With regard to the use of a Private Placement Variable Life Insurance to own privately held business interests of the insured, I have set forth a detailed outline in response to some of the generally raised questions about the use of private placement life insurance (“PPLI”) for interests in closely held companies or funds and investment partnership (including real estate partnerships) which are managed by the insured. I look forward to the opportunity to answer any further questions that you may have.
Basic issues pertaining to PPLI for Business Interests, Management Company Interests, etc.: Central to the issue involved in the transfer and maintenance of any private business interests, or closely held business interests (including interests in hedge fund and private equity fund management companies and carried interests) to PPLI policies, is the question of compliance with the diversification rules and the investor control doctrine. As we have advised our clients in our description of the technical details of the plan and the nature of the intricacies of the plan, as well as compliance with the rules that have evolved over time, especially in light of the Tax Court decision in the Webber case in 2015.
The Webber decision provided the planning community with guidance on three very important fronts, as follows: 1) Based on the judge’s ruling and the full opinion in that case, it seems to be clear that the Tax Court believes that the enactment of Section 817(h)’s Diversification Rules did not eliminate the applicability of the so called “Investor Control Doctrine”. As such, there needs to be a set of policies and procedures maintained for dealing with the assets a policy (whether separately managed account (“SMA”) or an insurance dedicated fund (“IDF”)), so that the policy does not run afoul of the Investor Control Doctrine such that the Policy Holder is not viewed as the owner of the assets in the policy or the IDF, and accordingly, is not treated as the owner of the income therefrom for federal income tax purposes; 2) that the degree of control and communication has to be somewhat constrained, although the facts of Webber are clearly quite egregious and unlikely to be repeated by anyone in the future; and 3) that there is
nothing in the rules regarding PPLI either before or after Webber which would prohibit the use of private company securities, actively operated and closely business interests, and real estate enterprises within a policy IDF or SMA. In fact, quite the opposite was the case under the facts of Webber as will be spelled out in greater detail hereinafter.
Webber specifically allows for the ability to own those assets within a policy both based upon the statutory and regulatory authority set forth in this memorandum and based upon the text of the opinion itself. Notwithstanding the misconception harbored by some parties about the Court’s discussion of the fact that Jeffrey Webber made statements that these business interests and opportunities to invest in these companies could not have arisen “but for his participation” that was not the issue which was troublesome for the court. Rather, the issue which was troublesome for the Tax Court was the fact that Mr. Webber was on the board of every company in which the policy invested, invested his own funds from his personal wealth and his IRAs, and that he negotiated the terms of every loan on behalf of the company and then gave the instruction to Mr. Lipkind, a total of more than 1,200 communiques of instructions to be given to the IDF Manager (Butterfield Bank); and Mr. Lipkind’s direction and commands in furtherance thereof to both the accountant, Susan Chang, and Bank/ IDF Manager (over 70,000 emails and even more phone calls) to carry out exactly that which Mr. Webber had instructed that they do in terms of investing the funds of the IDF. In other words, the problem was not the fact that Jeffrey Webber was an officer, board member, lender to, finance committee chairman, investor (both directly and through his IRA as well); rather, the court was troubled by the fact that these companies were almost exclusively the investments which the IDF manager chose to invest in after being told to do so by Lipkind or Chang following Webber’s mandate. When private company stock, membership interests, partnership interests, convertible debentures or warrants are invested in through the policy, it is very clear that they should not comprise a substantial majority of the policy investment assets on the long term time horizon if the policyholder (or policy funder in the case analogous to Webber) is an operator or affiliate of those companies.
There is a very old expression among tax lawyers which states that bad facts make bad law. However, in the case of the “tangled web” of Jeffrey Webber, there is actually good law which emanates from the extremely egregious and bad facts of the case, to wit: Guidance of how not to do things and how to get our clients to listen to us when we advise them that there are things which can be done and things which cannot be done without jeopardizing the integrity of the policy and the overall strategy.
Background
Without a doubt, the best source of guidance comes from the relevant Internal Revenue Code Sections and the applicable Treasury Regulations themselves. The critical road map to follow in understanding the taxation of the proposed transaction is as follows:
Taxation of Life Insurance – The tax law definition of life insurance is found in IRC Sec 7702. Most private placement contracts use the guideline premium test and cash value corridor test.
Variable Life Insurance – IRC Sec 817(h) provides guidelines for the taxation of variable insurance contracts. Under a variable insurance contract, the policyholder has the ability to select among various investment sub-accounts. The policyholder assumes all of the investment risk and receives a pass-through of the investment performance for the benefit of the insurance contract.
The insurance company owns the actual investment holdings in its “separate account” for the benefit of the variable insurance policyholder. Under state insurance law or the laws of the foreign jurisdiction, the investment assets in the separate account are separate or segregated from the Insurer’s general account assets. All of the investment gains and losses flow through to the Policy for the benefit of the policyholder. As a result, the Insurer’s creditors have no claim on separate account assets. Generally, there are no investment restrictions on the type of investments in the variable universal PPLI unlike the general account of life insurers.
The offshore life insurance Company which is issuing the proposed PPLI contract is a Company which makes an election to be taxed as a U.S. life insurance company pursuant to section 953(d) of the Internal Revenue Code (the “Code”). As a result, the life insurance company is
able to take reserves deduction under IRC Sec 807(b) equal to the amount of its investment income in its separate account. Most life insurers for PPLI establish a separate “separate account” for each policyholder. The life insurance company would not pay taxes on the business income that it receives from its ownership of closely held stock in its separate account holding.
IRC Sec 817(h) has diversification requirements that provide that no single assets in a fund represent more than 55% of the fund; two assets 70%; three assets 80% and four assets 90%. As a result, a fund within a PPLI contract must have a minimum of at least five different investments. Treasury regulation 1.817-5 provides a more detailed discussion of these variable insurance contract investments.
Treasury Regulation 1.817-5 is very revealing in this sense that is anticipates a much wider range of investments than what is customarily seen in retail variable insurance contracts. The range of investments discussion in the treasury regulations corresponded with the large amount of institutional private placement group variable deferred annuity contracts issued by life insurers such as John Hancock, Prudential, Travelers, Met Life, Aetna and others. The primary investors in these transactions were tax-exempt public and private pension plans, endowments and foundations subject to Unrelated Business Taxable Income (UBTI) without the benefit of these contracts. Under IRC Sec 512(a),”annuity” income is exempt from UBTI. The annuity contract converted the character of the income for tax purposes from what would have been taxable income into tax-exempt income.
These transactions have been completed on a direct basis “under the radar” screen with no agent involved in the transactions. These transactions have represented a wide range of alternative asset classes that would have been taxed as “business” income to the institutional investors.
The range of investments include the following:
A. Hedge Fund Management Company Interests
B. Private Equity Fund Management Company Interests
C. Oil and Gas
D. Hotel and Resort
E. Development real estate projects
F. Residential real estate
These investments characteristically represent “business” income without the benefit of the variable insurance contract. The treasury regulations support these types of investments allowing for a period of time to meet the diversification requirements of IRC Sec 817(h). For non-real estate accounts, the regulations provide for a one-year period to meet the diversification requirements. Real estate accounts provide for a five-year start up period and a two-year liquidation period. Furthermore, the diversification regulations provide that an account that was diversified will remain diversified but for appreciation or depreciation in a particular holding within the fund.
Tax Summary – The Insurance Company is technically and legally the Owner of the policy’s investment holdings. The Insurance Company regardless of the tax character of any income received is able to take a reserve’s deduction for its investment income under IRC Sec 807(b) regardless of the character of the income. The policyholder is not taxed on any of the income providing that the policy is tax qualified. In order for the PPLI contract to be tax-qualified it must meet the requirements of state insurance law and the Internal Revenue Code – IRC Sec 7702 and IRC Sec 817(h). For the life insurance policy owner, the policy cash value will accrue tax-free. Investment income within the policy is tax-free. The policy death benefit is income tax- free. Policy loans may be taken from the policy on a tax-free basis. If the policy is owned by an Irrevocable Trust, the death benefit is also estate tax free.
The treasury regulations do not limit and discuss a broad range of alternative investments. From a practical matter, a wide range of alternative investments has been owned within variable insurance contracts.
