Opinion
No. 97-695 MMS
October 16, 2000
Carl Schnee, Esquire, United States Attorney, and Ellen W. Slights, Esquire, Assistant United States Attorney, United States Department of Justice, Wilmington, Delaware; Of Counsel: Paula M. Junghans, Esquire, Acting Assistant Attorney General; Dennis M. Donohue, Esquire, Special Litigation Counsel; James D. Hill, Esquire, Special Counsel to the U.S. Department of Justice; Charles M. Ruchelman, Esquire, Alex E. Sadler, Esquire, and Joseph A. Sergi, Esquire, United States Department of Justice, Washington, D.C.; attorneys for plaintiff.
Pauline K. Morgan, Esquire, of Young Conaway Stargatt Taylor, LLP, Wilmington, Delaware; of Counsel: Michael I. Saltzman, Esq., Lawrence M. Hill, Esquire, and Richard A. Nessler, Esquire, White Case LLP, New York, New York; Francis A. Vasquez, Jr., Esquire, Jennifer L. Chapin, Esquire, Charles C. Doumar, Esquire, and Michael D. Levin, Esquire, White Case LLP, Washington, D.C.; attorneys for defendant.
OPINION
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 Benefit Life Insurance Company ("MBL"). The COLI VIII policies were designed to be owned on a broad base of employees, to be financed through a highly leveraged transaction, and to provide the policyholder with a positive cash flow in every year of the policy. To achieve these design goals, the designers of the COLI VIII policies incorporated several innovative features in an attempt to comply with the Internal Revenue Code governing life insurance. In doing so, the designers obviously inched toward that invisible line which separates true life insurance from tax driven or tax sheltering investments.
Camelot Music, Inc., a wholly owned subsidiary of respondent, CM Holdings, Inc., (collectively "Camelot"), Stipulations of Fact ("Stip.") ¶ 1, Docket Item ("D.I.") 64, purchased COLI VIII policies on the lives of 1,430 of its employees. Camelot took out large policy loans to pay the first three annual premiums and claimed interest deductions attributable to these loans for the taxable periods ending August 31, 1991, August 31, 1992, August 31, 1993, for Camelot and ending February 28, 1994, for CM Holdings, Inc. The IRS disallowed $13,836,901 of Camelot's interest deductions. See Petitioner's Proposed Findings of Fact and Conclusions of Law and Proposed Order, D.I. 117 at 2.
According to the introduction of Petitioner's Proposed Findings of Fact and Conclusions of Law, the IRS assets there is tax due because of the disallowed deductions in the amount of $5,290,554 and also asserts it assessed accuracy related penalties for substantial understatement of income tax, pursuant to 26 U.S.C. § 6662, in the amount of $950,900.40. The Court was unable to fine these particular numbers in the voluminous record.
The outcome of this case potentially has far greater consequences than the approximately $6 million allegedly owed by Camelot. In addition to MBL, seven other life insurance companies have sold similar COLI plans to many Fortune 500 companies and mid-sized corporations. George Imwalle ("Imwalle"), Transcript ("Tr.") 977-80, 3288. At the time of trial, 85 taxpayers with similar plans had been identified by the IRS, 50 investigations were underway, and many more were expected to be added to the list. Imwalle, Tr. 3317, 3287. As a result of these investigations, there is an aggregate potential tax liability of $6 billion. Imwalle, Tr. 977.
Both Camelot and MBL met financial misfortune unrelated to the COLI VIII policies. MBL went into rehabilitation and its COLI business was ultimately acquired by the Hartford Life Insurance Company ("Hartford"). On August 9, 1996, Camelot filed a voluntary petition under Chapter 11 of the Bankruptcy Code. The IRS filed proofs of claim against Camelot based in part upon its proposed disallowance of the deductions taken by Camelot for interest it claims to have paid on policy loans under its MBL COLI VIII policy plan for taxable years 1991 through February, 1994. Stip. ¶¶ 5, 7; J134, J135, J140. On October 15, 1997, Camelot filed an objection to the IRS's proofs of claim, creating an adversary proceeding. By order dated May 29. 1998, the IRS's motion for withdrawal of reference was granted with respect to the adversary proceeding. See Internal Revenue Serv. v. CM Holdings, Inc., 221 B.R. 715, 724 (D. Del. 1998) ("CM Holdings I"); D.I. 11. This Court has jurisdiction pursuant to 28 U.S.C. § 157(d) and 1334.
The IRS's exhibits are referred to as G___; the respondent's, Camelot's, exhibits will be referred to as R___; and the joint exhibits will be referred to as J___. When referring to an expert report, the expert's name will precede the exhibit designation.
Trial was held between March 27, 2000, and May 5, 2000, generating 4,994 pages of transcript and 622 admitted exhibits. The Court has considered the Stipulations of Fact and carefully assessed the testimony, demeanor, and credibility of all witnesses, including those who testified by deposition. In addition, the Court has read and evaluated the combined 378 pages of proposed findings of fact, conclusions of law and legal arguments advanced by the respective parties, and has scrutinized all admitted exhibits cited by either litigant in their post trial submissions.
In those few instances when depositions were not taken by video, witness demeanor could not be evaluated.
The Court holds the interest deductions should be disallowed for two alternative reasons. First, they should be disallowed because they were created as part of a transaction which was partially a factual sham and, therefore, did not fall within the safe harbor for policy loan interest deductions of Internal Revenue Code ("I.R.C.") § 264, 26 U.S.C. § 264. Second, the interest is not deductible, pursuant to I.R.C. § 163(a), 26 U.S.C. § 163(a), because the deductions were created as part of a transaction which was a sham in substance. In addition, the Court concludes this is an appropriate case for assessment of accuracy related penalties for substantial understatement of income tax, pursuant to 26 U.S.C. § 6662.
This opinion shall constitute the Court's Findings of Facts and Conclusions of Law pursuant to Rule 52 of the Federal Rules of Civil Procedure.
II. BACKGROUND
The IRS has challenged Camelot's federal income tax deductions for interest it allegedly paid on policy loans as part of a highly structured, leveraged transaction to purchase the COLI VIII policies (the transaction will be referred to as the "COLI VIII plan"). This section discusses life insurance generally, the history of the development of the MBL COLI VIII policy, Camelot's purchase of the COLI VIII policies, and the features of Camelot's COLI VIII policies and plan. Unfortunately, because of the relatively recent development of the COLI VIII plan, the industry and trial witnesses have used "the same terms to mean different things and different terms to mean the same thing." Christian DesRochers ("DesRochers"), Tr. 1979. Given this state of affairs, in working with the record, the Court has proceeded with the utmost caution.
A. General Background of Life Insurance
All life insurance policies have certain features in common. A life insurance policy is a contract between a life insurance company and a person who purchases the policy, known as the "policyholder." Glossary of Life Insurance Terms, Appendix F to Petitioner's Reply Brief, D.I. 127; Glossary of Insurance Terms, Appendix to Respondent's Post Trial Brief, D.I. 123. The contract insures against the death of an individual, known as the "insured." Also named in the policy is a "beneficiary," who receives money from the insurance company upon the death of the insured. The policyholder, insured, and beneficiary may be the same or different persons. The money received upon the death of the insured is known as the "death benefit" and is received free of federal income tax. Jack Rogers ("Rogers"), Tr. 499. The amount of the death benefit is the "face amount" of the policy.
At the request of the Court, the litigants supplied glossaries of terms. Because the definitions are largely undisputed, the Court draws upon the IRS's glossary, which was prepared by Dan M. McGill, Frederick H. Ecker Emeritus Professor of Life Insurance at the Wharton School of the University of Pennsylvania. This glossary will be used without attribution.
In order to purchase the death benefit, the policyholder pays the insurance company a fee called a premium. EDWARD E. GRAVES ED., McGILL'S LIFE INSURANCE 26 (2d ed. 1998) ("McGILL'S LIFE INSURANCE") The premium is used, in whole or in part, to pay the cost of insurance ("COI") charge, which is determined by multiplying an assumed rate of mortality times the face amount of the policy. Id. at 29-30, and 34 n. 12. The assumed rate of mortality varies by gender and tends to rise dramatically with age. The duration of the policy, known as the "term," may vary between one year and the whole life of the insured. Id. at 28.
McGILL's LIFE INSURANCE was referenced at trial, and a copy provided to the Court, so that the Court could obtain a better general understanding of life insurance. As appears from the text, the Court has heavily drawn upon it in this non-controversial background discussion. However, because it is not in evidence, it will not be relied upon in the more substantive portion of this opinion, unless actually referenced in the transcript.
There are five basic types of life insurance contracts: term, whole life, universal life, endowment, and annuity. Id. at 35. Only whole life and universal life are of interest in this case.
