................613
                                (5) Virtually Guaranteed .................................................614
                                (6) Accounting for Dividends .............................................616
                             c. Partial Withdrawals ......................................................618
                             d. Annual Premium ...........................................................619
                             e. Considering All Features Together ........................................620
                          3. Sham in Substance/Economic Substance Doctrine ...............................620
                             a. Objective Economic Substance of Camelot's COLI Transaction ...............622
                                (1) Pre-Interest Deduction Profit ........................................622
                                    (a) 20- and 40-Year Illustrations Received by Camelot Prior
                                        to and Contemporaneous with its COLI Purchase ....................625
                                    (b) 81-Year Illustrations ............................................626
                                (2) Substance of Non-tax Components of Camelot's COLI VIII
                                    Policy ...............................................................631
                                    (a) Inside Cash Value Build-Up .......................................631
                                    (b) Tax Free Death Benefits ..........................................632
                                (3) Substance of MBL/Hartford's Reporting of Transaction .................635
                                (4) What Camelot Got For its High Premiums and Policy Loans ..............637
                             b. Subjective Aspects of Economic Sham Analysis .............................637
                                (1) Business Purpose .....................................................638
                                (2) Expectation of Pre-tax Profitability .................................641
                             c. Cases Cited By Camelot Do Not Support COLI VIII Plan Having
                                Economic Substance .......................................................641
                             d. Conclusion ...............................................................643
                      B. Generic or "Abusive" Tax Shelter ................................................644
                      C. The I.R.C. ? 264(c)(1) Four out of Seven Safe Harbor .......................645
                      D. Penalties .......................................................................647
                          1. Substantial Authority Exception Under I.R.C. ? 6662(d)(2)(B)(i) ........647
                          2. Reasonable Cause and Good Faith Exception Under I.R.C
                             ? 6664(c)(1) ...........................................................649
                          3. Common Law Issue of First Impression Exception ..............................652
                  IV. CONCLUSION .........................................................................653
                

I. INTRODUCTION

Congress has long favored the life insurance industry by giving favorable tax treatment to two components of life insurance policies. First, a death benefit paid out on a life insurance policy is received by the beneficiary free of income tax. Second, income taxes are deferred, and in some cases never paid, on the cash value built-up inside a life insurance policy. Combined with this favorable tax treatment of life insurance policies, interest on many types of loans, including life insurance policy loans, is tax deductible provided certain statutory criteria are met.

One can readily appreciate that these tax advantages have invited talented actuaries to design life insurance policies which approach becoming tax driven investment vehicles and/or tax shelters, which were never intended by Congress to receive favorable life insurance tax benefits. Over the years, Congress has limited, but not eliminated, these tax advantages in an attempt to curb the use of life insurance policies as investment vehicles. In addition, courts have applied the sham transaction doctrine to deny tax benefits where the life insurance policies have as their sole purpose the creation of tax deductions. Thus, Congress and the courts have stepped in when life insurance policies have crossed the line separating insurance against an untimely death and tax driven or tax sheltering investments.

The Internal Revenue Service ("IRS") calls upon the Court to determine whether a particular set of life insurance policies has crossed this line. The policies at issue, known as COLI VIII policies, were underwritten by the Mutual...