The ownership of closely held stock in any type of business (apparel, retail etc.) does not change the tax treatment of the insurance tax laws in any manner. Upon transfer to the offshore life insurance company, the insurance company will report this income and tax an
offsetting deduction for a contribution to reserves. The policyholder, your family trust, will be taxed under the insurance tax rules and not have any taxable income on the inside buildup of the cash value; the death benefit will be income tax-free; policy loans will be income tax-free and the death benefit will also be estate tax free.
Diversification of Investment Account
The structure of the insurance policy is designed and maintained so that the foreign insurance policy satisfies the requirements of Section 817(h) of the Code concerning investment diversification. The general diversification requirements state that no more than 55 percent of the aggregate value of the policy investment account may be invested in any single asset; not more than 70 percent of the total value in any two investments; and not more than 90 percent in any four investments. The diversification requirement is tested at the end of each calendar quarter over the life of the policy. However, this requirement does not apply during the first year of the policy’s existence. A hedge fund investment will normally satisfy these diversification requirements based on the portfolio investment strategy which is regularly employed and because of the substantial transactional nature of most hedge funds (funds generate substantial short-term capital gains from active trading of accounts in a wide variety of investment assets).
Diversification and Investor Control
If the policy owner holds the power to select a particular mutual fund or other investment asset (directly to indirectly), then: a) that fund must be adequately diversified, and
b) that fund may not be generally available to the public in any other form except for the purchase thereof via a life insurance or annuity contract. If the mutual fund selected by the policy owner directly (or in a manner whereby control is asserted over the investment advisor) is generally available to the public, then the Internal Revenue Service (“IRS” or “Service”) may deem that investment to be a single asset for diversification purposes and not “look-through” the mutual fund at its underlying assets to determine the adequacy of diversification. It is the Service’s position that at each situation in which a policy owner has the power to select specific investments, an independent portfolio is represented that must separately meet the diversification requirements. Therefore, it is possible that the Service will hold that an account is not diversified and attempt to disqualify the tax-free status of the policy of insurance where the policy owner selects the specific investments within the segregated account. Based upon these issues and the severity of the consequences of failing to comply with them, the policy should be purchased from an insurer which requires the appointment of an independent investment advisor (fund manager) who selects the individual investments within the segregated account and designs its portfolio strategy. That fund manager/investment advisor may then invest the segregated account assets into mutual funds or hedge funds which are available to the general public without any negative repercussions.
Investor Control Issues
Variable Life Insurance Policies (“VLI”) and Foreign Variable Life Insurance Policies (“FVLI) are designed to provide for the investment assets to be treated as owned by the insurance company (issuer) as part of a segregated asset account, rather than forming part of its general account, because of the desire to have the policy investment performance track the actual investment performance of the chosen portfolio of assets. In a general account product, the investment yields that are credited to the policy are based upon the yield of the total pool of assets held by the insurer. Likewise, general account assets are generally subject to the claims of insurer’s general creditors while segregated asset accounts are generally not so exposed. Notwithstanding these distinctions, it is the objective of the parties to the policy (the insurer, the insured, and the investment manager) to cause the assets of the segregated account to be treated as owned by the insurance company. If such treatment is obtained, then the income earned by the account assets is that of the insurance company and is not reportable as the income of the taxpayer.
The IRS has asserted, in a series of private and published rulings that, if a policy holder is in a position to exercise too much control over the specific investments within a policy’s segregated investment account, then that policy holder, rather than the insurer, will be considered as the owner of the assets, and the account income will be currently taxable to him or her in the year that the income is earned. In essence, the protective features of the
insurance policy as an insulator from income tax will be lost. The IRS has no legislative or statutory basis for the position that it has asserted, but it derives this position from various general tax law principles articulated by the courts over the past seventy-five years.
This “investor control” position of the IRS is primarily based on the theory that the policy holder who can dictate investment decisions and control day-to-day buying, selling, trading or holding strategies is in “constructive receipt” of the earnings within the segregated investment account. Moreover, the IRS position is somewhat based on the premise that the policy issuer is acting as the alter ego of the policy holder and as a mere conduit for carrying out the investment directions given by that policy holder. Under such circumstances, the Service has ruled that the policy holder’s position is substantially identical to that which his position would have been had the investment been directly maintained in an investment account in his own name.
The Service has ruled, however, that some degree of investor discretion is permissible but the level of policy holder (investor) involvement in investment decision making must be minimal and must not be exercisable at will. Likewise, the policy holder’s interest in the underlying assets of the separate account must be limited to a contractual claim against the insurance company for cash surrender value once the insurance contract is in force.
Regardless of whether the Service will or will not be flexible in allowing investor discretion and regardless of whether the investor control and constructive receipt theories of the Service apply to insurance policies after the enactment of Code Section 817(h) and 72(e)17 , a more conservative approach to FVLI is recommended for client use. In order to take a conservative, protective position on this issue, the policy recommended should be established with an independent investment advisor or hedge fund manager who will control and direct all investments made within the segregated policy investment account. The use of a pass-through entity such as a partnership, which qualifies for the look-through rule treatment discussed above, may be the most appropriate structure for the policy.
817(h) Treatment of Certain Non-diversified Contracts
(1) In General–For purposes of subchapter L, section 72 (relating to annuities) and section 7702(a) (relating to definition of life insurance contract) a variable contract (other than a pension plan contract) which is otherwise described in this Section and which is based on a segregated asset account shall not be treated as an annuity, endowment, or life insurance contract for any period (and any subsequent period) for which the investments made by such account are not, in accordance with regulations prescribed by the Secretary, adequately diversified:
(2) Safe Harbor for Diversification
A segregated asset account shall be treated as meeting the requirements of paragraph
(1) for any quarter of a taxable year if as the close of such quarter …
(a) it meets the requirements of section 851(b)(3), and
(b) no more that 55 percent of the value of the total assets of the account are assets described in section 851 (b )(3)(A)(i) …
The general diversification requirements of Treasury Regulation Section 1.817-5(b)(i) state that (A) no more than 55 percent of the aggregate value of the policy investment account may be invested in any single asset, (B) no more than 70 percent of the total value in any two investments; (C) no more than 80 percent in any three investment and (D) no more than 90 percent in any four investments. The diversification requirement is tested at the end of each calendar quarter over the life of the policy, however, this requirement does not apply during the first year of the policy’s existence. In addition, once the separate account has been determined to be diversified for purposes of section 817(h) it will not be deemed to lose such status during any subsequent period in which a re-testing and re-evaluation of its assets is required, merely because of the appreciation or depreciation in the value of assets which it owned at the time of a prior determination of qualification. Treasury Regulation s Section 1.817-5(d) provides the following rules which control this issue regarding the determination of status in circumstances where subsequent valuation changes occur in the assets of the separate account:
(d) MARKET FLUCTUATIONS. A segregated asset account that satisfies the requirements of paragraph (b) of this section at the end of any calendar quarter (or within 30 days after the end of such calendar quarter) shall not be considered non-diversified in a subsequent quarter because of a discrepancy between the value of its assets and the diversification requirements unless such discrepancy exists immediately after the acquisition of any asset and such discrepancy is wholly or partly the result of such acquisition.
1. I.R.C. § 514(g), enacted in 1984, directs the Secretary to “prescribe such regulations as may be necessary or appropriate to carry out the purposes of the [debt-financed income rules], including regulations to prevent the circumvention of any provision of this section through the use of segregated asset accounts.”
a. The Conference Committee Report .n the Tax Reform Act of 1984, which enacted I.R.C. § 514(g), states that any such regulations will be prospective in effect. H. Rep 96- 861, 98th Cong., 2d Sess. 1098.
b. Until recently, there had been no regulatory activity, and insurance companies were marketing such products.
2. I.R.C. § 817(h), also enacted in 1984, requires that investments underlying a variable contract must generally be diversified if such variable contract is to qualify as an annuity under the Code.
a. I.R.C. § 817(h) was enacted “in order to discourage the use of tax- preferred variable annuities and variable life insurance primarily as investment vehicles.” S. Rep. No. 98-169, vol. 1, 98th Cong., 2nd Sess. 546 (1984).
b. Under I.R.C. § 817(h)(1), a variable contract is not treated as an annuity, endowment, or life insurance contract unless the investments made by the segregated asset account on which such contract is based are “adequately diversified” in accordance with regulations.
c. Under Treas. Reg. § 1.817-5(b)(1), the assets of a “segregated asset account” will be treated as adequately diversified only if no more than 55% of the value of the
assets of the account is represented by anyone investment, no more than 70% by any two investments, no more than 80% by any three investments, and no more than 90% by any four investments.
