Appeals Court Rules 'Janitors' Insurance a Tax Scheme

April 29, 2003 ( - A federal appeals court has ruled American Electrical Power Co's (AEP) purchase of "janitors" life insurance policies on 20,000 employees was nothing more than a scheme to generate tax deductions.

>The ruling by the 6th US Circuit Court of Appeals in Columbus, Ohio stands in contrast with a separate decision last month by a US district judge in Michigan in favor of Dow Chemical Co, which had claimed tax benefits under similar arrangements established in the late 1980s and early 1990s. However, other court cases involving companies’ janitors-insurance policies have resulted in government victories, according to a Wall Street Journal report.

>Under these arrangements, companies purchased broad-based corporate owned life insurance (COLI) arrangements, nicknamed janitors insurance by brokers selling the policies, only to take the policy out on workers, with the company as the beneficiary. By borrowing most or all of the cash value within the policies and deducting the interest on the loans, companies could generate cash flow with little capital outlay. Employers took out these policies on workers at all levels, often without their consent.

>In 1996, the Internal Revenue Service disallowed $66 million in deductions that AEP claimed from interest it paid on its janitors-insurance-policy loans, according to the court’s decision. The company paid the resulting $25 million in taxes but contested the decision. After a two-month trial in 2000, a federal district court ruled against AEP, which appealed.

>AEP said it bought the policies to pay for employee benefits after new accounting standards required public companies to account for retiree health care and other retirement benefits in advance. However, the opinion from Senior US Circuit Judge David Nelson dismissed that argument. The “fact that the tax savings AEP hoped to realize from the sham would have been used for perfectly legitimate business purposes cannot legitimize the transaction itself,” Nelson wrote.

>Lawyers and insurance-industry officials have said other companies have awaited the outcome of the AEP case and other litigation to gauge whether they will also be forced to pay taxes related to janitors insurance policies. The IRS last year offered to allow companies to keep some of their tax deductions in exchange for voluntary payments. The decision will not have a financial impact on AEP, which says it already paid and recorded as an expense the $317 million in taxes on the arrangements dating back to 1991, including the year at issue in the lawsuit.

>AEP, the nation’s largest electric producer and based in Columbus, said it hasn’t decided whether to appeal Monday’s decision. “We’re obviously disappointed, and we will decide in the next few days what our next step is,” AEP spokesman Pat Hemlepp said.

>However, the recent decision does not affect the kinds of corporate-owned life-insurance, or COLI, that hundreds of large employers continue to buy on millions of employees, typically managers and executives, with the company as beneficiary.