Hedging the IRS-A Policy Justification for Excluding Liability and Insurance Proceeds
Kahn, Jeffrey H., Yale Journal on Regulation
Uncertainty about tax results is an ever-present obstacle to business transactions despite the extensive number of Internal Revenue Code sections and Treasury Regulations. Some insurance companies now provide an insurance product to protect taxpayers against adverse tax consequences from proposed transactions. Ironically, this new insurance product, labeled "tax insurance," poses uncertain tax consequences itself. This Article argues that if the adverse tax consequences arise (that is, the taxpayer has additional tax liability) and the insurance company is contractually required to cover that liability, the tax insurance proceeds are not includable in the insured's gross income. As part of the reasoning that underlies this conclusion concerning tax insurance, the Article examines and develops a novel approach that provides a tax policy justification for excluding general liability insurance proceeds from the insured's income. The Article concludes that the same justification also applies to exclude tax insurance proceeds from the insured's gross income. The Article also examines whether the premiums paid for tax insurance coverage are deductible business expenses. Finally, the Article examines the appropriate tax treatment of other types of tax indemnity arrangements.
Despite - or perhaps on account of - the incredibly complex nature of our tax laws, individuals and business organizations face uncertainty as to the tax results of many transactions. Congress and the Internal Revenue Service,1 even if they so desired, could not set out rules in sufficient detail to provide certainty as to every possible transaction that may arise in the future.2 Unless alleviated, this uncertainty will cause some taxpayers to avoid engaging in transactions that would otherwise benefit society or the economy, resulting in a deadweight loss. Thus, it is desirable to derive ways to eliminate or mitigate this uncertainty in order to avoid deterring financially and socially beneficial transactions.3
Taxpayers frequently are faced with a choice of either abandoning a project or proceeding with it and accepting the question of the tax liability as one of the risks of the venture. Insurance companies have seen this circumstance as presenting an opportunity for them to enter the market and provide a useful service. To that end, some companies now provide insurance to protect a taxpayer against adverse tax consequences from a proposed transaction.4
If an insured client does not receive the tax treatment for which he purchased insurance and thereby collects from the insurance company an amount equal to the additional taxes he is required to pay the Service, what is the tax consequence of his receiving that payment? While the Service apparently has not yet challenged a taxpayer's treatment of tax insurance proceeds, one possible explanation for the absence of litigation is that taxpayers are voluntarily reporting it as income.5 In any event, anyone considering the purchase of tax insurance will want to take into account the extent to which there is a risk that payments received pursuant to the policy will themselves be taxed.6 The purpose of this Article is to examine that issue and several related topics.
Part I of this Article briefly explains and reviews the history of tax insurance and its predecessors. Part II examines the treatment of insurance proceeds received because of the damage or destruction suffered by an insured item of property7 and also discusses the tax treatment of liability insurance.8 In this Part, the Article will propose a policy justification for the tax law's treatment of the receipt of proceeds from property insurance and from liability insurance, including a discussion of Clark v. Commissioner9 and its progeny. The treatment of those insurance proceeds constitutes the backdrop against which my analysis of the proper treatment of tax insurance rests.
Part III examines whether the proceeds of a tax insurance policy are to be taxed to the recipient and whether premiums paid for a tax policy are deductible. …