The Regulations Promulgated by the Treasury Department With Respect to Diversification Provide Clear Authority for the Making of Investments Private Business Interests and Real Estate Properties (as well as Interests in such Properties), In a Private Placement Variable Life Structure.
I have set forth below a listing of the regulations issued under Treasury Regulation Sections 1.817-5(b) and 1.817-5(h) which are most pertinent to the analysis and answer to the question of whether such interests may be contained within the policy:
(b) DIVERSIFICATION OF INVESTMENTS–
(1) IN GENERAL.
(i) Except as otherwise provided in this paragraph and paragraph (c) of this section, the investments of a segregated asset account shall be considered adequately diversified for purposes of this section and section 817(h) only if–
(A) No more than 55% of the value of the total assets of the account is represented by any one investment;
(B) No more than 70% of the value of the total assets of the account is represented by any two investments;
(C) No more than 80% of the value of the total assets of the account is represented by any three investments; and
(D) No more than 90% of the value of the total assets of the account is represented by any four investments.
(ii) For purposes of this section–
(A) All securities of the same issuer, all interests in the same real property project, and all interests in the same commodity are each treated as a single investment; and
(B) In the case of government securities, each government agency or instrumentality shall be treated as a separate issuer.
(iii) See paragraph (f) of this section for circumstances in which a segregated asset account is treated as the owner of assets held indirectly through certain pass- through entities and corporations taxed under subchapter M, chapter 1 of the Code.
(h) DEFINITIONS. The terms defined below shall, for purposes of this section, have the meanings set forth in such definitions:
(1) GOVERNMENT SECURITY–
(i) GENERAL RULE. The term GOVERNMENT SECURITY shall mean any security issued or guaranteed or insured by the United States or an instrumentality of the United States; or any certificate of deposit for any of the foregoing. Any security or certificate or deposit insured or guaranteed only in part by the Unite States or an instrumentality thereof is treated as issued by the United States or its instrumentality only to the extent so insured or guaranteed, and as issued by the direct obligor to the extent not so insured or guaranteed. For purposes of this paragraph
(h) (1), an instrumentality of the United States shall mean any person that is treated for purpose of 15 U.S.C. 80a-2(16), as amended, as a person controlled or supervised by and acting as an instrumentality of the Government of the United States pursuant to authority granted by the Congress of the United States.
(ii) EXAMPLE. A segregated asset account purchases a certificate of deposit in the amount t of $150,000 from bank A. Deposits in bank A are insured by the Federal Deposit Insurance Corporation, an instrumentality of the United States, to the extent of $100,000 per
depositor. The certificate of deposit is treated as a government security to the extent of the $100,000 insured amount and, is treated as a security issued by bank A to the extent of the $50,000 excess of the value of the certificate of deposit over the insured amount.
(2) TREASURY SECURITY–
(i) GENERAL RULE. For purposes of paragraph (b) (3) of this section and section 817(h) (3), the term TREASURY SECURITY shall mean a security the direct obligor of which is the United States Treasury.
(ii) EXAMPLE. A segregated asset account purchases put and call options on U.S. Treasury securities issued by the Options Clearing Corporation. The options are not Treasury securities for purposes of paragraph (b) (3) and section 817(h) (3) because the direct obligor of the options is not the United States Treasury.
(3) REAL PROPERTY. The term REAL PROPERTY shall mean any property that is treated as real property under 1.856-3(d) except that it shall not include interests in real property.
(4) REAL PROPERTY ACCOUNT. A segregated asset account is a real property account on an anniversary of the account (within the meaning of paragraph (c) (2) (iii) of this section) or on the date a plan of liquidation is adopted if not less than the applicable percentage of the total assets of the account is represented by real property or interests in real property on such anniversary or date. For this purpose, the applicable percentage is 40% for the period ending on the first anniversary of the date on which premium income is first received, 50% for the year ending on the second anniversary, 60% for the year ending on the third anniversary, 70% for the year ending on the fourth anniversary, and 80% thereafter. A segregated asset account will also be treated as a real property account on its first anniversary if on or before such first anniversary the issuer has stated in the contract or prospectus or in a submission to a regulatory
agency, an intention that the assets of the account will be primarily invested in real property or interests in real property, provided that at least 40% of the total assets of the account are so invested within six months after such first anniversary.
(5) COMMODITY. The term COMMODITY shall mean any type of personal property other than a security.
(6) SECURITY. The term SECURITY shall include a cash item and any partnership interest registered under a Federal or State law regulating the offering or sale of securities. The term shall not include any other partnership interest, any interest in real property, or any interest in a commodity. Please note that all of your LLC business interests are deemed to be securities for State and federal Securities Law purposes, and by extension, they would be classified as securities for federal income tax purposes as well.
(7) INTEREST IN REAL PROPERTY. The term INTEREST IN REAL PROPERTY shall include the ownership and co-ownership of land or improvements thereon and leaseholds of land or improvements thereon. Such term shall not, however, include mineral, oil, or gas royalty interests, such as a retained economic interest in coal or iron ore with respect to which the special provisions of section 631(c) apply. The term “interest in real property” also shall include options to acquire land or improvements thereon, and options to acquire leaseholds of land or improvements thereon. Please note that all of your LLC and Limited Partnership and Tenant in Common business interests are deemed to be Interests in Real Property for purposes of this section.
(8) INTEREST IN A COMMODITY. The term INTEREST IN A COMMODITY shall include the ownership and co-ownership of any type of personal property other than a security, and any leaseholds thereof. Such term shall include mineral, oil, and gas royalty interests, including any fractional undivided interest therein.
Such term also shall include any put, call, straddle, option, or privilege on any type of personal property other than a security.
(9) VALUE. The term VALUE shall mean, with respect to investments for which market quotations are readily available, the market value of such investments; and with respect to other investments, fair value as determined in good faith by the managers of the segregated asset account.
(10) TERMS USED IN SECTION 851. To the extent not inconsistent with this paragraph (h) all terms used in this section shall have the same meaning as when used in section 851.
Analysis of Investor Control and Diversification with Regard to Private Placement Variable Life
Although the diversification rules have been in effect since 1984, concerns remain about the income tax treatment of variable life insurance contracts (and other variable contracts) due to the IRS’s publicly and privately expressed opinions.
In a series of rulings issued in the late 1970s and the early 1980s, the IRS took the general position that in some instances, the assets held in segregated asset accounts underlying variable contracts would be viewed for federal income tax purposes as owned by the holder of the variable contract and not by the issuer of the variable contract. As a result, any income with respect to those assets would be currently taxable to the contract holder as income in the taxable year in which the income was earned. The IRS can find no legislative basis for its position, but rather derives its position from various judicially articulated general tax law principles. The principal rulings, and the IRS’s reasoning, are described below.
Rev. Rul. 77–85, 1977–1 C.B. 12
Addressed whether a specific custodial account would be treated as a segregated asset account of an insurance company. By way of an arrangement among the insurance company, a policyholder, and a custodian, a custodial account was established in connection with the purchase of an investment annuity policy. After the purchase of the annuity, the policyholder made a deposit to the custodial account and, at his discretion, additional amounts could be deposited before the annuity starting date. The custodian invested the deposited amounts at the direction of the policyholder, although the policyholder was required to choose from a limited number of investments. In addition to being able to direct the custodian to sell, purchase, or exchange securities or other account assets, the policyholder could direct the investment and reinvestment of principal/income and control the voting of securities or exercise other rights associated with account assets. Although the policyholder could not receive any amount directly from the custodian, he could, before the annuity starting date, make a full or partial surrender of his policy, prompting the partial or complete liquidation of account assets. The IRS concluded that the custodial account could not be considered a segregated asset account of the insurance company because the policyholder, and not the insurance company, was the actual owner of the assets. The IRS stated the following:
Under the subject custodial arrangement, the bundle of rights that the individual policyholder has with respect to the assets in the custodial account makes such individual the owner of such assets for federal income tax purposes.
