Life Insurance Without an 'Insurable Interest'
by Burgess J.W. Raby and William L. Raby

Burgess J.W. Raby, Esq., and William L. Raby, CPA, both associated with the Raby Law Office, Tempe, Ariz., discuss the tax aspects of the latest decision in Tillman, which deals with who is entitled to the proceeds from a corporate-owned life insurance policy on a rank-and-file employee.

Date: May 26, 2005

Full Text Published by Tax AnalystsTM

Camelot Music purchased life insurance on all of its full-time employees, including Filipe M. Tillman, a rank-and-file employee. The company actively concealed the existence of those insurance policies from the insured employees. When Tillman died, Camelot collected approximately $340,000 in tax-free life insurance proceeds. Tillman's personal representative, Betina Tillman, brought suit against Camelot under a provision of Oklahoma law providing that if someone who does not have an insurable interest in the person being insured takes out a contract of insurance, either that insured person or his representative may recover the proceeds. As an alternative argument, she also claimed that Camelot unjustly enriched itself at Mr. Tillman's expense.

Insurable Interest

In Betina L. Tillman v. Camelot Music, Inc., No. 03-5172, Doc 2005-10398 [PDF], 2005 TNT 92-11 Database 'Tax Notes Today', View '(Number'(10th Cir. 2005), Circuit Judge Monroe G. McKay reviewed the district court conclusion that Camelot had an insurable interest in Mr. Tillman's life and was not unjustly enriched when it collected the $340,000. His starting point was Oklahoma law, which, as he pointed out, "requires the beneficiary of a life insurance policy to have an insurable interest in the life of the insured in order to be entitled to the proceeds of the policy." As codified in the Oklahoma Insurance Code, insurable interest is defined as:

a lawful and substantial economic interest in having the life, health, or bodily safety of the individual insured continue, as distinguished from an interest which would arise only by, or would be enhanced in value by, the death, disablement or injury of the individual insured.

Okla. Stat. Ann. section 3604(C)(2)

Betina Tillman's argument on appeal was that the district court erred when it failed to weigh the financial interest Camelot had in Mr. Tillman's continued life against the $340,000 it received because of his death. Her interpretation of the statute was that it required such a balancing. If Camelot's interest in Mr. Tillman's life was less than $340,000, then to the extent of that difference it was being wrongfully enriched. Judge McKay disagreed:

In support of her balancing-of-monetary-values approach Plaintiff relies on the phrase "distinguished from." In construing this phrase, we are required to give it its ordinary meaning. See Biodiversity Legal Found. v. Babbitt, 146 F.3d 1249, 1254 (10th Cir. 1998). "Distinguish" means to "recognize a difference in." Webster's Third New International Dictionary 659 (1985). It does not mean to compare with. Therefore, we construe the meaning of the phrase "distinguished from" in section 3604(C)(2) to be a means of clarification -- not as an instruction to weigh the respective monetary values of people alive versus dead. Hence, properly read, section 3604(C)(2) requires a determination of whether a party procuring insurance on another has "a lawful and substantial economic interest in having the life, health, or bodily safety of the individual insured continue," not "an interest which would arise only by, or would be enhanced in value by, the death, disablement or injury of the individual insured."

That did not mean that the appeals court affirmed the district court, however. "[A]bsent evidence of considerable expenditures in relation to the company's overall budget," stated Judge McKay, "or other relevant evidence establishing the substantial nature of the expenditure, human resources' monies spent to attract and keep employees is a general cost of doing business and is not sufficient alone to support a finding of a substantial interest in a specific employee's continued life." Camelot had not provided any such evidence. In fact, Camelot's sole evidence on the question of insurable interest was evidence that it provided its full-time employees with a complete benefits package, which included life insurance as to which the employee named the beneficiary. "Camelot did not have an insurable interest in Mr. Tillman's life," concluded Judge McKay, reversing the district court as to that issue.

Unjust Enrichment

Betina Tillman had a right to recover the $340,000 under Oklahoma law, under a provision that if someone who does not have an insurable interest in the person being insured takes out a contract of insurance, either that insured person or his representative may recover the proceeds. That issue was not part of the suit. Betina Tillman said that it was "contrary to equity and good conscience for one to retain a benefit which has come to him at the expense of another." That might be, said Judge McKay, but there was no evidence of any advantage accruing to Camelot's benefit at Mr. Tillman's expense. "Camelot paid all of the premiums for the COLI policy on Mr. Tillman's life. In so doing, Mr. Tillman was not prevented from obtaining life insurance himself."