1. Whole Life Insurance
A whole life insurance policy has a term equal to the whole life of the insured. McGILL'S LIFE INSURANCE at 49. The policyholder must be able to cover the COI charges, which rise dramatically with age, for the entire life of the individual. Id. at 50. Rather than paying increasing premiums each year, a policyholder may pay a level premium over the entire life of the insured or for a limited period of time (limited-payment life insurance). Id. at 49, 57-59. Either way, the premiums are much higher than the COI charges in early years and lower than the COI charges in later years. Id. at 50-51, 57-59.
Every time a premium is paid, the amount of the premium, less an expense charge, is added to the "policy value," also known as the "cash value." Id. at 51-52. The expense charge is a percentage of the premium which is set aside to cover the administrative costs of the policy, including broker commissions. Ordinarily, the magnitude of the expense charge exceeds the projected actual expenses by a small amount known as a "margin." A major reason for the margin is to protect the insurance company against higher than anticipated expenses. Dwight K. Bartlett ("Bartlett"), Tr. 3364, 3374-75; Dan R. McGill ("McGill"), Tr. 3621-24.
In addition, the insurance company credits the policy value with interest, at an interest rate which the parties have labeled as the "crediting rate." Among other things the crediting rate allows the policy value to grow to support higher future COI charges. The litigants have adopted what the Court understands to be life insurance industry terminology and called this growth "inside build-up." The inside build-up is tax deferred for federal income tax purposes.
One important feature of whole life policies is the ability of the policyholder to take a "policy loan," in an amount not exceeding the policy value, based upon ownership of the life insurance policy. McGILL'S LIFE INSURANCE at 52-54. The term "policy loan" is at best a misnomer and at worst misleading. The policyholder does not borrow its own money from the policy value. Id. Rather, the policyholder borrows directly from the insurance company, using the policy value as collateral. Id. The Court understands the government and Camelot are in agreement that the policy value becomes "encumbered" to the extent of the principal balance and accrued interest on the loan. However, the encumbered policy value continues to be credited with interest which increases the inside build-up. Id. In order for policy loans to be fully secured by the policy value, the total amount of all outstanding policy loans, plus accrued but unpaid loan interest, cannot exceed the policy value. Id.
The interest rate on the policy loan, known as the "policy loan interest rate," is set in the policy and is either a fixed rate or a variable rate tied by formula to some specified index. Id. at 52. There is no fixed repayment schedule for the policy loan, but all policy loan principal and accrued interest will be deducted from the payment of the death benefit. Id. at 53. Therefore, another way to think of a policy loan is as an advance on the death benefit. Id. If there is sufficient policy value, policy loans may be used by the policyholder to pay premiums. Id.
Another important feature of whole life policies is a nonforfeiture or surrender option. Id. at 54-55. A policy may be surrendered or terminated at any time in exchange for the insurance company paying the policyholder the policy value. Id. at 54. However, at that time, any outstanding policy loans plus accrued interest must be repaid from the policy value. Id. The "cash surrender value," also known as "net equity," is the amount of actual cash the policyholder will receive upon surrender of the policy. Steven A. Eisenberg ("Eisenberg"), Tr. 2218-19.
A final notable feature of whole life insurance policies is the payment of "dividends." McGILL'S LIFE INSURANCE at 57. There are two types of whole life policies, participating and non-participating. Id. With a participating policy, the policyholder may receive a dividend paid by the insurance company based on the insurance company's experience. Id. Dividends may be paid to the policyholder in cash, added to policy value, or used to purchase paid up additions to the face amount of the policy. Id. A dividend is declared by the board of directors from a portion of the insurance company's surplus which government witnesses have called "divisible surplus." That portion of the company's surplus labeled "divisible surplus" is also determined by the board of directors for any given year.
2. Universal Life Policy
Universal life was "introduced in 1979 as a revolutionary new. . . variation of whole life insurance." McGILL'S LIFE INSURANCE at 77. A traditional whole life policy is opaque or, in the words of two witnesses, a "black box." James M. Campisi ("Campisi"), Tr. 1036; Eisenberg, Tr. 2190. In contrast, a universal life policy is translucent — all the features of the policy are unbundled to allow the policyholder to see how the money is used. Eisenberg, Tr. 2189-90. A universal life insurance policy contains all of the features of a traditional whole life insurance policy plus several additions.
First, universal life offers the ability to pay flexible, as well as fixed, annual premiums. McGILL'S LIFE INSURANCE at 79; McGill, G737 at 7. of course, over the life of the insured, the total policy value must still be able to support payment of the COI charges. McGILL'S LIFE INSURANCE at 50, 80. However, this feature allows the policyholder to maintain either a very high or very low policy value, depending on his investment goals. Id. at 79-80.
Second, universal life offers a choice between fixed or increasing death benefits. Id. at 83-84; McGill, G737 at 8. In an increasing death benefit policy, the death benefit may increase as the policy value increases. McGILL'S LIFE INSURANCE at 83-84.
Third, universal life permits the policyholder to make a partial withdrawal of a portion of the policy value, without having the amount withdrawn treated as a policy loan. McGill, G737 at 8. A partial withdrawal has two potentially negative consequences: it reduces the death benefit and it may negatively affect future earnings as there is less policy value to accumulate inside build-up. McGILL'S LIFE INSURANCE at 84.
Finally, and most importantly, universal life pioneered the use of a "differential crediting rate." McGILL'S LIFE INSURANCE at 84-87. As previously rehearsed, a traditional whole life policy has two interest rates: the policy loan interest rate and the crediting rate on the policy value. In contrast, a universal life policy has three interest rates: (1) a policy loan interest rate; (2) a "loaned crediting rate," an interest rate credited to the portion of the policy value equal to the policy loan balance (i.e., the "encumbered policy value"); and, (3) an "unloaned crediting rate," an interest rate credited to the remaining portion of policy value (i.e., the "unencumbered policy value").
The loaned crediting rate is usually less than the unloaned crediting rate in an effort to avoid the effects of disintermediation. McGILL'S LIFE INSURANCE at 84-87. Disintermediation occurred, starting in the late 1960s and accelerating in the late 1970's when policy loan interest rates in most life insurance contracts were in the range of 5% to 6%, while market interest rates climbed to unprecedented levels. Bartlett, Tr. 3429-30, G736 at 29; McGill, Tr. 3697-3701, R163/G737 at 19-20; Donald J. Puglisi ("Puglisi"), Tr. 4343-45. When the prime rate reached 20% and the interest rate on six-month treasury bills reached more than 15%, GS at 537, droves of policyholders made policy loans at low policy loan interest rates in order to invest in the market at higher interest rates. Bartlett, Tr. 3429-31, G736 at 29; McGill, Tr. 3700-01, R163/G737 at 9, 20-21. This policy loan drain threatened the solvency of some life insurance companies and placed others in a hazardous financial position, especially if they had to sell their long term, relatively low yielding investments at distress prices to raise cash to meet the burgeoning policy loan demand. Bartlett, Tr. 3430, G736 at 29; McGill, Tr. 3700-01, R163/G737 at 20-21; G5; Eisenberg, Tr. 2374-75. The differential crediting rates were created to curb the effects of disintermediation. Bartlett, Tr. 3430; McGill, Tr. 3697-3703; McGILL'S LIFE INSURANCE at 84-87.
The disintermediation crisis also led the creation of the Model Bill on Policy Loan Interest Rates by the National Association of Insurance Commissioners ("NAIC"). The Model Bill is discussed in greater detail in section III.A.2.a.(3), infra.
B. Development of the MBL COLI VIII Policy and Plan
The term "COLI" is an acronym which refers to "corporate owned life insurance" policies purchased by a corporate employer covering the lives of its officers or employees. Stip. ¶ 11. The corporate employer is the policyholder, premium payer, and beneficiary of a COLI policy. Id. The concept of COLI has existed for many years to help insure against the loss of key employees and to fund executive deferred compensation, supplemental retirement, and other benefit plans. McGILL'S LIFE INSURANCE at 16, 18; McGill, G737 at 6. Common types of COLI policies, some of which were owned by Camelot, are known as "key man" policies, split dollar policies, and supplemental employee retirement policies ("SERP"). McGILL'S LIFE INSURANCE at 314-45; Stip. ¶ 34.
The idea behind what has evolved into the MBL COLI VIII policy and plan was originally conceived in 1985 by Henry F. McCamish ("McCamish"), a life insurance entrepreneur. Eisenberg, Tr. 2 163-65; 2168-69. McCamish retained Milliman Robertson ("MR"), a nationally prominent actuarial consulting firm, to perform the developmental and actuarial work for a new type of COLI product. Stip. ¶¶ 80-81; Eisenberg, Tr. 2163-65, 2168-69; McCamish, Tr. 4782-83. McCamish's instructions were to design a COLI policy for large corporations that had policy value at the end of the first policy year that exceeded the first year's premium and that generated positive earnings and cash flow to the corporation in the first plan year. Stip. ¶ 81; Eisenberg, Tr. 2 164-66; McCamish, Tr. 4782-85; G542 at Bates NJ3429. Eisenberg, managing consulting actuary of MR's life insurance practice, and Timothy Millwood, an actuary who joined MR in 1987, worked on the project. Stip. ¶ 81.
