Hedging the IRS - A Policy Justification for Excluding Liability and Tax Insurance Proceeds

Uncertainty as to tax results is an ever present obstacle to business transaction despite the extensive number of Code sections that exist. Private insurance companies have seen an opportunity to enter the market and provide a useful service which can reduce tax uncertainty obstruction to engaging in promising endeavors. Some insurance companies now provide an insurance product to protect the insured against adverse tax consequences from proposed transactions.Ironically, this new insurance product, labeled tax insurance, poses uncertain tax consequences itself. 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, are the insurance proceeds that reimburse the insured for the additional tax liability included in the insured's gross income? If so, the insured might need to purchase additional coverage to pay for the tax incurred on receiving the proceeds.Commentators have concluded that the proceeds are taxable, and insurance companies also appear to adopt that view since tax insurance generally includes gross-up provisions to cover the tax that might be imposed on the disbursement of the proceeds. Contrary to that general opinion, this article argues that the tax insurance proceeds are not includable in the insured's gross income.The proceeds of general liability insurance have not been treated as taxable to the insured when paid to satisfy a liability of the insured. Some commentators have questioned whether there is a justification for that treatment under tax policy. As part of the reasoning that underlies the author's conclusion concerning tax insurance, the article examines that question and develops a novel approach that provides a tax policy justification for excluding those 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.