The fact that under state law such individual does not formally have legal title to such assets, or that for certain state insurance law purposes such assets are treated as assets in a separate asset account of an insurance company, is not controlling for federal income tax purposes. The IRS ruled that any interest, dividends, or other income received by the custodian with respect to the securities or other assets held in the account would be includible in the gross income of the policyholder in the year of receipt by the custodian.
Several years later, the IRS issued a similar ruling with respect to the ownership of certain savings and loan accounts. The facts of Rev. Rul. 80–274, 1980–2 C.B. 27., indicate that an insurance company, upon selling an annuity contract to an existing or prospective depositor of the savings and loan institution (“S & L”), would place the funds received in consideration for the contract (reduced by certain fees) in a certificate of deposit issued by the S & L for a term designated by the contract holder. On expiration of the CD, the insurance company would reinvest the proceeds in another CD unless the additional term would expire after the annuity starting date; in those circumstances, the funds would be placed in a passbook savings account. The annuity contract holder could transfer additional amounts to the insurance company as consideration for the contract, and before the annuity starting date, the contract holder could surrender part or all of the contract in exchange for its cash value. Under the terms of the agreement between the insurance company and the S & L, the insurance company could not dispose of the deposit or convert it into a different asset (other than another CD or a passbook savings account). Further, the insurance company was prohibited from using the CD for any purpose other than to benefit the particular policyholder.
In concluding that the insurance company was little more than a conduit between the contract holder and the S & L, the IRS noted that the “policyholder’s position is substantially identical to what the policyholder’s position would have been had the investment been directly maintained or established with the savings and loan association.” The IRS went on to rule that the policyholder, not the insurance company, was the owner of the CD for federal income tax purposes; thus, interest earned on the account was includible in the gross income of the contract holder.
Rev. Rul. 81–225, 1981-2 C.B. 13, amplified and clarified by Rev. Rul. 2003-92, 2003-33
I.R.B. 350, and by Rev. Rul. 2007-7, 2007-7 I.R.B. 468, is generally regarded as the principal IRS ruling reflecting its position on investor control of separate account assets. In this ruling, the IRS set forth a series of factual circumstances for purposes of determining whether mutual fund shares underlying an annuity contract would be considered as owned by the contract holder or the issuing life insurance company for federal income tax purposes.
In Rev. Rul. 2003-91, 2003-33 I.R.B. 347, applied in, for example, PLR 201502003 and PLR 200915006. 551 and in Rev. Rul. 2003-92 2003-33 I.R.B. 350 (which amplifies and clarifies Rev. Rul. 81-225), the IRS supplemented the guidance provided in Rev. Rul. 81-225, addressing the circumstances under which the owner/holder of a variable life insurance contract or a variable annuity contract is considered the owner of the assets that fund the variable contracts
(unspecified assets in Rev. Rul. 2003-91; interests in unregistered private investment partnerships in Rev. Rul. 2003-92).
Rev. Rul. 2007-7, 2007-7 I.R.B. 468 further clarified Rev. Rul. 81-225 and Rev. Rul. 2003-92, in ruling that the holder of a variable annuity or life insurance contract is not treated as the owner of an interest in a regulated investment company that funds the variable contract solely because interests in the same regulated investment company are also available to investors described in Reg. § 1.817-5(f)(3).
The essence of Rev. Rul. 81-225 proved persuasive to the Eight Circuit in Christoffersen v. United States, 749 F.2d 513 (8th Cir. 1984). In that case, the taxpayer purchased a contract entitling him to buy an annuity in 2021. At his direction, the consideration was invested in a publicly-available mutual fund. He directed that income from the investment for the year 1981 be reinvested, and he reported the income on his joint return. He then filed an amended return requesting a refund for the “erroneous” income inclusion, and the IRS denied the request, prompting the taxpayer to file a refund suit. The court noted that the taxpayer had the right to choose which mutual fund to invest in and could change to another fund at any time. The court also noted that although the taxpayer had to bear the full investment risk, he could withdraw any or all of his investment upon seven days’ prior notice. The court held that the taxpayer was the beneficial owner of the investment funds, noting the following:
Although [the insurance company] maintains the shares in its name, the Christoffersens are the beneficial owners of the investment funds held in [their account]. * * * The Christoffersens have surrendered few of the rights of ownership or control over the assets of the subaccount. *
* * The payment of annuity premiums, management fees and the limitation of withdrawals to cash, rather than shares, do not reflect a lack of ownership or control. * * * In addition, the possibility that the assets will be converted into an annuity in 2021 does not significantly impair the Christoffersens’ ownership since all, or any portion, of the assets may be withdrawn before that time. 749 F. 2d at 515-516.
The Christoffersen decision has never been expressly overruled. At least one court, however, has taken a position contrary to that of the Eight Circuit in Christoffersen. Although the decision may have relatively little precedential value, the court in Investment Annuity Inc. v. Blumenthal, 442 F. Supp. 681 (D.D.C.), rev’d on other grounds, 609 F.2d 1 (D.C. Cir. 1979), held that investment annuity policyholders were not the owners of separate account assets, despite the fact that they had retained substantial rights in account assets. The court emphasized that “ [w]hile [the policyholders] retain investment control over the account assets, they by no means retain control over such assets ‘in all essential respects’ as before the investment. * * * [They are] unable to receive the account assets back in kind should they exercise their cash surrender option, and they may not receive any amount directly from the account.” Id. at 690 The court further pointed out that after annuitization, the policyholder did not have the right to receive the liquidated value of the account assets and that “[w]hile the ability to control investment decisions is one attribute of ownership, it is not necessarily determinative of ownership.” Id. At 691
Whatever the precise import of the conflict between these two decisions, it remains true that many of the principles relied on by the Christoffersen court are cornerstones of tax jurisprudence. The Supreme Court noted in Poe v. Seaborn 282 U.S. 101 (1930), that taxation follows ownership in the federal tax arena. Under the federal tax scheme, actual ownership of property is more than a matter of mere legal title, and the courts have repeatedly noted that title and beneficial ownership may be held by different persons. See, e.g., Holbrook v. Commissioner, 450 F.2d 134, 141 (5th Cir. 1971); Rupe Inv. Corp. v. Commissioner, 266 F.2d
624, 630 (5th Cir. 1959).
Where that is the case, beneficial ownership governs for tax purposes, and courts have repeatedly emphasized that “taxation is not so much concerned with nice refinements of title as it is with actual command over property.” The Supreme Court has further noted the following:
[I]t makes no difference that such “command” may be exercised through specific retention of legal title or the creation of a new equitable but controlled interest, or the maintenance of effective benefit through the interposition of a subservient agency. Griffiths v. Helvering, 308
U.S. 355, 357–58 (1939). See also Helvering v. Clifford, 309 U.S. 331 (1940) (where “the benefits directly or indirectly retained blend so imperceptibly with the normal concepts of full ownership, we cannot say that the triers of fact committed reversible error when they found that the husband was the owner of the [trust] corpus”); Holbrook v. Commissioner, 450 F.2d 134 (5th Cir. 1971) (noting that “[t]he mere transfer of bare legal title to property is not enough to constitute a ‘sale’ for income tax purposes if the transferor continues to exercise virtually all his former control, and stands in the same economic position as he did prior to the transfer”).
Along these lines, courts emphasize that “property” comprises a bundle of rights; “ownership” refers to those rights. DeGuire v. Higgins, 159 F.2d 921 (2d Cir. 1947). Where some, but not all, ownership rights have been transferred, it is necessary to compare the rights retained with those transferred in determining which person or entity owns the property and is therefore subject to tax on income with respect thereto. Applying this approach in Helvering v. Clifford, the Supreme Court noted the following in assessing the actual ownership of assets held in trust:
So far as his dominion and control were concerned, it seems clear that the trust did not effect any substantial change. In substance his control over the corpus was in all essential respects the same after the trust was created, as before. The wide powers which he retained included for all practical purposes most of the control which he as an individual would have.
There were, we may assume, exceptions, such as his disability to make a gift of the corpus to others during the term of the trust and to make loans to himself. But this dilution of his control would seem to be insignificant and immaterial, since control over the investment remained.
309 U.S. at 335. The Court concluded that because the rights retained by the grantor of the trust were significant, he could properly be treated as the owner, notwithstanding the fact that the trust itself was otherwise valid.