In response to a question as to what an actuary is and does, Eisenberg responded:
An actuary is trained to analyze risks, the types of risks you find particularly with insurance, such as the risks of dying too early, living too long, becoming sick, disabled, having catastrophes, things like that, and how to measure and quantify those risks and put a price on those risks.
Eisenberg, Tr. 2153. Within the life insurance field, one of the primary functions of an actuary is to develop an insurance product. In order to do that, an actuary has to understand economies, math, and statistics and have a working knowledge of contract law and accounting. In addition, an actuary must prepare an actuarial memorandum which becomes part of the filing on seeking state approvals. The actuarial memorandum demonstrates how the policy complies with various regulatory laws for nonforfeiture values and minimum reserves. In addition, it discusses how the product operates with much more detail than found in the policy itself, including what the guarantees in the contract are and how the policy value evolves. Eisenberg, Tr. 2187.
In addition, MR was in charge of ensuring the new COLI policy and plan complied with all pertiment then-existing provisions of the I.R.C., including I.R.C. §§ 264 and 7702, 26 U.S.C. § 264, 7702. Eisenberg, Tr. 2169-70. I.R.C. § 264(a)(3) generally disallows interest deductions on amounts systematically borrowed on an insurance policy to pay premiums unless "no part of 4 of the annual premiums due during the 7 year period . . . is paid under such plan by means of indebtedness." 26 U.S.C. § 264(c)(1) (now codified at I.R.C. § 264(d)(1) but referred to herein as I.R.C. § 264(c)(l)) (known as the "four out of seven safe harbor"). Thus, MR had to design a plan in which the policyholder would not take policy loans in four out of the first seven policy years.
In 1984, Congress enacted I.R.C. § 7702 to define a life insurance contract for purposes of federal tax law as a contract which: (1) is a life insurance contract under applicable state law and (2) satisfies either a statutory cash value accumulation test or meets the guideline premium requirements of § 7702(c) and falls within the cash value corridor test of § 7702(d). 26 U.S.C. § 7702. One witness described § 7702 as governing the relationship between the death benefit and the policy value. DesRochers, Tr. 1877. Another witness described § 7702 as defining what a life insurance policy had to do to be a life insurance policy under the I.R.C. so as to get the taxfree death benefit and tax-deferred cash build-up. Eisenberg, Tr. 2169. Whether Camelot's COLI VIII policies qualify as life insurance contracts under I.R.C. § 7702 is not an issue in this case.
MBL agreed to underwrite the new COLI product being designed by MR. Stip. ¶ 81; Wendell J. Bossen ("Bossen"), Tr. 1733-35; James Van Etten ("Van Etten"), Tr. 2683-84, 2687-91; G22 at Bates MBL3271; G944 at Bates ICMG 249. As part of this arrangement, MR performed the actuarial design for the COLI product under MBL's general oversight. Id.
McCamish formed two corporations that provided administrative and consulting services for the new MBL COLI policies, Integrated Administration Services, Inc. ("LAS") and LAS Development Corporation ("IDC"). Stip. ¶ 82; Bossen, Tr. 1998; G22 at Bates MBL 3271; G944 at Bates ICMG 249. As compensation for these services, MBL agreed to pay McCamish and/or LAS and IDC a flat policy administration fee for every COLI policy sold by MBL, as well as a percentage of the annual premiums generated by the policies. Van Etten, Tr. 269 1-93; McCamish, Tr. at 4787-91.
By early 1986, MR, MBL, and McCamish developed policy form FA85, and supporting computer software, which was designated by MBL as "COLI I." Eisenberg, Tr. 2180-82; G542 at 2-3. From 1986 to 1991, policy form FABS was modified at various times in response to tax law changes and perceived competitive pressures in the marketplace. The modifications consisted of adding a series of "endorsements" or amendments to the form. Stip. ¶ 83. MBL designated this series of COLI products that were offered in the marketplace as COLI III, COLI V, COLI VIII, and COLI X. Id.
The COLI III policy was created in late 1986 in response to an amendment to I.R.C. § 264, which limited the deductibility of policy loan interest to interest to $50,000 per insured. Eisenberg, Tr. 2181-82; G542 at 3. The COLI III policy initiated the use of dividends to offset payment of premiums in four out of the first seven policy years. Id.
The COLI V policy modified COLI III by making it into a "limited-payment plan," i.e., making premiums payable for only a defined number of years at the beginning of the policy. Since the policy was designed so that all but four out of the first seven premiums would be paid by policy loan, the COLI V policy contemplated that premiums would stop being paid once the policyholder reached the $50,000 loan limit of I.R.C. § 264. Eisenberg, Tr. 2183-85; G542 at 3-4. Once the premiums stopped, the policyholder would hold its policies under an extended term nonforfeiture option. Id.
Finally, the COLI VIII policy modified COLI V by reducing the amount of premium per thousand dollars of death benefits. The level of life insurance premiums is measured by the "premium per thousand," the amount of premium dollar charged by the insurance company for every $1,000 of death benefits payable upon the death of the insured. Eisenberg, Tr. 2209-10, 2432; Kristie Sayre, Tr. 3946. In 1986, Congress enacted I.R.C. § 7702A, which placed a cap on the premium per thousand in life insurance contracts. 26 U.S.C. § 7702A. If the premium per thousand exceeds this cap, the contract is considered a "modified endowment contract" and loses the tax benefits of a life insurance contract. Id. The COLI VIII policy reduced the premium per thousand in order to ensure compliance with I.R.C. § 7702A. Eisenberg, Tr. 2185-86; Bossen, Tr. 2004; G542 at 4.
After she prepared her expert reports, Kristie Sayre became unable to testify at trial. By stipulation of the parties, her husband and business partner, Ralph Sayre, adopted her reports and testified on her behalf at trial. Ralph Sayre also served as an expert witness on other issues for the IRS and testified at trial. For convenience, this opinion will refer to Ralph Sayre' s testimony on behalf of Kristie Sayre as Kristie Sayre's testimony.
While I.R.C. §§ 7702 and 7702A limited the design freedom of the actuary and occupied considerable time at trial, they play only nonsubstantive roles in the resolution of the litigation.
C. Camelot's Decision to Purchase the MBL COLT VIII Plan
Attracting and retaining quality employees was considered by Camelot's owner, Paul David, to be critical to the success of the business. See R1; Rogers, Tr. 153; Thomas Knoll ("Knoll"), Tr. 736. In order to accomplish this objective, Camelot developed the "Camelot Associate Program," an employee benefit program offered to all employees who worked a minimum of 20 hours per week that included health and dental coverage in addition to other benefits. See J172; Rogers, Tr. 152, 155, 162-63. In the late 1980s, similar to other employers, Camelot experienced escalating health care costs, which were of mounting concern to the company. See J6; J11; R325-28; Rogers, Tr. 159, 161, 165-66, 188; Knoll, Tr. 737; Barbara Bald ("Bald"), Tr. 855-56. Compounding the impact of the health care cost inflation of the late 1980s, the number of Camelot employees eligible for health benefits more than doubled, from 600 to 1300 associates, between 1987 and 1989. See J6; Stip. ¶ 25.
As part of his investigation into ways to finance the company's increasing medical benefits costs, Rogers, Camelot's Chief Financial Officer, spoke with Campisi of The Newport Group, Inc. ("Newport") regarding possible funding vehicles. Rogers, Tr. 150-52, 169, 174; Campisi, Tr. 118-20. Camelot was first introduced to the MBL COLI product as a possible means to fund employee health benefits in a letter from Campisi to Rogers dated July 6, 1987. J7/G934. In this letter, Campisi described the MBL COLI product and emphasized that "[t]he key factor is being able to absorb the interest deductions." J7/G934. The July 6, 1987 letter, in an attached example, also illustrated to Rogers how higher policy loan interest rates advantaged the policyholder under the MBL COLI product. J7/G934, Bates 000071; Rogers, Tr. 408-09; Campisi, Tr. 1125-26, 1364-68.
Newport is a national insurance brokerage firm which also provides a range of administrative services for COLI plans. Campisi, Newport's president, was primarily responsible for the COLI VIII sale to Camelot. Stip. ¶ 31; Campisi, Tr. 1044; R539.