He noted that the real injustice of which Ms. Tillman complained was that Camelot violated the law when it obtained insurance on Mr. Tillman's life. "Oklahoma law provides that courts are not to invoke their equitable jurisdiction when an adequate legal remedy is available," he continued. Because there was a statutory remedy for Betina Tillman's complaint, Judge McKay concluded, the district court had properly dismissed the claim for unjust enrichment. He remanded the case for the district court to untangle the paradoxical consequences of holding both that Camelot had no insurable interest in Mr. Tillman and that Betina Tillman, on behalf of the Tillman estate, had nothing coming on her claim of unjust enrichment, although she might have a claim to the $340,000 under Oklahoma law as a result of the holding that Camelot had no insurable interest.

But that was not a tax case, so the question of the exclusion of the $340,000 from Camelot's income under section 101 was not an issue. If there is no insurable interest as a matter of state law, however, can there be a life insurance contract? And if there is no valid life insurance contract, then are the proceeds received by reason of death of the insured just as taxable as the proceeds of any other wagering transaction?

The Tax Side of Corporate-Owned Life Insurance

Camelot had corporate-owned life insurance. Under a typical COLI program, a corporation purchased life insurance policies on thousands of corporate employees. The economics of the arrangement, ignoring the insurable interest issue, produced a profit or loss before tax that would reflect the cash surrender values of the unmatured policies plus the death benefits received on policies covering employees or ex-employees who had died. That would be reduced by the premiums paid, accrued interest on any policy loans, and administration fees. In Winn-Dixie Stores, Inc. v. Commissioner, 113 T.C. 254, Doc 1999-33731, 1999 TNT 202-6 Database 'Tax Notes Today 1999', View '(Number'(1999) aff'd 254 F.3d 1313 (11th Cir. 2001), Doc 2001-18038 [PDF], 2001 TNT 127-6 Database 'Tax Notes Today 2001', View '(Number', cert. denied 535 U.S. 986 (2002), the pretax net of those items had produced a cumulative loss of $682 million but was projected to produce an after-tax profit of more than $2 billion until the arrangement was challenged by the IRS. The difference between a pretax loss and after-tax profit resulted from the nontaxability of life insurance proceeds paid by reason of death, the nontaxability of the investment returns credited to the account values of the life insurance contracts (inside build-up), the nontaxability of the proceeds of life insurance loans, and the deductibility of the interest on life insurance loans (subject to the restrictions in section 264(a)). In 1996 Congress substantially eliminated the interest deduction for COLI policy loans.

Since 1980 Winn-Dixie had purchased life insurance policies on some management-level employees to fund promised death, disability, and retirement benefits. That program covered 615 employees in 1993 and was "leveraged" through borrowing against the policy values to the extent permitted by section 264(a). In 1992, however, Winn-Dixie was approached by a joint venture of financial analysts and insurance brokers who proposed that it expand its COLI purchases from that limited program for management into a "broad-based" pool covering all of its employees eligible for its general benefit program. The program contemplated that Winn-Dixie expand its employee death benefit program, thus providing, as the proposal explained, "incentive for obtaining employees' consent to being insured . . . after an employee leaves the company, the benefit is normally reduced or discontinued. With normal rates of retirement and attrition, only a small proportion of the participants will receive a benefit. As a result, the cost of providing the benefit is insignificant." The company adopted the plan, purchasing whole life policies covering approximately 36,000 employees. The aggregate death benefits provided by those COLI policies totaled $2.9 billion. Those policies were kept in force from 1993 to 1997, when the 1996 tax law change eliminating interest deductibility resulted in the program being discontinued.

In the Tax Court, the IRS conceded that Winn-Dixie's COLI program complied with the code's "four of seven" safe harbor, its $50,000 cap on policy loans, and its definition of life insurance. The IRS said, however, that based on projections the policies were not likely to produce a "pretax profit" and therefore were "tax motivated, unsupported by any independent business purpose, and lack[ing in] economic substance" within the meaning of the judicially-developed "sham transaction doctrine." Winn-Dixie's response was that Congress has carefully studied the tax implications of leveraged life insurance and that the elaborate legislative compromise embodied in sections 264 and 7702 could not be displaced by a judicial doctrine. The company also said that, even if the judicial "sham transaction doctrine" did have a role to play in this area, the IRS's focus on the likelihood of a pretax profit was an inappropriate and unworkable test for determining economic substance -- particularly in the context of insurance policies. By the very nature of life insurance, the profitability of a policy in an investment sense will always depend on whether the insured dies soon or lives longer than actuarial predictions. Specialists also noted that the death benefits and inside build-up received were indisputably tax-free. They should have been either treated as post- tax numbers or "grossed up" to a pretax equivalent in any "apples-to- apples" pretax calculation.