In the context of private placement variable life insurance, Webber v. Commissioner, 144 T.C. No. 17 (June 30, 2015), where the taxpayer retained significant control over the segregated asset accounts that were held for the benefit of the life insurance policies. The accounts purchased investments in startup companies with which the taxpayer was intimately familiar and in which he otherwise invested personally and through private-equity funds he managed. The court stated that the core “incident of ownership” is the power to select investment assets by directing the purchase, sale, and exchange of particular securities, and that other incidents included the power to vote securities and exercise other rights relative to those investments; the power to extract money from the account by withdrawal or other means; and the power to derive the “effective benefit” from the underlying assets. The purported investment manager appeared to take detailed directions from the taxpayer and performed little due diligence or investment research. In a fact-heavy opinion, the court concluded that the taxpayer held significant incidents of ownership over the assets.
While these decisions indicate that a given transfer may result ultimately in the transferor being considered the beneficial owner of the subject property, the courts have noted that “no one factor is normally decisive but that all considerations and circumstances . . . are relevant to the question of ownership.” Hash v. Commissioner, 152 F.2d 722 (4th Cir. 1945).
Private Placement Variable Life Insurance’s (PPVLI’s) Basic Premise and Value Proposition as an Estate and Income Tax Planning Tool
A variable life insurance policy is a cash-value policy with an investment component allowing the owner to allocate premium dollars to a separate account comprised of stocks, bonds, funds, and other investments within the insurance company’s portfolio. A private placement life insurance policy (PPLI) is a type of variable life insurance policy where the investments within each policy are customized and are not limited to the insurance company’s portfolio of investments. If the assets in the separate accounts perform well, the policy’s value may substantially exceed its minimum death benefit. Upon the insured’s death, the beneficiary receives the greater of the minimum death benefit or the value of the separate account, each of which is income tax free based upon Code Section 101(a). If owned by a properly designed irrevocable life insurance trust, the death benefits and all of the earnings will likewise be estate tax free. There are many ways in which the grantor of the life insurance trust can retain a route to access the growth within a PPLI. However, in a post-Webber world (as such will ultimately come to exist after the speculated retrial following the appeal), the taxpayer/ grantor/ funder/ insured and his or her advisors will have to make certain that the Trust is structured as a Non- Grantor Trust for income tax purposes.
Before and after the decision in Webber, I have worked with others, to design a series of rules and one or more sets of protocols designed to be “best practices”. These would certainly serve the purpose of assuring (or in some cases, determining) whether or not an IDF, and the policy within which it resides will pass muster for federal income tax purposes, to wit: whether or not the policy of insurance which owns the investment assets that are a part of the IDF, will be found to be a compliant policy, for purposes of sections 72 and 817 of the Internal Revenue Code, of 1986 as amended (the “Code). Webber provides the PPLI and advisory/ planning community with some long awaited guidance with respect to the Investor Control Doctrine, as well as an assurance that the Diversification Rules of Code Section 817(h) was not intended to dispose of the Investor Control Doctrine in determining who is the owner of the assets in a variable life or annuity product for income tax purposes, and who will be taxed on the income and gains produced thereby. See, Beers D., “Tax Court Says ‘Investor Control” Doctrine Still Relevant To Taxation of Private Placement Variable Life Insurance, 34 TMWR 1496 (11/16/2015).
The Basic Facts of Webber Jeffrey T. Webber (“Webber”), a successful private-equity investor, upon the recommendation of his tax advisers, including estate planning attorney, William Lipkind, purchased two PPLI policies as one part of an overall tax planning structure, in 1998. It involved the use of an Alaska Trust and two private placement variable universal life insurance policies, insuring the lives of two elderly relatives of Webber. As such, it is readily apparent that the primary objective of the plan was the avoidance of the income tax, in what can only be deemed to be a permanent tax avoidance plan. The policies were not for estate planning purposes, as they were not on the life of either Mr. Webber or his spouse (who he was later divorcing from), rather, they were on elderly relatives of Mr. Webber. Therefore, Mr. Webber and Mr. Lipkind designed the ultimate in wealth enhancement planning for permanent income tax deferral and avoidance. The plan as designed would result in both tax-free growth of the investment assets during the lives of Elder 1 and Elder 2 followed by a tax-free death benefit at their respective deaths. A bit mercenary but certainly creative from a tax planning perspective, to say the least.
In 1999, Webber contributed $700,000 to a grantor trust in which the trustee purchased the two “Flexible Premium Restricted Lifetime Benefit Variable Life Insurance Policies” (the policies) from Lighthouse, a life insurance company based in the Cayman Islands. The beneficiaries of the policies were Webber’s children, his brother, and his brother’s children.
Forms 709, United States Gift (and Generation-Skipping Transfer) Tax Return, were timely filed reporting the completed gifts. The policies each had a minimum guaranteed death benefit of $2,720,000. After subtracting administrative fees, the premiums were allocated to separate accounts for each policy. Lighthouse did not provide investment advice but permitted the policyholder to select an investment manager (IDF Manager) from an approved list. Webber selected Bank of Butterfield, an investment management company, and paid the company a nominal fee ($500.00 per annum per IDF).
Some terms of the policies included that: No one but the investment manager may direct investments; the policyholder could transmit “general investment objectives and guidelines”; the policyholder was allowed to offer specific investment recommendations to the investment manager, but the investment manager was free to ignore those recommendations and was supposed to conduct independent due diligence before investing in any non-publicly traded security. Shortly after the premiums were paid, the accounts purchased some stock that Webber owned in three startup companies for $2,240,000. Given that he had only paid $700,000 to the accounts via premiums, Webber speculated that this transaction was an installment sale.
Not long after the purchase, each of the three companies had a liquidity event, either an IPO or direct sale, which enabled the separate accounts to sell the shares at a substantial gain. Those profits were used to purchase other investments, although it is unclear how many. But the accounts held investments in 42 companies during 2006 and 2007, the years covered by the case, and at the end of 2007, somehow these accounts had a minimum of $12.3 million in assets.
Control or No Control over Investment Decisions
According to the Court, Mr. Lipkind recommended the PPLI structure to Webber and provided insulation to avoid direct contact between Webber and Butterfield so that Webber would not appear to exercise any control over the investments. However, the evidence reflected extensive communications between Webber, the lawyer, and the personnel of every target investment. By and large, the body of this communication showed that, in no uncertain terms, Webber was in control of all investment decisions. The Tax Court noted the following specific evidences, although the detail and depiction is quite extensive, it all leads to the same conclusion and the basic parameters which do so are as follows: Webber recommended every investment made by the accounts; virtually every security the accounts held was issued by a startup company in which Webber had a personal financial interest; the investment manager did no independent research or due diligence about these “fledgling” companies, aside from boilerplate document requests; and the investment manager was paid $500 annually for its services.
The Court’s Analysis and Conclusion
Whether a taxpayer has retained significant incidents of ownership over assets is determined on a case-by-case basis, taking into account all of the relevant facts and circumstances. The core incident of ownership is the power to select investment assets by directing the purchase, sale, and exchange of particular securities. Other incidents of ownership include the power to vote securities and exercise other rights relative to those investments; the power to extract money from the account by withdrawal or other means; and the power to derive “effective benefit” from the underlying assets. The court determined that Webber enjoyed all of these powers over the assets in the accounts. The court specifically determined the following problematic retained powers which would call a “Policyholder” to be deemed the owner of the investments within the policies.
The Court found that these basic powers, in addition to a variety of other enumerated and implied powers caused Mr. Webber to be the owner of the policy’s investments rather than the insurer, Lighthouse: The power to direct investments and control the voting of the shares of the various companies in which the funds invested: Webber enjoyed an unfettered ability to select investments by directing the investment manager to buy, sell, and exchange securities; although the policies purported to give the investment manager complete discretion to select investments, in practice this restriction meant nothing; and the investment manager acted merely as a rubber stamp for Webber’s “recommendations,” which were found to have been equivalent to directives. Webber enjoyed and retained the power to vote shares and exercise other options with regard to the investee companies. Webber repeatedly directed what actions the accounts would take for their ongoing investments, and the investment managers took no action without a signoff from Lipkind or Susan Chang, who was Webber’s personal accountant and agent. Moreover, the Tax Court found numerous examples of Webber exercising these powers, vote concerning an amendment to a certificate of incorporation and participation in a second round of financing; the manner in which the accounts should respond to capital calls; direction regarding whether the accounts should participate in bridge financing; the retained right to give direction regarding whether the accounts should take their pro rata share of newer and later rounds of financing of the companies series D financing; and the power to direct whether certain convertible and nonconvertible notes owned by the IDF in its investment accounts should be converted from debt to equity.