Between 1987 and 1990, Rogers and Campisi met several times to discuss Camelot's medical benefits cost funding issues. Rogers, Tr. 168-70, 174-76; Campisi, Tr. 1162-63. In addition Campisi sent a letter to Rogers, dated December 5, 1989, addressing a question Rogers had raised regarding the policyholder's ability to terminate a COLI VIII plan. J15. Campisi stated that plan termination would only be desirable if the policy loan interest deduction could not be used by the corporation or if it was eliminated by Congress. J15, Bates 000461 000463; see also Rogers, Tr. 423-24, 427; Campisi, Tr. 1405-12.
Sometime between December 5 and December 22, 1989, Campisi sent an undated letter to Rogers enclosing a set of 40-year sales illustrations showing the projected cash flows and earnings performance of a COLI VIII plan based on a annual premium of $12,000 per employee and 1,294 covered employees. J188. The illustrations reflected premiums would be paid by policy loans in years one through three and through a combination of dividends and partial withdrawals in policy years four through seven. Campisi subsequently sent Rogers additional sales illustrations showing the projected financial performance of a COLI VIII plan with varying levels of premiums and number of covered employees. Based on these various sales illustrations, Rogers understood that Camelot could increase its aggregate policy loan, policy loan interest deduction, and after-tax cash flow by selecting a high level of premium. Rogers, Tr. 447-49, 450-51, 487; see also Campisi, Tr. 1441-43.
On December 22, 1989, Campisi sent a letter to Rogers enclosing two sets of 40-year sales illustrations showing the projected financial performance of a COLI VIII plan with an annual premium of $16,428 per employee and 1,294 covered employees, the only difference between the two sets of illustrations being that the second set assumed that no employees would die in the first plan year. J17; see also Rogers, Tr. 447-49; Campisi, Tr. 1464-66. The illustrations were based on payment of premiums by policy loans in years one through three and through a combination of dividends and cash value withdrawals in policy years four through seven. At some point in late 1989, Rogers asked Lee Ann Thorn ("Thorn"), Camelot's Director of Tax, to project the company's future taxable income to ensure that Camelot would be able to fully deduct the anticipated policy loan interest under the COLI VIII plan and thereby obtain the illustrated after-tax cash flows. Thorn, Tr. 668-69, 696, 699.
On February 13, 1990, Campisi forwarded to Rogers a binder package consisting of an application for a COLI VIII plan and a Prepayment Agreement. Campisi instructed Rogers to sign and return the enclosed forms along with a check in the amount of $200 times the number of employees to be insured under the Prepayment Agreement, which would provide interim coverage for a period of 60 days. Campisi's letter explained to Rogers that the 60-day prepayment period "will allow us to tailor the size of the program to best fit Camelot's taxable income expectations." J22/J23. Campisi advised Rogers to date the forms "no later than February 20, 1990," so that the policies, once issued, could be backdated to the application date, thereby increasing the probability that Camelot's COLI VIII plan would be grandfathered in the event adverse legislation then being considered by Congress was enacted. J22/J23; see also Rogers, Tr. 484-87; Campisi, Tr. 1195-97.
In response, by letter dated February 16, 1990, Rogers forwarded to Campisi a signed application and Prepayment Agreement and a check in the amount of $278,200 to bind coverage and obtain interim death benefit coverage under the Prepayment Agreement for 60 days. J27; J28. Rogers indicated the 60 days would allow Camelot to evaluate the COLI VIII plan and also stated that Camelot wanted the ability to rescind its purchase if negative tax legislation were enacted at any time in 1990. J26 at Bates CAM004637-38; see also Stip. ¶ 55; Rogers, Tr. 236, 243-44, 493-94, 496; Campisi, Tr. 1197-98, 1496; J27; J28. At this point, Camelot had not yet determined the level of the annual premium or the number of insured employees under its COLI VIII plan. Rogers, Tr. 236, 243-44; G374, Bates 000079.
On February 16, 1990, Rogers wrote a file memorandum titled "COLI Summary" that documented various issues related to Camelot's COLI VIII purchase, including the company's efforts to minimize the risk that the policy loan interest deduction would be eliminated by legislation and the potential impact to Camelot of "freezing" the COLI VIII plan if adverse tax legislation were enacted or Camelot could not absorb the interest deductions. J25. Rogers' memorandum concluded: "[t]he decision to go forward and institute a COLI plan boil down to the risks involved. Those risks specifically include: 1) A retroactive tax law change[,] 2) Camelot's failure to generate taxable income over several years in a row[, and] 3) IRS attack[.]" J25; see also Rogers, Tr. 245-47, 501, 507.
During the prepayment period, Camelot evaluated its potential COLI VIII purchase, including soliciting advice from its outside tax advisers, Ernst Young, and its outside legal counsel, Stark Knoll. During this period, Camelot also evaluated various options regarding the premium level and number of insureds. By letter dated March 26, 1990, Campisi forwarded to Rogers two sets of sales illustrations projecting the financial performance of a COLI VIII plan assuming an annual premium per employee of $16,667 and $12,000 (characterized by Campisi as "Scenario I" and "Scenario II," respectively), 1,432 insured employees, and for payment of premiums by policy loans in the first three years and by dividends and cash withdrawal in years four through seven. J33. Campisi recommended Camelot choose the higher premium if Camelot could take advantage of the larger tax deductions: "[I]f you feel comfortable with Camelot's ability to absorb the higher tax benefit during the first seven years, Scenario I [the higher annual premium per employee of $16,667] would be an appropriate choice." J33; see also Rogers, Tr. 299-300, 509-11; Campisi, Tr. 1497-98.
On April 11, 1990, Camelot held a meeting at its offices to finalize the design of Camelot's COLI VIII plan. Campisi gave a presentation and distributed an "Executive Summary" describing the COLI VIII plan as a "financial tax-advantaged strategy" that would generate positive cash flows in every plan year without materially competing for Camelot's use of capital. R406; see also J34; Rogers, Tr. 252-254; Campisi, Tr. 1200-02.
By letter dated April 24, 1990, Campisi sent Rogers three additional sets of sales illustrations projecting the financial performance of the COLI VIII plan based on (1) a premium of $16,667 on 1,000 employees, (2) a premium of $10,000 on 1,432 employees, and (3) a premium of $10,000 on 1,432 employees with the tax savings from the policy loan interest deduction artificially capped at $2.5 million. J35/G403. In the letter, Campisi recommended Camelot choose a premium of $10,000 per employee. J35/G403; Rogers, Tr. 519-23; Campisi, Tr. 1213-14, 1501-02. Camelot followed Campisi's advice and elected an annual premium of $10,000 on 1,431 employees, covering all employees working at least 20 hours a week, ranging from Chairman and owner Paul David to part-time, entry-level sales associates at Camelot stores. Stip. ¶¶ 56, 61, 72; Rogers, Tr. 297-98, 314-16, 419-20. On April 30, 1990, Camelot issued a check payable to MBL in the amount of $707,719.63, the balance owing on the first-year premium. Stip. ¶ 64; G405; J39.
One policy was subsequently rescinded. Stip. ¶ 61.
By memorandum dated May 1, 1990, McCamish's IAS forwarded to Newport three sets of 81-year illustrations for Camelot's COLI VIII plan. J42. Two of the sets of illustrations generated by IAS, labeled "Scenario 1" and "Scenario 2," projected the financial performance of Camelot's plan assuming that Camelot paid the annual premiums with cash or financing external to the policy in all or some of the first seven plan years. J42. "Scenario 3" projected the financial performance of the plan assuming payment of premiums predominantly through a combination of policy loans, dividends and partial withdrawals, similar to the prior sales illustrations provided to Camelot. Rogers did not recall seeing these illustrations prior to this litigation. Rogers, Tr. 298-99, 465-66.
By letter dated May 3, 1990, Campisi forwarded to Rogers issue illustrations projecting the financial performance of Camelot's COLI VIII plan for 20 years, reflecting that premiums would be offset with policy loans in the first three plan years and a combination of loading dividends and partial withdrawals in the fourth through seventh plan years. J44; see also Rogers, Tr, 536-37; Campisi, Tr. 1241-42. On May 21, 1990, Newport delivered the COLI VIII plan policies to Rogers at Camelot's offices in Ohio. Stip. ¶ 70; J45; Rogers, Tr. 548.
