Tax Free Profits Available Via Insurance Company Loophole

by Leroy Baker, Tax-News.com, New York

02 April 2003

A little known tax loophole created fifty years ago to help hard-up farmers is being used by wealthy investors to legally avoid paying taxes on large portions of their assets, according to a report in the New York Times.

A law passed by Congress in 1954 stipulated that small insurance companies which received less than $350,000 per year in premiums could operate tax-free provided the primary nature of the cover they provided related to property or casualty insurance, rather than life assurance. The law remains on the statute book today, though was updated in 1986 when an amendment did away with the requirement for the insurance firm to be mutual, and allowed a sole owner to benefit from the loophole - provided their primary interest remained insurance.

However, because the law does not limit the amount of assets these concerns may own, many large scale investors created such companies and set aside huge amounts of reserves against potential insurance claims. Because the revenue created by selling policies is intentionally so small, the corresponding liabilities are also tiny, and therefore a significant proportion of these reserves will never be needed in the event of a claim. This capital can then be invested elsewhere, for example in stocks or bonds, and the dividends and interest accrued from these investments will be exempt from tax - as long as they stay within the insurance firm.

According to the NY Times report, there are several examples where firms have used this law to reduce their tax bills and boost income. It is claimed around 85 hospitals in New York state have saved some $27.5 million in taxes over the last five years using this method, and one high profile Wall Street investor is also alleged to have profited by about $100 million over the last four years from insurance companies set up specifically to exploit this loophole.

Whilst the IRS seems well aware of this practice, at present it is perfectly legal if one follows the strict letter of the law. Consequently, the IRS has traditionally shown little interest in pursuing such cases in the past and industry experts say that legislation is needed to plug the loophole. However, it seems that the IRS has begun to take notice of the increasing use of this mechanism, and the tax agency has recently begun a study on this rather shady sector of the insurance industry.

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