Tax Court Judge Robert P. Ruwe concluded that characterization of a transaction as a "substantive sham" depended on "a flexible analysis that focuses on two related factors, economic substance apart from tax consequences, and business purpose." He said that "[e]conomic substance depends on whether, from an objective standpoint, the transaction was likely to produce economic benefits aside from tax deductions." Examining the projections shown to Winn- Dixie before it adopted the COLI plan, Judge Ruwe concluded that an overall pretax profit for the company -- while concededly possible if actual mortality diverged from the actuarial projections -- was not likely. In his calculations, Judge Ruwe used the nominal cash flows found in those projections and did not gross up any of the assertedly "pretax" values to reflect the fact that death benefits and inside build-up are actually post-tax (that is, tax free) numbers.

He then held that the business purpose prong of the sham inquiry "involves a subjective analysis of the taxpayer's intent" and concluded that Winn-Dixie had no genuine business need for the insurance, and the 1993 COLI purchases were subjectively motivated solely by a desire to realize tax benefits. Literal compliance with the code provisions was essentially beside the point because a transaction that lacks substance "is not recognized for tax purposes." Section 264, he noted, "does not confer the right to a deduction but simply denies, disallows, or prohibits deductions that might otherwise be allowable." The Eleventh Circuit then affirmed, based on Knetsch v. United States, 364 U.S. 361 (1960). It added one worrisome gloss, however. While Judge Ruwe had characterized the sham transaction test as a "flexible analysis" that "focuses on two related factors," the Eleventh Circuit found that a transaction is a "sham" unless it has both objective "economic substance" and a subjective "non-tax business purpose." That latter formulation seems to us a tougher standard to meet.

Charities, Dead Pool Investors, and "Free" Insurance

On May 12, 2005, H.R. 2251 was introduced in the U.S. House with the goal of reforming the use of COLI. "This is a bipartisan bill, with over two-thirds of Ways and Means Committee Members signed on as cosponsors," said Rep. Thomas M. Reynolds, R-N.Y. It would restrict COLI to coverage of a limited class of employees; require employers to provide notice to insured employees and obtain employee written consent to being insured; establish disclosure and recordkeeping requirements for businesses holding COLI policies; and impose a tax on COLI policy benefits unless the requirements of the bill were met. (Doc 2005-10429 [PDF], 2005 TNT 92-19 Database 'Tax Notes Today', View '(Number'.) COLI is not really an important tax issue now like it was in the early 1990s, however. We see more questions today involving life insurance that is being offered for free and life insurance pools being created by tax-exempt organizations.

Earlier this month, Senate Finance Committee Chair Chuck Grassley, R-Iowa, and ranking minority member Max Baucus, D-Mont., jointly introduced a bill to block insurance contracts in which tax- exempt organizations hold an interest, effective for contracts issued after May 3, 2005. It would do that by imposing an excise tax equal to 100 percent of the acquisition costs on some life insurance, annuity, or endowment contracts in which both the exempt organization and a person or persons that is not an exempt organization have both held an interest, even if those interests are not held at the same time. The bill would also require reporting of existing life insurance, endowment, and annuity contracts held by exempt organizations as of that date. (See Doc 2005-10320 [PDF], 2005 TNT 91- 62 Database 'Tax Notes Today', View '(Number').

The concern today is partly a carryover from outrage over the use of exempt organizations in charitable split-dollar and reverse charitable split-dollar insurance plans that had a significant tax avoidance component. The IRS succeeded in getting the courts to shoot those down in Addis v. Commissioner, 118 T.C. 528, Doc 2002-13918 [PDF], 2002 TNT 112-10 Database 'Tax Notes Today 2002', View '(Number'(2002), aff'd 374 F.3d 881, Doc 2004-14119 [PDF], 2004 TNT 132-7 Database 'Tax Notes Today 2004', View '(Number'(9th Cir. 2004), and Weiner v. Commissioner, T.C. Memo. 2002-153, Doc 2002- 14582 [PDF], 2002 TNT 118-9 Database 'Tax Notes Today 2002', View '(Number', aff'd No. 02-73609, Doc 2004- 16201 [PDF], 2004 TNT 155-8 Database 'Tax Notes Today 2004', View '(Number'(9th Cir. 2004). Earlier this year, certiorari was denied in both Addis and Weiner. (Doc 2005-3517 [PDF], 2005 TNT 35-4 Database 'Tax Notes Today', View '(Number'.) Before the cases were decided, however, Congress had acted. In the Tax Relief Extension Act of 1999, section 170(f) was amended to provide that contributions to a charity after February 8, 1999, were not deductible if the charity directly or indirectly paid a premium on a life insurance, annuity or endowment contract that benefited the transferor, any member of his or her family, or another person named by the transferor.