D. Features of Camelot's COLT VIII Policies and Plan
The COLI VIII policies purchased by Camelot were issued by MBL on Policy Form FA85 with endorsements EFA85-3, EFA85-4a, EFA85-6, and EFA 85-7. Stip. ¶ 12. Camelot's witnesses have characterized Camelot's COLI VIII policies in varied ways. Each COLI VIII policy was denominated as an "Increasing Death Benefit Whole Life" policy with "Premiums Fixed and Payable During Lifetime of Insured or Until End of Premium Period." J189 at Bates 001064; see also Stip. ¶ 15. Camelot's actuarial expert, DesRochers, characterized the COLI VIII policies as "increasing [death] benefit whole life contracts" with "fixed premiums," which use "universal life type mechanics to generate policy values." DesRochers, Tr. 1950. He testified that, within the industry, a COLI VIII policy would probably be characterized as an interestsensitive whole life policy or a fixed-premium universal life policy. Id. The chief actuarial architect of the COLI VIII plan, Eisenberg, has described the COLI VIII policy variously as a fixed-premium universal life policy, Eisenberg, Tr. 2189, a fixed-premium increasing death benefit whole life policy, id. at 2578, and an interest-sensitive participating whole life policy which, from a risk perspective, is annual, renewable term insurance. Id. at 2582.
Rather than be confused by the varying characterizations of the COLI VIII policies, the operation of the complex COLI VIII policies and plan can best be understood by describing their features and function. To understand the mechanics of the COLI VIII policies, the parties have stipulated to the use of a sample COLI VIII policy covering a 28 year old male. J189. This policy is representative of the 1,430 COLI VIII policies Camelot purchased. In addition, to understand the mechanics of the highly structured, leveraged financing plan for the purchase of the COLI VIII policies, it is helpful to consider some of the "Issue Illustrations" Newport provided to Camelot.
The Camelot COLI VIII plan consists of 1430 individual policies on each Camelot employee. For convenience, from this point forward the COLI VIII policies will be referred to in the singular unless the context demands otherwise.
Appendix A contains a modified version of the illustration, J44, which Camelot received immediately after it purchased the COLI VIII plan. J44 illustrates the projected cash flow of Camelot's COLI VIII plan over 20 years. Columns (2),(3), and (4) illustrate the premium, administrative fee, and accrued policy loan interest that was projected to be due at the beginning of each policy year. Columns (5),(6),(7), and (8) show the aggregate amounts of policy loans, loading dividends, partial withdrawals, and cash used to pay the amounts due at the beginning of each policy year. Column (9) reveals the net equity remaining in the policy at the end of a given policy year. Column (10) displays the amount of net death benefits Camelot was projected to receive during the course of a given policy year. Column (11) illustrates the projected annual cash flow before taking into account the policy loan interest deductions. Column (12) shows the amount of the tax benefit from the interest deductions in each policy year. Finally, column (13) displays the net annual cash flow after taking into account the interest deductions in each policy year. Appendix B contains a similar modified illustration showing the actual values of each of these features for Camelot's COLI VIII plan over the first seven policy years. The mechanics of the COLI VIII plan can best be understood by elaborating on each of these features.
1. Amounts Due Each Policy Year (Columns(2),(3), and (4))
The COLI VIII policies were designed to have fixed annual premiums (column (2)), payable on the first day of each policy year. The policyholder could select the magnitude of the annual premiums, ranging from $2,000 to $16,667 per policy, to tailor the plan to its needs. Camelot selected an annual premium of $10,000 per employee. The total annual premium due on the first day of the first policy year was equal to $10,000 multiplied by 1,430 COLI VIII policies, or $14,300,000. As employees died, their policies would cease to be in effect and Camelot would no longer pay premiums on those policies. Thus, in each subsequent year, the total annual premium would be equal to the number of employees still alive multiplied by $10,000. In addition, Camelot planned to stop paying premiums after the ninth policy year and have the policies go into "paid — up status."
The illustration in Appendix A actually shows a first year annual premium of $14,310,000. This is because, at the time of the projection, Camelot had purchased policies on 1,431 employees. Later, Camelot amended its COLI VIII plan to include only 1,430 COLI VIII policies. Stip. ¶ 61. The COLI VIII plan covered only those Camelot employees. If an employee left Camelot, the policy on his or her life remained in effect until death (a fact ascertainable by a sweep of Social Security numbers) unless Camelot otherwise chose to terminate the COLI VIII plan. Conversely, employees new to Camelot after the plan was purchased are not part of the plan.
Also, in some policy years, there was projected to be a small administrative fee (colunm (3)). This administrative fee is relatively unimportant to understanding or analyzing the plan.
Finally, because Camelot was projected to take a policy loan to pay the premium, it had to pay accrued interest on the policy loan. The accrued interest was payable on the first day of the following policy year. For example, interest on a policy loan taken on the first day of the first policy year was due on the first day of the second policy year. Column (4) reflects the projected accrued policy loan interest due on the first day of each policy year.
2. Sources of Funds to Pay Amounts Due (Columns (5),(6),(7), and (8))
a. Policy Years One through Three
In the first through third and eighth and ninth policy years, Camelot's COLI VIII plan was designed for Camelot to pay approximately 90% of the annual premiums and accrued policy loan interest through a policy loan, and the remaining 10% in cash, in a simultaneous netting transaction. On the first day of the first policy year, the following transactions occurred simultaneously: (i) Camelot paid a premium of approximately $14 million to MBL, creating a policy value of approximately $14 million; (ii) Camelot took a policy loan of approximately $13 million from MBL, using the policy value as collateral; (iii) the $13 million policy loan was used to offset payment of the $14 million premium; and (iv) Camelot paid approximately $1 million in cash to MBL. Stip ¶¶ 64, 97, 167. On the first day of the second and third policy years, similar simultaneous netting transactions occurred, whereby: (i) Camelot paid the premium plus accrued loan interest; (ii) Camelot took a policy loan equal to approximately 90% of the annual premium plus accrued loan interest; (iii) the policy loan was used to offset payment of the premium plus accrued loan interest; and (iv) Camelot paid the approximately 10% balance by cash. Stip. ¶¶ 100, 103, 149, 153, 169, 171; J54; J71;Kristie Sayre, Tr. 4017-4020, 4036; R314/G738 at 42. These simultaneous netting transactions were necessary to create the policy value needed as collateral to support making the policy loan. Eisenberg, Tr. 2418-25; Kristie Sayre, Tr. 4016-17, 4019-20, 4036; R314/G738 at 42-46. Because of the broad base of employees and the pattern of borrowing, the COLI VIII plan is sometimes referred to as "broad-based leveraged COLI." See, e.g., Tr. 7, 8, 14, 44, 68, 89, 91.
Camelot did not pay a premium and did not take a policy loan in policy years eight and nine, as originally planned.
Although these transactions actually occurred on April 30, 1990, they were deemed to have occurred on February 16, 1990, the date of the Prepayment Agreement. Campisi, Tr. 1199-1200.
Camelot actually made payments by check to MBL. On February 16, 1990, Camelot paid approximately $278,000 as part of the Prepayment Agreement. Stip. ¶ 55; J26; J28. On April 30, 1990, Camelot paid MBL an additional approximately $708,000, which was deemed to have been paid as of February 16, 1990. Stip. ¶ 64; J39.
In policy year three, the total amounts due were also projected to be paid, in part, by a relatively small cash dividend of $967,000. The mechanism of the cash dividends is discussed, infra, with regard to policy years four through seven.
b. Policy Years Four through Seven
In policy years four through seven, the annual premiums and accrued loan interest were designed to be paid by a combination of cash, a loading dividend, and a partial withdrawal, in another simultaneous netting transaction. On the first day of each of the fourth through seventh policy years the following simultaneous transactions were deemed to have occurred: (i) Camelot paid the annual premium plus accrued interest; (ii) approximately 95% of the annual premium was taken by MBL or Hartford as an expense charge, while approximately 5% was credited to the policy value; (iii) approximately 5-8% of the expense charge was set aside to cover MBL or Hartford's actual expenses; (iv) approximately 92-95% of the expense charge was immediately returned to Camelot in the form of a "loading dividend"; (v) Camelot received a partial withdrawal of policy value in an amount equal to approximately 99% of the accrued loan interest; (vi) the loading dividend and partial withdrawal were used to offset payment of the annual premium and accrued loan interest; and (vii) Camelot paid the balance due in cash. Eisenberg, Tr. 2453-54, 2583; Bartlett, Tr. 3398-3402, G736 at 5-6, 19-20; Kristie Sayre, Tr. 4036-38, 4042-46, 4056, 4059-60, R314/G738 at 42-43, 47-48; J93; J109; J115; J123; J128; G738 at 40; G527 at Bates 027108-09.