A basic premise in the construct of most life insurance contracts that are not treated as Modified Endowment Contracts (“MEC”s) under Code Section 7702A is the power to borrow cash from the policy and be charged interest by the carrier (a portion of which is credited to the policy) and to never pay it back until the point in time when the death event occurs and the loan reduces the cash value and death benefit payout to the policy beneficiaries. As such, the loan mechanism allows for Policyholder to reach most of the cash value and never pay it back. As this cash value includes the accumulated earnings inside the contract, the policy’s tax deferred earnings (“inside build-up”) can be accessed and is never taxed unless the contract lapses. Webber caused the policy to indirectly give him access to the cash in a different manner, which served to foster the Court’s conclusion that he was the owner of the investment assets and the earnings all-the-more-so. Rather than doing it the “customary way” via loan, Mr.
Webber did the following shortly after one of the policy investments experienced a liquidity event in order to access cash:
Shortly after the policies were initiated, Webber sold shares of startup companies to the accounts for $2,240,000.00. Because of the fact that the companies were startups, their shares could not be sold on any established market, and there would be a substantial marketability discount applied, these shares would have sold on the open market, if one even existed, at a substantial discount; Webber took out and accessed the cash by directing the IDF Manager to make a $450,000.00 loan to his corporation, for an investment he wished to make. Why would some adviser not advise Mr. Webber that the proper thing to do was to have the Trustee of the trust borrow from the policy and make the loan to Mr. Webber’s corporation? That would have been the proper manner in which to access the cash of the Policy subaccount.
In 2006, Webber again accessed the policy separate account for $50,000.00 by directing the investment manager to purchase a promissory note from him from an investee company, and in 2007, Webber accessed $386,600.00 from the accounts by directing the IDF Manager to purchase from him promissory notes from an investee company, and also to lend that amount to an investee company, which enabled that company to repay its $200,000.00 promissory note to him. Moreover, Mr. Webber retained a variety of other powers which entitled him to derive benefits from the policies and the profits in the subaccounts. Webber used the accounts to finance personal investments, including a winery, a resort in Big Sur, Calif., and a Canadian hunting lodge. In fact, the account investments mirrored or complemented the investments in his personal portfolio and the portfolios of the private-equity funds he managed; and Webber regularly used the separate accounts synergistically to bolster his other positions and his negotiating leverage vis-à-vis the companies in which the subaccounts were investing and upon the boards on which Webber served.
As a result of these various actions and retained rights (both expressed and implied), the U.S. Tax Court reaches an undeniable conclusion that the Taxpayer, rather than the insurance company and the policy segregated account, was the owner of the income within the policy due to the retention of too much control over the assets in the segregated account. The Court ruled that Mr. Webber, on both an implicit (perhaps read as preconceived), applied and de facto basis had control over the investments within the policy and the decision making with respect thereto, rather than the IDF manager or the insurance company, Lighthouse Insurance. In the
course of rendering this opinion, the Tax Court has provided a sense of greater certainty with regard to one issue and a great deal more clarity with regard to another. The former, is the issue of whether the enactment of the “Diversification Rules” of Code section 817(h) in 1984 [FN], eliminated the Investor Control Doctrine and its applicability, or not. The Court has clearly indicated that it does not believe that Taxpayers and their counsel are correct on that front. The latter issue is potentially somewhat more subtle and deals with the operations and underpinnings of practices and procedures with regard to PPLI policies and IDFs, etc.
In the case of Mr. Webber, however, the court found his conduct and that of his advisors to be so transparent with regard to who was pulling the string and who was the puppet applying the rubber stamp and found that based upon the facts at hand, the policyholder would be deemed the owner of the policy. However, Mr. Webber was not even the policyholder, nor was he the insured under either of the policies. He was, however, the grantor and deemed owner of the irrevocable life insurance trusts that owned the policies. The court found the conduct in this case to be egregious enough not to even look to, or even discuss the grantor trust rules, other than in a tangential or parenthetical fashion, and found that Mr. Webber was the owner of the assets and the income thereon within the policy (as opposed to the insurer) based upon the facts outlined above. In ruling the way that it did, the Tax Court provided some much needed sense of guidance for the insurance companies which issue these policies, attorneys and CPAs and others who advise clients with regard to the uses of Private Placement Life Insurance for Income and Estate Tax purposes.
This new guidance is something which we have not seen in the history of the PPLI industry (whether the companies are based in the U.S. Onshore or Offshore) and which has been much needed for a very long time, namely: a set of basic principles with regard to the conduct of an insurance dedicated fund (“IDF”) and the interaction between the policyholder/ owner of the policy and the insurer and the IDF Manager, in a manner which will allow the professional advisors who deal with these policies and the clients for whom we establish them, to establish a set of “best practices, policies, procedures and protocols” for our clients to implement. To date, there has been no case which has dealt with the subject matter of the Investor Control Doctrine subsequent to Christoffersen, Supra. Moreover, there has never been
a case which dealt with Investor Control doctrine issues following the enactment of the so- called “Diversification Rules” of Code section 817(h). For many years there has been debate, within the community of tax planning attorneys and other advisors who work with PPLI, as to the continuing validity of and the need to be concerned with, the Investor Control Doctrine, discussed earlier in this analysis.
Impact of Post-Christoffersen legislation Before Rev. Rul. Rev. Rul. 2003-91 and Rev. Rul. 2003-92 were issued, some had suggested that enactment of the diversification requirements under § 817 (and other measures) effectively rendered Christoffersen (and, necessarily, Rev. Rul. 81-225) obsolete. See, e.g., ABA Section of Taxation, Committee on Insurance Companies, A Roadmap to the Federal Income Taxation of Non-Qualified Annuity Contracts, 45 Tax Law. 123 (1991).
This view was supported by language from the General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984 (“DEFRA Blue Book”) indicating that Congress introduced diversification requirements under § 817(h) to address any and all concerns with respect to investor control of assets underlying variable contracts. The Joint Committee on Taxation stated the following:
In authorizing Treasury to prescribe diversification standards, the Congress intended that the standards be designed to deny annuity or life insurance treatment for investments that are publicly available to investors and investments which are made, in effect, at the direction of the investor. Thus, annuity or life insurance treatment will be denied to variable contracts (1) that are equivalent to investments in one or a relatively small number of particular assets (e.g., stocks, bonds, or certificates of deposit of a single issuer); (2) that invest in one or a relatively small number of publicly available mutual funds; (3) that invest in one or a relatively small number of specific properties (whether real or personal); or (4) that invest in a non-diversified pool of mortgage-type investments. Joint Committee on Taxation, General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984 at 608 (“DEFRA Blue Book”).
However, it should be noted that when the Treasury Department issued proposed regulations for Section 817(h), it specifically sidestepped the investor control issue. In the
preamble to the regulations, the Treasury expressly noted that the regulations “do not provide guidance concerning the circumstances in which investor control of the investments of a segregated asset account may cause the investor, rather than the insurance company, to be treated as the owner of the asset in the account.” 51 Fed. Reg. 32664 (Sept. 5, 1986). The preamble to those never finalized regulations went on to state that guidance on this issue would be provided in subsequent regulations or revenue rulings. The IRS later issued Rev. Rul. Rev. Rul. 2003-91 and Rev. Rul. 2003-92, which indicated that there was and still is flexibility in regard to the issue of Investor Control.
Some IRS Flexibility Presumed from Absence of Any Prohibition on In-Kind Premium Contribution and other Factors
Although Christoffersen, other decisions, and several of the rulings issued by the IRS threaten unfavorable tax results where the purchaser of a variable contract is able to exercise some degree of investment discretion, the IRS has issued revenue rulings indicating that some degree of investor discretion is permissible.