The Grassley-Baucus legislation targets a different problem. Current tax deductions are not involved. Charitable organizations are being used to facilitate private investment in life insurance. As explained by J.J. MacNab of the Insurance Barometer LLC to the Finance Committee on June 22, 2004:

Using a technique called a "dead pool" such investors know that the more policies they hold in their portfolio, the more predictable the death rate becomes, enabling them to play the statistical odds. The gambling behind such an investment strategy is the reason why the state insurable interest laws exist; they ensure that life insurance is only purchased by someone who has a financial interest in the continued life of the insured. Institutional investors are actively looking for ways to fund insurance pools as an investment. . .. [M]any charities are also financially unsteady right now and are willing to engage in somewhat aggressive techniques in order to raise donations. Add these factors together, and the investors have found a willing -- and cheap -- partner in charitable industry. . . . As anyone familiar with the secondary life insurance market can attest, many investors would love to start an insurance pool insuring older, wealthy lives. . . . [I]nsurance companies don't have the ability to go out and buy 10,000 policies on the lives of targeted people. Charity, however, does . . . . While the charity may have an unlimited insurance interest in the life of a donor, the trust funded by the institutional investors does not. . . . [P]romoters . . . have been actively lobbying at the state level to get the insurable interest laws expanded, effectively gutting the purpose of these laws . . . . From a charity's point of view, participating in a scheme that enriches outside investors is bad public policy, even if the charity receives funds it would not ordinarily get. Doc 2005-12952 [PDF].

The Senate Finance Committee will likely agree, and so a tax will be imposed to solve a problem that is only indirectly a tax problem.


Regulation of the life insurance business is primarily a matter of state law, and the determination of whether A has an insurable interest in B is also a matter of state law. Federal courts do get involved however, either because of diversity of citizenship, as in Tillman, or because of federal tax issues, as in Winn- Dixie and several other COLI cases. The tax law gets modified from time to time in the process, to prevent what Congress views as abuses of provisions that are being used in ways it concludes (with hindsight) were never intended. Life insurance, however, is apt to be a staging ground for tax avoidance schemes so long as the tax law continues to exclude most life insurance proceeds paid by reason of death from income while allowing borrowing against life policies without tax consequences, even when the loans exceed the tax basis of the policies. The imperfections of actuarial tables and other actuarial assumptions will mean that from time to time promoters will view some types of policies as underpriced. Those then become fertile ground for pools of capital that will take advantage of that underpricing, as has existed recently with no-lapse guarantee universal life products. For example, policy pricing has assumptions about policies that are allowed to lapse. Those assume individual decisions by individual insureds. Those assumptions lower the premium cost but are invalid to when pools of capital are being invested in large numbers of policies that are being managed as a unit.

If we may be permitted a tongue-in-cheek postscript, we would suggest that the Bush administration may have missed the boat with its Social Security proposals. There is money to be made by taking out either or both life insurance and annuity policies on large groups of the elderly, as witness what has been happening with the investment groups that have been working in conjunction with charities. But who, we ask, has as large a group of the elderly among its constituents as the Social Security Administration? It certainly has a financial interest in the well-being of those insureds, although whether that rises to an insurable interest we will leave to others more expert on that point. Our suggestion is that instead of, or in addition to, partially privatizing the investment side of Social Security, perhaps the administration could turn its inventory of insurable lives into cash by packaging life insurance and annuity policies with private insurance companies for the benefit of private investment pools. If the Grassley-Baucus bill is enacted, it will shut down charities as a source for those pools of insureds, so the administration should find a ready market for its product. It can provide insureds meeting almost any specifications, such as upper-income persons age 65 to 80, and in almost any number. Actuaries and statisticians would have a field day.

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Tax Analysts Information

Code Section: Section 163 -- Interest; Section 264 -- Nondeductible Premiums
Geographic Identifier: United States
Subject Area: Individual income taxation
Author: Raby, Burgess J.W.; Raby, William L.
Institutional Author: Tax Analysts
Tax Analysts Document Number: Doc 2005-11521 [PDF]
Tax Analysts Electronic Citation: 2005 TNT 101-91