The loading dividends are sourced from the expense charge, also called the "loading charge." Each Camelot COLI VIII policy contractually provides the magnitude of the loading charge (called "premium expense charge rate") as a percentage of the annual premium. J189 at Bates 001135. The expense charge covers the anticipated actual expenses plus a margin for a loading dividend. The designers of the COLI VIII policies issued actuarial memoranda with the anticipated expenses for each year. See, e.g., G877. The following chart compares the loading charges and anticipated expenses for each year, expressed in terms of percentage of premium, for a 25 year-old male:
Year Loading Charge Anticipated Expenses Difference 1 10.00% 2.00% 8.00% 2 20.00% 6.80% 13.20% 3 30.00% 6.80% 23.20% 4-7 95.00% 7.30% 87.70% 8-9 70.00% 7.30% 62.70%
The values in this chart are a fair representation of the loading charges and anticipated expenses for males and females of most ages insured by Camelot. Eisenberg, Tr. 2478-2483; J165 at Bates 001418. For a 28 year old male, the expense charges are the same in years one through seven but are 68% in years and eight and thereafter. J189 at Bates 001135.
See G887. Because the loading charge is projected to exceed the anticipated expenses by approximately 87.7% in policy years four through seven, the COLI VIII design proposed that this excess be returned to Camelot in the form of a loading dividend. Bartlett, Tr. 3399; G736 at 19-20; G844 at Bates 5583. The amount of the loading dividend is equal to the difference between the expense charge and the actual expenses for the COLI VIII policies. McGill, R163l/G737 at 53.
The partial withdrawals are deducted from the policy value of each COLI VIII policy. The policy value is generally equal to the total annual premiums, less expense charges, plus the inside build-up on the annual premium, plus any dividend credited to policy value, less the CCI charges. J189 at Bates 001073. The COLI VIII policy provides Camelot may take a partial withdrawal of the policy value. J189 at Bates 001093 (Endorsement EFA 85-7); Bossen, Tr. 1743; DesRochers, Tr. 4859. A partial withdrawal reduces policy value and death benefits. Eisenberg, Tr. 2495; DesRochers, Tr. 1983. The COLI VIII policy places no limit on the amount of policy value that may be taken as a partial withdrawal. Bossen, Tr. 1758.
However, if the policy has zero net equity, any partial withdrawal may only be used to pay off policy loans and accrued policy loan interest, and not to pay the premium. The policy states "[w]e will use the amount withdrawn to reduce the loan balance to the new loan limit, and then we will pay the rest in cash." J189 at Bates 001093. The "loan balance" is the loan principal plus accrued interest less unearned interest. J189 at Bates 001069. The "loan balance" cannot exceed the "loan limit," which, on the last day of a policy year, is the policy value plus the dividend value. J189 at Bates 001090 (Endorsement EFA 85-4a). "Cash surrender value," or net equity, is equal to the policy value plus dividend value less the policy loan and accrued interest, i.e., the loan balance. J189 at Bates 001089 (Endorsement EFA 85-4a). In other words, on the last day of a policy year, the net equity equals the loan limit less the loan balance. If the net equity in the policy is zero, i.e., the loan balance is equal to the loan limit, a partial withdrawal will be fully used to lower the loan balance on a dollar for dollar basis.
For example, assume the policy has a policy value of $10,000 and there is an outstanding loan balance of $10,000, consisting of $8,500 in loan principal and $1,500 in accrued interest. Although the policy has a net equity of zero, the policyholder may make a partial withdrawal of an amount up to the policy value of $10,000. If the policyholder makes a partial withdrawal of $2,000, the policy value will decrease to $8,000.
3. Loan Interest Rate and Differential Crediting Rates
Like traditional universal life policies, Camelot's COLI VIII policy had three interest rates: the policy loan interest rate, the loaned crediting rate (called the "Current Credited Loaned Interest Rate" in Camelot's COLI VIII plan) and the unloaned crediting rate (called the "Current Credited Unloaned Interest Rate" in Camelot's plan). The unloaned crediting rate was always the greater of a rate declared by MBL or 4%. J189 at Bates 001089.
The loan interest rate and the loaned crediting rate were set as follows. The COLI VIII policies permitted Camelot to annually elect between a fixed or variable loan interest rate. J189 at Bates 001077-80. The fixed loan interest rate was 8% per annum if charged in arrears or 7.4% if charged in advance. J189 at Bates 001080. If Camelot elected the fixed loan interest rate, the loaned crediting rate would be set by MBL but would be no less than 4%. J189 at Bates 001080.
If Camelot elected the variable loan interest rate, the loan interest rate would be the greater of: (1) the Moody's Corporate Bond Yield Average — Monthly Average Corporate (hereinafter "Moody's Corporate Average") or (2) the loaned crediting rate plus 1%. J189 at Bates 001078. Under Endorsement EFA85-3, the loaned crediting rate was calculated according to the mathematical formula (hereinafter "Baa enhanced"):
Baa + T% 100% — Baa
where Baa refers to Moody's Corporate Bond Yield Average — Monthly Corporate Baa ("Moody's Baa"). Camelot could elect between T=0% and T=l%. J189 at Bates 001088; Eisenberg, Tr. 2256-59; McGill, Tr. 3722-23, R163/G737 at 23.
The loaned crediting rate under the original version of FA85, without endorsement EFA8S-3, was Moody's Baa. J189 at Bates 001079.
Moody's Baa has historically exceeded Moody's Corporate Average by about 0.60% to 1.00%. Eisenberg, Tr. 2291-94, 2323-24; McGill, Tr. 3720-21, R163/G737 at 23; G935. Mathematically, the Baa enhanced loaned crediting rate will always yield a rate which is greater than Moody's Baa. Eisenberg, Tr. 2258-59, 2326-27; McGill, Tr. 3722-23, R163/G737 at 23. Therefore, the Baa enhanced loaned crediting rate is also always greater than the Moody's Corporate Average. Accordingly, the second prong of the variable loan interest rate provision will always govern. Eisenberg, Tr. 2326-27.
To summarize, if Camelot elected the variable loan interest rate, it could elect between two Baa enhanced loaned crediting rates, and the loan interest rate would automatically be 1% greater than the loaned crediting rate. Eisenberg, Tr. 2324-26; Campisi, Tr. 1332-33; Kristie Sayre, Tr. 3964-65, R314/G738 at 32; G56 at Bates NJ650; G958. The following chart illustrates the three choices of loan interest rate and loaned crediting rate combinations available to Camelot under its COLI VIII policy:
Loaned Crediting Rate Loan Interest Rate
Set by MBL or Fixed Rate of 4% Fixed Rate of 8%
Baa +0% Baa +0% 1-Baa 1-Baa +1%
Baa+ 1% Baa+ 1% 1-Baa 1-Baa +1%
Campisi, Tr. 1332-33; Kristie Sayre, Tr. 3964-65; R314/G738 at 32; G958. In each relevant policy year, Camelot elected the variable loan interest rate option. Camelot also selected the Baa enhanced loaned crediting rate with T=l %, which generated the highest possible loan interest rate. Rogers, Tr. 291-93, 396; Hoag, Tr. 4578-80.
4. Net Equity (Column (9))
The COLI VIII policy was projected to have a net equity equal to zero at the end of each and every policy year. The net equity, also known as cash surrender value, is equal to total policy value less policy loans and accrued interest. When a policy has a net equity equal to zero, all of the policy value is said to be encumbered and the policy value cannot support taking an additional policy loan. The undisputed evidence shows the policy achieved a net equity equal to zero on the last day of each policy year. Eisenberg, Tr. 2226, 2518-22; Kristie Sayre, Tr. 3994-96, 4002-09, 4010-11; R314/G738 at 40; G792; G844 at Bates 5583; G848 at 2; G949 at Bates 015150; G972; G987.
5. Death Benefit (Column (10))
Camelot's COLI VIII policy was an increasing death benefit policy, meaning that the death benefit could grow to exceed the original face amount of the policy. Each COLI VIII policy had a different face amount based upon the age and gender of the insured. According to the sample COLI VIII policy:
The death benefit on any date is the greater of:
(a) the specified [face] amount . . . and
(b) the policy value on that date divided by the net single premium based on the sex, age, and rate class of the insured on that date . . .
J189 at Bates 001071-001072. Thus, as the policy value increased, the death benefit could also increase over the specified face amount.
The death benefit shown in Appendix A is the projected net death benefit, which is the amount of proceeds Camelot was projected to receive upon the death of insured employees in any particular year. The net death benefit is the sum of:
(d) the death benefit;
(e) the amount of any dividend additions;
(f) any amount payable under an extra benefit rider; and
(g) if the insured dies during a period which is covered by a payment of premiums, a refund of that part of any premium which did not increase the death benefit based on the number of days between the date of death and the end of the period; reduced by:
(h) any loan balance; and
(i) if death occurs during the grace period, any unpaid premiums.
J189 at Bates 001072.
6. Net Pre-Interest Deduction Cash Flow (Column (11))
Column (11) shows the net cash flow Camelot was projected to receive absent the tax benefit from the policy loan interest deductions. This number is simply equal to the net death benefit (Column 10) less the cash Camelot paid out of pocket (Column (8)).