In Rev. Rul. 82-54, 1982-1 C.B. 11, an insurance company issuing deferred annuity contracts was found to be the owner of assets underlying a segregated asset account. Under the terms of the annuity contracts, account funds were to be invested, as the contract holder directed, in shares of any or all of three open-end diversified management investment companies (i.e., mutual funds); each mutual fund adopted a different investment strategy (e.g., stock, bonds, money market instruments). Contract holders were free to allocate and reallocate their purchase payments among the various mutual funds before the contract’s maturity date. The insurance company served as investment advisor for each of the mutual funds, and shares of the mutual funds were not available for sale to the general public (but were available to the segregated account and other segregated accounts, excluding those described in Rev. Rul. 70- 525).
In concluding that the insurance company was the owner of the account assets, the IRS noted that “the [contract holder’s] ability to choose among broad, general investment strategies such as stocks, bonds or money market instruments, either at the time of the initial purchase or subsequent thereto, does not constitute sufficient control over individual investment decisions so as to cause ownership of the private mutual fund shares to be attributable to the [contract holder].” The IRS ruled similarly in PLR 8427085, which addressed the investor control issue in the context of the issuance of variable life insurance contracts. In the ruling, a corporation issued variable life insurance contracts to contract owners. The premiums received for the contract were allocated to a separate account with three divisions. Each division invested assets in the corresponding portfolio of a non-public mutual fund (“Funds”). Contract owners had the right to allocate net premiums among the three divisions. The insurance company had the right to add or remove investment divisions, to transfer the assets of the separate account to another separate account (of that company), and the right to transfer assets of an investment division in excess of reserves and other contract liabilities to another investment division or to the company’s general account. In addition to being able to choose among broad investment strategies (e.g., stock, bonds, etc.), the contract owners had the right to surrender their policies at any time before the death of the insured and receive the cash value, less any unpaid policy loan balance. The insurance company represented that no contract owner had legally binding rights to require the insurance company, the separate account, or the Fund to acquire any particular assets and that there was no prearranged plan to that effect. After briefly discussing the various investor control revenue rulings, the IRS concluded that the fund (or portfolio) was the owner of the assets and that income, gain, or loss was includible in the computation of the Fund’s income. Further, the stock of the Fund held by the insurance company was determined to be owned by the insurance company (and not the contract owner), and income, gain, or loss was properly includible in the calculation of the income of the insurance company (and not the contract owner). See also PLR 201436005 (variable contract holders not owners of investment series insurance company segregated asset accounts where no exercise of control over fund’s activities exists); PLR 201240018 (insurer owns investments where factors such as passing of legal title, rights of possession, benefits and burdens of ownership so indicate); PLR 200915006 (where Fund is available only to insurance company segregated asset accounts and will invest in assets (regulated investment companies and ETFs) that are available to the general public, Fund’s investments in such assets will not cause variable contract holders to be treated as owners of Fund’s shares for federal income tax purposes). PLR 8427091 (involving facts identical to those in PLR 8427085, however, there was no incorporation of a specific individual contract owner; thus, the ruling was stated in general terms (i.e., assets/stock not owned by “any policyholder, or by any annuitant or beneficiary”)).
The IRS ruled similarly again in Situation 3 of Rev. Rul. 2003-92, which is set forth below and discussed in greater detail. In Rev. Rul. 82-55, 1982-1 C.B. 12. issued to clarify Rev. Rul. 81-225, the IRS noted that if a mutual fund was currently available to the general public as well as annuity purchasers and was later closed to further purchase by the public, purchasers of annuity contracts after the date of closure would not be considered owners of the mutual fund shares. Those holding contracts both before the date of closure and after 1980 would be considered owners of the mutual fund shares. Closure is not deemed to occur unless existing public shareholders can invest in the mutual fund only by dividend reinvestment or through the purchase of an annuity contract.
Given the high degree of taxpayer uncertainty with respect to asset ownership in the variable contract context, the IRS issued several letter rulings setting forth the various representations it would require if asked to rule that the insurance company, and not the policyholder, owned the assets of the segregated asset account supporting a variable life insurance or variable annuity contract. See, e.g., PLR 8427085, PLR 8427091, and PLR 8335124. The representations embody the IRS’s views as to the permissible limits of a variable contract owner’s control over separate account investments, but these positions may or may not withstand litigation challenge. The relevant representations required by the IRS are, in substance, as follows:
• No policyholder will have a legally binding right to require the insurance company or separate account to acquire any particular investment item with premiums or other amounts paid to, or earned by the insurance company and/or separate account or to invest any premiums or other amounts they receive in any particular investment item. However, policyholders may be informed of the general investment strategy to be followed.
• Policyholders will be permitted to choose among broad investment strategies such as, for example, stocks, bonds, money market instruments, instruments of financial institutions (that is, savings and loan associations, banks, and savings banks), instruments of governmental bodies, U.S. Government securities, state government securities, foreign government securities, real property, and commodities.
• No policyholder will have any legal, equitable, direct, indirect, or other interest in any specific investment item held by the insurance company and/or the separate account.
• A policyholder will have only a contractual claim against the insurance company and/or the separate account for cash as a result of purchasing the life insurance contract.
Over course of several years, the IRS issued several private rulings with respect to the investor control issues, before finally issuing Rev. Rul. 2003-91 and Rev. Rul. 2003-92. See, e.g., PLR 8820046 (concluding that the contract owners were not the owners of any assets or stock held in connection with the funding of their annuity contracts), and PLR 8820044 (indicating, with respect to PLR 8820046, that the addition of new sub-accounts and two corresponding portfolios in the fund would not result in a change in the rulings issued previously).
In Rev. Rul. 2003-91, the assets that fund the variable contracts are held in different accounts that are maintained separately from those holding the assets that fund the issuer’s traditional life insurance products. The accounts are divided into subaccounts, each offering a different investment strategy, which are available only through the purchase of a variable contract. The purchaser of a variable life insurance or annuity contract (Holder) specifies the premium allocation among the sub-accounts, may change the allocation, and may transfer funds among subaccounts, but has no legal, equitable, direct or indirect interest in any of the assets and may not select or recommend investments or investment strategies. On these facts, the IRS ruled that Holder will not be considered the owner of the assets that fund the contract; therefore, income derived from the assets is not included in Holder’s gross income in the year it is earned. Rev. Rul. 2003-91, 2003-33 I.R.B. 347. See, e.g., PLR 201502003 (where the segregated asset accounts supporting taxpayer’s universal variable life insurance policies invest only in insurance dedicated funds (IDFs) and the facts and circumstances indicate that taxpayer did not possess significant control over the IDF assets once the assets are a part of the IDF and the insurance contract, the life insurance company — not the taxpayer — is the owner of the assets for federal income tax purposes); PLR 201436005 (variable contract holders not owners of investment series insurance company segregated asset accounts where no exercise of control over fund’s activities exists); PLR 200938006 (where fund is available only to insurance company segregated asset accounts or other permissible investors, and invests in regulated investment companies and other pooled investment vehicles available to general public, variable contract holder has no more control over assets held under contract than was case in Rev. Rul. 2003-91); PLR 200701016 (where life insurance company alone has complete control to acquire and dispose of an account’s investment assets and a contract owner cannot select an account’s particular investments and has no right to have the investment objective of the accounts changed, life insurance company, and not contract-holders, is considered owner of underlying investment assets of annuities); PLR 200601007 (taxpayer-issuer not considered owner of underlying assets where assets were available for purchase by public directly, contracts did not comply with § 72(s) or the diversification requirements, and did not qualify as pension plan contracts or variable contracts); PLR 200601006 (contract holders not considered owners of subaccount assets invested according to holder’s approximate year of retirement because owner lacked sufficient investment control and other incidents of ownership and shares were not sold to general public); PLR 200420017 (variable contract owners not considered owners of the underlying investments, where owner is not able to direct portfolio’s investment in any particular portfolio asset and all investment decisions are made by an investment manager of the insurance company).
