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A recent Delaware federal court ruling that pulled the plug on a corporate life insurance program that provided a music retailer with millions in income tax breaks could open the door for Uncle Sam to collect as much as $6 billion from 85 companies with similar plans. “It’s an incredibly important development in the tax law, no question,” said Gordon Henderson, a long-time tax attorney and of counsel with Weil Gotshal & Manges in Manhattan and the author of “Failing and Failed Businesses,” which deals with tax planning for troubled corporations. U.S. District Judge Murray M. Schwartz held last week in a 143-page opinion that the corporate-owned life insurance plan used by Camelot Music Inc. — a string of 280 music stores bought last year by Trans World Entertainment Co. of Albany, N.Y. — was a sham transaction with no bona fide business purpose other than to reduce the company’s tax bite. Under the plan, Camelot deducted from its 1991 to 1993 federal income tax bills the millions it paid in interest on policy loans covering the lives of its 1,430 employees. “Camelot, in going forward with its … plan, crossed the line separating a life insurance contract where policy loan interest is deductible and a tax advantaged investment program where it is not,” the opinion said. The retailer is now faced with paying $8 million in taxes, as well as interest, according to John J. Sullivan, chief financial officer with Trans World Entertainment. “We’re surprised. We thought the judge would rule in our favor since it was a fairly standard insurance practice,” said Sullivan. Sullivan was not able to say if the company will appeal the decision. “We’re reviewing our options — but we’ve got to see what the opinion says,” he said last week. The Internal Revenue Service set the matter in motion when it filed a proofs of claim action against Camelot after the company filed a voluntary petition under Chapter 11 in Delaware’s U.S. Bankruptcy Court in 1996. Camelot then filed an objection, creating an adversary proceeding. After the IRS was granted a motion for withdrawal of reference in May 1998, the matter rested with district court. Because 50 companies that used such plans were being investigated by the IRS at the time of the Camelot trial last spring, it’s likely that many more of these complex tax cases will wind up in court in the coming months and years, experts say. Anthony Burke, spokesman for the IRS, said the service is forbidden by law to comment on any investigations. “The opinion raises some significant tax policy issues,” said Lawrence M. Hill, an attorney with White & Case of New York City, which represented Camelot in the matter. “Quite a number of companies took out these policies thinking they qualified under state rules and satisfied Internal Revenue Code requirements. Now the IRS has retroactively changed the rules.” Such plans were used during the late 1990s by dozens of Fortune 500 and mid-sized companies, including American Electric Power of Columbus, Ohio; Winn-Dixie Stores Inc. of Jacksonville, Fla.; Dow Chemical Co. of Midland, Mich.; and Procter & Gamble of Cincinnati, according to court records and lawyers involved in the case. The insurance product used by Camelot — described in court testimony as “innovative” — was one of the highly structured programs developed by the insurance industry in the late 1980s to reportedly help companies generate cash flow. Camelot took out its plan from Mutual Benefit Life Insurance Co., which later ran into financial problems and was acquired by the Hartford Life Insurance Co. Seven other life insurance companies sold plans similar to the one purchased by Camelot, the opinion said. ‘BROAD-BASED LEVERAGE’ Known as “broad-based leveraged,” corporate-owned life insurance, the plans allowed businesses to take out life insurance on all its employees, with the company as beneficiary. Companies would, in turn, take out loans, using the policies as collateral. The interest paid on the loans was then used to offset federal taxable income. In the case of Camelot, total interest deductions over the life of the plan were projected to be $177 million, according to court documents. These insurance programs are so complex, Schwartz had to write detailed explanations of the intricacies of the Camelot plan to address the IRS challenges that the plans are shams both in fact and in substance. The sham transaction doctrine originated with the 1935 Supreme Court decision Gregory v. Helvering, 293 U.S. 465. In that case, the court affirmed an opinion by then-U.S. Circuit Judge Learned Hand that denied deductions for a corporate reorganization that followed each step required by the Internal Revenue Code, but lacked economic substance. Schwartz cites from the landmark Supreme Court decision Commissioner v. Court Holding Co., 324 U.S. 331, 334 (1945) in his opinion: “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.” As Schwartz said in his opinion, the plans were designed to “generate predictable positive cash flows based on precise calibrations of various plan elements including high premium levels, high interest rates, large numbers of insureds, and pre-orchestrated combinations of loans, loading dividends and policy withdrawals.” “This only could have been done in the computer age,” said Dennis M. Donohue, special litigation counsel with the U.S. Department of Justice in Washington. Donohue was the lead attorney arguing the IRS’ case last spring in a six-week trial that generated nearly 5,000 pages of transcript. In 1996, Congress decided to phase out the interest deductions on corporate-owned life insurance policies when it enacted the Health Insurance Portability and Accountability Act. At the end of the month, Donohue will face off with American Electric Power in U.S. District Court in Columbus, Ohio, over the company corporate-owned life insurance plan. Pat D. Hemlepp, spokesman for American Electric, said that $317 million in taxes are at stake in the case. DOUBLE SHAMS? The IRS argued that the Camelot plan was both a factual sham — which means it occurred only on paper — and a sham in substance or without economic purpose beyond creating tax deductions. “It was a money loser from day one — except for the tax benefit,” said Donohue. Schwartz ruled that the plan was indeed a factual sham because four of the seven annual premiums were paid by a dividend that flowed from the premium — or a circular accounting. The Internal Revenue Code allows for the deduction of interest paid on policy loans secured by an insurance policy so long as no part of four of the annual premiums due during the first seven-year period is paid by means of indebtedness. This is known as the “four out of seven safe harbor.” Schwartz called the loading dividends used by Camelot “cleverly designed accounting entries which occurred on paper, but not in reality.” “The premiums come from the policyholder, the loading charges come from the premiums, the loading dividends come from the loading charges, which dividends are then used by the policyholder to pay the premiums,” the opinion said. The court also agreed with the IRS that the corporate-owned life insurance plan was a sham in substance because Camelot could not expect in any individual year or over the life of the plan any positive cash flows or earnings absent the tax benefit. “The only financial benefit provided to Camelot by its … plan, and the reason the transaction was profitable to all involved except the United States Treasury, was the tax benefit attributable to policy loan interest deductions,” Schwartz wrote. However, Schwartz declined the IRS request to find the Camelot plan a “generic or abusive tax shelter.” “It’s my view, if the judge had found it to be a generic tax shelter it would have been more of a deterrent to any type of insurance scheme out there — and there are plenty, believe me,” Donohue said. Hemlepp of American Electric said lawyers at the utility who reviewed Schwartz’ opinion feel the court did not have the benefit of the complete and expert testimony in the Camelot case. “We plan to have expert witnesses that are highly respected in the insurance and financial areas,” Hemlepp said. “We’re going into this with a lot of confidence.” The case was In Re Cm Holdings Inc., et al. v. Internal Revenue Service, petitioner, v. CM Holdings Inc., respondent, CA 97-695. Attorneys representing the government included Carl Schnee, U.S. attorney for Delaware and Ellen W. Slights, assistant U.S. attorney. Defendants’ counsel included Pauline K. Morgan of Young Conaway Stargatt & Taylor of Wilmington, Del.; and Lawrence M. Hill, Michael I. Saltzman and Richard A. Nessler of White & Case in New York.

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