7. Interest Deduction Tax Benefit (Column (12))
Camelot was projected to receive each year a tax benefit from a deduction for the interest paid on the policy loan, pursuant to 26 U.S.C. § 163. The tax benefit was to be offset from Camelot's federal taxable income in an amount equal to the policy loan interest paid that year. Because Camelot was projected to have a corporate income tax rate of 40%, the tax benefit of the interest deduction would be 40% of the amount of the deduction. It is these interest deductions which are the subject of the dispute in this case.
8. Net After Interest Deduction Cash Flow (Column (13))
Column (13) shows the net cash flow Camelot was projected to receive after taking into account the tax benefit from the interest deductions. This is computed by summing the preinterest deduction cash flow (Column (11)) and the interest deduction tax benefit (column (12)).
One word best captures the complex, highly-calibrated COLI VIII plan that Camelot purchased — "innovative." Eisenberg, Tr. 2671-75. The COLI VIII plan contains an innovative combination of features, some of which are innovative in their own right, designed to generate positive cash flows every policy year. First, the COLI VIII plan had a very high policy value on the first day of the first year of the policy. The high policy value was made possible by high premiums per employee and in the aggregate because the plan included purchase of policies on a broad-base of 1,430 employees, as well as agents forgoing first year commissions. Second, the high policy value was used to secure maximum policy loans, which paid the high premiums in the first three policy years and sourced substantial interest deductions that were intended to fuel the positive cash flows. Third, computer technology enabled maximum leveraging of these high policy values through programs designed to achieve zero net equity at the end of each policy year. Fourth, Camelot had the right to determine among crediting rates for the inside build-up on the loaned portion (i.e., virtually all) of the policy value, which necessarily determined the policy loan interest rate because of the 1% spread between the loaned crediting rate and policy loan rate. Fifth, the 1% spread essentially fixed Camelot's cost of borrowing with the counterintuitive result that the higher the loaned crediting interest rate paid by Camelot, the greater the cash flows to it as a result of higher interest deductions. Sixth, the COLI VIII plan had an extremely high expense loading component in policy years four through seven, which expense loads were used to create first day dividends intended to pay a substantial portion of the premiums.
Although the record contains evidence of policy loans taken on the first day of the policy year, apart from Eisenberg's testimony describing this innovative feature and stating he had heard there was another policy with first day dividends, there is nothing else in the trial record indicating there had ever been a first day "dividend."
In sum, through a pre-planned, highly-structured and calibrated combination of innovative features, Camelot's broad-based leveraged COLI VIII plan was designed to produce positive cash flows in each and every plan year, assuming the deductibility of the policy loan interest. The question which the Court must answer is whether these innovative features, either singly or in combination, crossed the line so as to render the policy loan interest non-deductible.
III. DISCUSSION
The IRS challenges Camelot's policy loan interest deductions on three alternative bases. First, the IRS asserts the policy loan interest was not deductible under I.R.C. § 163 because the COLI VIII policy and plan were sham transactions. Second, the IRS contends Camelot's COLI VIII policy and plan comprise a generic tax shelter. Third, the IRS argues the policy loan interest deductions should be disallowed under I.R.C. § 264(a)(3) because Camelot failed to pay four out of the first seven annual premiums due by a means other than indebtedness in order to qualify for the safe harbor of I.R.C. § 264(c)(l). In addition, the IRS asserts Camelot is liable for accuracy related penalties for substantial understatement of its income tax under I.R.C. § § 6662(a) and 6662(b)(2). These four issues will be addressed in turn.
A. Deductibility of Interest Under § 163 and the Sham Transaction Doctrine
1. General Principles
Section 163(a) of the I.R.C. provides "there shall be allowed as a deduction all interest paid or accrued within the taxable year on indebtedness." 26 U.S.C. § 163(a). At issue is whether the amounts characterized as policy loan interest under Camelot's COLI VIII plan were, in fact, "interest" on "indebtedness" for federal tax purposes.
It has been long established that, for federal income tax purposes, interest is defined as "compensation for the use or forbearance of money." Deputy v. du Pont, 308 U.S. 488, 498 (1940); see also Old Colony R.R. Co. v. Comm'r, 284 U.S. 552, 560 (1932); Weller v. Comm'r, 270 F.2d 294, 296 (3d Cir. 1959), cert. denied, 364 U.S. 908 (1960). Interest can be deducted only if paid with respect to actual or genuine indebtedness. See Knetsch v. United States, 364 U.S. 361, 369 (1960); Goldberg v. United States, 789 F.2d 1341 (9th Cir. 1986); Bridges v. Comm'r, 325 F.2d 180 (4th Cir. 1963). Genuine indebtedness does not exist under § 163 if the underlying transaction is a sham transaction aimed solely at tax avoidance. See United States v. Wexler, 31 F.3d 117, 122 (3d Cir. 1994), cert. denied, 513 U.S. 1190 (1995); Weller, 270 F.2d at 297; CM Holdings I, 221 B.R. at 722.
The sham transaction doctrine originated with the Supreme Court decision of Gregory v. Helvering, 293 U.S. 465 (1935). In Gregory, the Court affirmed the Commissioner in denying deductions claimed by taxpayers for losses and expenses incurred in a corporate reorganization. Although the taxpayers had followed each step required by the I.R.C. for the reorganization, the Court nonetheless held these losses nondeductible, reasoning that the transaction was a "mere device" for the "consummation of a preconceived plan" and not a reorganization within the intent of the Code as it then existed. Id. at 469. Because the transaction lacked economic substance, as opposed to formal reality, it was not "the thing which the statute intended." Id.
The sham transaction doctrine requires a thorough examination by courts of the challenged transaction as a whole, as well as each step thereof, to determine if the substance of the transaction is consistent with its form. See ACM Partnership v. Comm'r, 157 F.3d 231, 246 (3d Cir. 1998), cert. denied, 526 U.S. 1017 (1999); Weller, 270 F.2d at 294. If a transaction's form complies with the Code's requirements for deductibility, but the transaction lacks the factual or economic substance that the form represents, then expenses or losses incurred in connection with the transaction are not deductible. See Knetsch, 364 U.S. at 365-66; Wexler, 31 F.3d at 122; Lerman v. Comm'r, 939 F.2d 44, 45 (3d Cir. 1991), cert. denied, 502 U.S. 984 (1991); Kirchman v. Comm'r, 862 F.2d 1486, 1490 (11th Cir. 1989). "To permit the true nature of a transaction to be disguised by mere formalisms, which exist solely to alter tax liabilities, would seriously impair the effective administration of the tax policies of Congress." Commissioner v. Court Holding Co., 324 U.S. 331, 334 (1945).
Courts have recognized two basic types of sham transactions: shams in fact and shams in substance. See ACM, 157 F.3d at 247 n. 30 (citing Kirchman, 862 F.2d at 1492). "[S]hams in fact" are transactions that never occurred in reality, that is, transactions that have been created on paper but which never took place. See id. "[S]hams in substance" are transactions that actually occurred but are devoid of economic substance. See id.; accord Lerman, 939 F.2d at 49 n. 6.
The IRS contends the evidence adduced at trial demonstrates that both the sham in fact and the sham in substance doctrines apply to Camelot's COLI VIII plan. It urges the Court to disallow the policy loan interest deductions under I.R.C. § 163(a). The burden is on the taxpayer, Camelot, to prove by a preponderance of the evidence that the form of the transaction reflects its substance. See Goldberg, 789 F.2d at 1343; accord National Starch and Chem. Corp. v. Comm'r, 918 F.2d 426, 429 (3d Cir. 1990), aff'd sub nom, INDOPCO v. Comm'r, 503 U.S. 79 (1992). See also, e.g., New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934); Welch v. Helvering, 290 U.S. 111, 115 (1933). The Court will discuss the sham in fact and sham in substance doctrines in turn after first addressing two preliminary arguments raised by Camelot.
The fact that a tax claim arises in a federal bankruptcy proceeding does not alter the taxpayer's burden of proof. See Raleigh v. Illinois Dep't of Revenue, ___ U.S. ___ 120 S.Ct. 1951, 147 L.Ed.2d 13 (2000) (where the burden of proof is on taxpayer under substantive law creating tax obligation, the burden of proof on the tax claim in bankruptcy court remains where it is under the substantive law); Resyn Corp. v. United States, 851 F.2d 660, 662-63 (3rd Cir. 1988).
Camelot devotes a considerable portion of its post-trial briefing to the argument that Camelot has complied with the detailed statutory regime regarding the deductibility of interest on life insurance policy loans as set forth in I.R.C. §§ 7702, 7702A, and 264. Camelot urges compliance with these provisions gives it the right to claim interest deductions and contends that if the Court were to disallow its policy loan interest deductions, it would effectively be legislating tax policy and usurping the power of Congress. The Court disagrees.