In an effort to amplify and clarify Rev. Rul. 81-225 and Rev. Rul. 2003-91 and 2003-92, the IRS issued Rev. Rul. 2007-7, 2007-7 I.R.B. 468. In that Revenue Ruling whereby an individual bought a variable contract within the meaning of § 817(d) from a life insurance company. All assets funding the contract were held in a segregated asset account that invested in a regulated investment company (RIC). All the beneficial interests in the RIC were held by one or more segregated asset accounts of the insurance company, or by investors described in Reg. § 1.817- 5(f)(3). Public access to the RIC was available exclusively either through the purchase of a variable contract, or to investors described in Reg. § 1.817-5(f)(3). The IRS ruled that the holder of a variable annuity or life insurance contract is not treated as the owner of an interest in a RIC that funds the variable contract solely because interests in the same RIC are also available to investors described in Reg. § 1.817-5(f)(3). The IRS explained that investors described in Reg. § 1.817-5(f)(3) are not members of the “general public” as that term is used in Rev. Rul. 2003-92 and Rev. Rul. 81-225. The IRS reasoned that all of the beneficial interests in the RIC were held by one or more segregated asset accounts of the insurance company, or by investors described in Reg. § 1.817-5(f)(3), and public access to the RIC is available exclusively either through the purchase of a variable contract, or to investors described in Reg. § 1.817-5(f)(3). Accordingly, the IRS ruled that interests in the RIC are not available to the “general public” as that term is used in Rev. Rul. 2003-92 and Rev. Rul. 81-225, and the taxpayer is not treated as the owner of an interest in a RIC that funds the variable contract.
Does the fact that an IDF Account is held for the Benefit of Single Customer or Policy Matter?
The IRS has ruled that account assets will not be deemed to be owned by a single customer solely because that account was established for that customer’s sole benefit. In PLR 9433030, an insurer issued a number of variable universal life insurance policies to an individual employer (“policy owner”) to insure the lives of each of the policy owner’s directors. The premiums paid to the insurer were initially placed in a “Right to Return Division” and, after expiration of the premium refund period, were placed in the Policy Owner’s Special Division, a separate account existing solely for the benefit of that policy owner. The separate account was non-public and was available to the policy owner only through its ownership of the policy. The policy owner was allowed to allocate the amounts in the separate account (no more than four times per year) to various account Segments (i.e., Short-term Bond, Common Stock, Intermediate Bond, and Money Market). Before purchasing the policy, the policy owner agreed with the insurer on the broad investment guidelines relating to each of the four segments within each separate account. Although the policy owner had the right to allocate premiums and contract values among the broad investment guideline segments, the insurer held the sole and absolute discretion to make all investment decisions. Further, “the insurer represented to the IRS that the policy owner, including any of its officers, directors, employees, or agents, would not communicate directly or indirectly with any “investment officer” of the insurer relating to the quality or rate of return of any specific investment or group of investments held in a Segment. As used here, “investment officer” refers to anyone whose responsibilities included giving investment advice to or making investment decisions for one or more Segments and to any person who directly or indirectly supervised the work performed by such individual.
In concluding that the insurer, and not the policy owner, was the owner of the assets held in the separate account, the IRS emphasized the following:
• The policy owner did not possess direct control over the investment assets.
• The policy owner was limited to choosing between general investment strategies.
• The insurer alone had complete control over acquisition and disposition of investment assets.
• The policy owner had to rely on the insurer’s investment expertise and independent decisions to obtain favorable returns on assets.
• Investment in the Special Division (separate account) was available to the policy owner only by purchase of the insurance policies.
There are a multiplicity of both domestic and offshore providers who allow for the funding of their Private placement structures with assets of the insured on the basis of either an in-kind premium contribution or an acquisition of the assets of the policyholder via note or other purchase transaction by the IDF manager or asset and investment manager selected by the insured in consultation with the Insurer. XXXXX Company private placement Memorandum provides as follows: “We develop vehicles that enable individuals and institutions to make tax- efficient investments in hedge funds, private equity, real estate and other alternative assets.
We work with each client and advisors to develop a tailored strategy that addresses risk management, financial planning and asset-protection needs…..Using vehicles developed by our team of advisors, individuals or institutions can make investments in alternative assets, such as hedge funds, private equity and real estate.”
The transaction that we have set forth in the planning for you deals with the sale or investment of fresh capital into a new management company or the transfer of an existing management company or other business interest (be they LLC membership interests or partnership interests), to a Private Placement Life Insurance Policy’s Insurance Dedicated Fund (IDF), in exchange for a long-term deferred promissory note from the IDF/ policy, pursuant to which, the Seller would receive whereby they would receive a series of payments of interest at the AFR or above, and a portion of the principal amount of the note amortized over 30 to 40 years. The sale would be accounted for on the installment method of reporting and the sellers would pay tax on both the interest and the capital gain on the transaction. The IDF manager is an independent party who would be appointed by the policy holder (Non-grantor trust) at inception, and the direction of the Insurance Company to approve their recommendation made by the Trustee/ policy holder owner (of which the IDF and all of the underlying investments are assets). The IDF Manager makes all of the investment decisions with regard to the policy assets and earnings and pays the Seller the payments required under the note based upon the cash flow of the assets within the IDF. The operations of each of the underlying operating companies is permissible under the provisions of the Investor Control Doctrine as it has nothing to do with the investment of policy funds, rather the Control spoken of in the history of the Investor Control Doctrine and the cases, rulings, etc., set forth herein, is that with regard to the investment of the IDF/ policy investment assets. It must be pointed out, that those two things are not the same.
IRC Sec 817(h) has diversification requirements that provide that no single assets in a fund represent more than 55% of the fund; two assets 70%; three assets 80% and four assets 90%. As a result, a fund within a PPLI contract must have a minimum of at least five different investments. Treasury regulation 1.817-5 provides a more detailed discussion of these variable insurance contract investments. Treasury Regulation 1.817-5 is very revealing in this sense that is anticipates a much wider range of investments than what is customarily seen in retail variable insurance contracts. The range of investments discussion in the treasury regulations corresponded with the large amount of institutional private placement group variable deferred annuity contracts issued by life insurers such as John Hancock, Prudential, Travelers, Met Life, Aetna and others. The primary investors in these transactions were tax-exempt public and private pension plans, endowments and foundations subject to Unrelated Business Taxable Income (UBTI) without the benefit of these contracts. Under IRC Sec 512(a) annuity income is exempt from UBTI. The annuity contract converted the character of the income for tax purposes from what would have been taxable income into tax-exempt income.
These transactions have been completed on a direct basis “under the radar” screen with no agent involved in the transactions. These transactions have represented a wide range of alternative asset classes that would have been taxed as “business” income to the institutional investors.
The range of investments include the following:
A. Timber
B. Oil and Gas
C. Coal
D. Natural Gas
E. Infrastructure
F. Hotel and Resort
G. Development real estate projects
H. Agriculture
I. Co-generation
J. Residential real estate
K. Private Equity and Venture Capital
L. Mezzanine Debt
These investments characteristically represent “business” income without the benefit of the variable insurance contract. The treasury regulations support these types of investments allowing for a period of time to meet the diversification requirements of IRC Sec 817(h). For non-real estate accounts, the regulations provide for a one-year period to meet the diversification requirements. Real estate accounts provide for a five-year start up period and a two-year liquidation period. Furthermore, the diversification regulations provide that an account that was diversified will remain diversified but for appreciation or depreciation in a particular holding within the fund.
Tax Summary – The Insurance Company is technically and legally the Owner of the policy’s investment holdings. The Insurance Company regardless of the tax character of any income received is able to take a reserve’s deduction for its investment income under IRC Sec 807(b) regardless of the character of the income. The policyholder is not taxed on any of the income providing that the policy is tax qualified. In order for the PPLI contract to be tax-qualified it must meet the requirements of state insurance law and the Internal Revenue Code – IRC Sec 7702 and IRC Sec 817(h). For the life insurance policy owner, the policy cash value will accrue tax-free. Investment income within the policy is tax-free. The policy death benefit is income tax- free. Policy loans may be taken from the policy on a tax-free basis. If the policy is owned by an Irrevocable Trust, the death benefit is also estate tax free.
The treasury regulations do not limit and discuss a broad range of alternative investments. From a practical matter, a wide range of alternative investments has been owned within variable insurance contracts. The ownership of closely held stock, partnership interests or LLC membership interests in any type of business (apparel, retail, private equity, venture capital, etc.) does not change the tax treatment of the insurance tax laws in any manner. Upon transfer to the life insurance company, the insurance company will report this income and tax an offsetting deduction for a contribution to segregated policyholder accounts and policy reserves. The policyholder will be taxed under the insurance tax rules and not have any taxable income on the inside build-up of the cash value; policy loans will be income tax-free and the death benefit will be both income and estate tax free.