Adopting Camelot's position would do away with the well-established sham transaction doctrine. Under the sham transaction doctrine compliance with the letter of the tax code does not confer a right to claim interest deductions if the transaction is a sham. See, e.g., Gregory v. Helvering, 293 U.S. 465, 468 (1935) (concluding the transaction lacked substance for tax purposes, even where the transactions on their face satisfied "every element required by" the relevant statutory language); ACM, 157 F.3d at 246 ("even where the `form of the taxpayer's activities indisputably satisfies the literal requirements' of the relevant statutory language, the courts must examine "whether the substance of those transactions was consistent with their form"' (citations omitted)). See also Winn-Dixie Stores, Inc. v. Comm'r, 113 T.C. 254, 290-94 (1999). The Court rejects Camelot's argument. Instead it will conduct a probing inquiry into whether the substance of the transaction is reflected in its form.
In a similar vein, Camelot also argues the Court should not give retroactive effect to Congress' decision in 1996 to eliminate COLI policy loan interest deductions prospectively through a phased-out "soft landing" when it in enacted the Health Insurance Portability and Accountability Act of 1996 (HIPA), Pub.L. No. 104-191, 110 Stat. 1936, 2090. Like Camelot, the taxpayer in Winn-Dixie, 113 T.C. 254, argued the 1996 HIPA legislation demonstrated that its deductions for COLI policy loan interest were condoned by Congress. The Tax Court squarely rejected this argument, stating "we are not persuaded that Congress, by enacting and amending section 264 or other related provisions that restrict the deductibility of interest, intended to allow interest deductions under section 163 based on transactions that lacked either economic substance or business purpose." Id. at 293. This Court agrees.
Contrary to Camelot's position, Congress did not, by enacting the 1996 HIPA legislation, approve of interest deductions related to COLI VIII plans that lacked economic substance. As noted in a report by the Joint Committee on Taxation, "the proposal would not affect the determination of whether interest is deductible under present law rules (including whether interest paid or accrued during the phase-in period is otherwise deductible)." Description of Revenue Provisions Contained In The President's Fiscal Year 1997 Budget Proposal (Released On March 19, 1996), Staff of the Joint Committee on Taxation, at 82 (March 27, 1996) (emphasis added). In describing the present law rules regarding the deductibility of policy loan interest, the Conference Report stated that "[p]rovided the transaction gives rise to debt for Federal income tax purposes, and provided the 4-out-of-7 rule is met, a company may under present law borrow up to $50,000 per employee . . . ." H.R. CONF. REP. No. 104-736, at 319-20 (1996), reprinted in 1996 U.S.C.C.A.N. 1990, 2132-33. The Conference Report further noted that "[i]n addition to the specific disallowance rules of section 264, generally applicable principles of tax law apply," id. at 320 n. 23, and "no inference, [was] intended as to the treatment of interest paid or accrued under present law." Id. at 322. Stated another way by the Joint Committee report: "[T]he IRS would not be precluded from applying common-law doctrines or statutory or other tax rules to challenge corporate-owned life insurance plans to which present law rules apply." Description of Revenue Provisions Contained In The President's Fiscal Year 1997 Budget Proposal (Released On March 19, 1996), Staff of the Joint Committee on Taxation, at 82 (March 27, 1996). Thus, the legislative history of HIPA makes clear that, in enacting restrictions on the deductibility of COLI policy loan interest, Congress did not intend to negate the continued validity of the sham transaction doctrine.
Finally, Camelot relies upon an e-mail from Teri Culbertson to Nancy Knapp, R99, a chart purporting to show the IRS's treatment of several other COLI plans offered by different carriers, R199, and the deposition testimony of George Imwalle, the Issue Specialist for IRS's COLI Program, Tr. 956-999, 3284-3324, to demonstrate the IRS has not disallowed interest deductions related to other similar COLI plans. See Respondent's Reply Brief, D.I. 128 at 28. The IRS has objected to the admission of these items of evidence as being irrelevant because the determination of tax liability for a taxpayer must be based on the facts of a particular case, not with reference to other similarly situated taxpayers. See Petitioner's Legal Argument and Evidentiary Objections, D.I. 118 at 54-55 (citing Hanover Bank v. Comm'r, 369 U.S. 672, 686 (1962); Weller v. Comm'r, 270 F.2d 294, 298 (3d Cir. 1959), cert. denied, 364 U.S. 908 (1960); Easter House v. United States, 12 Cl. Ct. 476, 490 (1987); Goodstein v. Comm'r, 267 F.2d 127 (1st Cir. 1959); Davis v. Comm'r, 65 T.C. 1014, 1022 (1976); Teichgraeber v. Comm'r, 64 T.C. 453 (1975); IBM Corp. v. United States, 343 F.2d 914 (Ct.Cl. 1965); Penn-Field Indus., Inc. v. Comm'r, 74 T.C. 720, 722 (1980)). The Court agrees these items are irrelevant to the determination of whether Camelot is entitled to take interest deductions and they will not be relied upon in the Court's sham transaction decision.
2. Sham in Fact
Factual shams are transactions which were created on paper but "[did] not occur in fact, or that `were performed in violation of some of the background assumptions of commercial dealing."' Peerless Indus., Inc. v. Comm'r, 1994 WL 13837 at *4 (E.D.Pa. 1994), aff'd, 37 F.3d 1488 (3d Cir. 1994) (quoting Horn v. Comm'r, 968 F.2d 1229, 1236 n. 8 (D.C. Cir. 1992)); see also ACM Partnership, 157 F.3d at 247 (citing Kirchman, 862 F.2d at 1492). Camelot must prove the purported transaction actually took place in a manner which did not deviate from relevant commercial norms. See Sheldon v. Comm'r, 94 T.C. 738, 753-58 (1990); see also Forseth v. Comm'r, 85 T.C. 127, 165 (1985) (finding purported commodity transaction to be factual sham, in part, because there was no evidence commodities actually traded); Krumhorn v. Comm'r, 103 T.C. 29, 39 (1994) (finding transaction to be factual sham, in part, because it "lacked common business formalities" and departed from industry norms). In evaluating whether a transaction constitutes a factual sham, the Court "will ignore accounting tricks and other transactional artifices." Peerless, 1994 WL 13837 at *4Z
Aff'd, 845 F.2d 746 (7th Cir. 1988) and aff'd sub nom., Enrici v. Comm'r, 813 F.2d 293 (9th Cir. 1987); Bramblett v. Comm'r, 810 F.2d 197 (5th Cir. 1987); Mahoney v. Comm'r, 808 F.2d 1219 (6th Cir. 1987); Wooldridge v. Comm'r, 800 F.2d 266 (11th Cir. 1986).
Eisenberg repeatedly described features of the Camelot COLI VIII plan as "innovative." In a factual sham analysis, the Court must determine whether these features, singly or together, are merely "innovative" variations of accepted life insurance policies, or are ingenious and contrived artifices that contravene accepted industry norms. The IRS asserts the following components of the Camelot COLI VIII plan are factual shams: the policy loans, the loading dividends, the partial withdrawals, and the annual premiums. The Court will evaluate each of these components in turn and then evaluate the COLI VIII plan as a whole.
a. Policy Loans
Camelot has proven by a preponderance of the evidence that these policy loans occurred in reality. Camelot was charged and paid significant interest on these policy loans. Stip. ¶¶ 167, 169, 171, 173-179; J189 ¶ 16. The policy loans also were considered real debts of Camelot, which had to be repaid at the time of death of the insured or when the policy lapsed. Bossen, Tr. 1722. When an insured Camelot employee died, a death benefit, reduced by the outstanding policy loan and unpaid interest, was paid to Camelot. Rogers, Tr. 326-29, 333-34, 336, 346-50; Campisi, Tr. 1252-1263; Eisenberg, Tr. 2267-68; Van Etten, Tr. 2796-99; J80; J82; J84; R52-R55; R58; R59; see also Coors v. United States, 572 F.2d 826, 834 n. 14 (Ct.Cl. 1978) (policy loans not illusory when repaid out of death benefits). Also, MBL and Hartford carried the policy loans as assets on their books and recorded them separately from the receipt of the premium. Bossen, Tr. 2128.
Despite this evidence, the IRS asserts the policy loans were factual shams because: (1) the loans were made on the first day of each of the first three policy years; (2) the loans lacked the risk characteristics of ordinary commercial and policy loans; (3) the loans had artificially high interest rates; (4) interest on the first-year loan was paid retroactively for a period preceding the date the loan was made; (5) MBL did not restrict COLI policy loans during rehabilitation; and (6) only 40% of accrued interest on the loans was paid in cash. These characteristics of the policy loans will be addressed in turn.