By Deborah M. Beers, Esq.
Buchanan Ingersoll & Rooney, Washington, DC
In Webber v. Commissioner,1 the Tax Court held that, under the "investor control" doctrine, taxpayer Jeffrey T. Webber was the actual owner of assets held in segregated accounts underlying certain life insurance policies, and that, accordingly, dividends, interest, capital gains, and other income received by the special purpose company set up to hold the accounts were directly includible in taxpayer's gross income under §61. The court nevertheless refused to impose the accuracy-related penalties assessed by the government, finding that the taxpayer had reasonably relied on professional tax advice.
Taxpayers that hold life insurance or annuity contracts are entitled to certain benefits under the Code that arguably make them more tax-favored than many other types of investments.
Under §72(e), the earnings - or "inside buildup" - of a life insurance contract are, in most cases, not taxable until actual receipt. If amounts are withdrawn from the contract, they are taxable only after the policyholder's investment in the contract has been recovered (commonly referred to as the "basis first" rule). In addition, §101(a) provides that amounts received under a life insurance contract by reason of the death of the insured are not includible in gross income unless the contract has been transferred "for a valuable consideration" by assignment or otherwise.
Under §72(b), an "exclusion ratio" is used to determine how much of an "amount received as an annuity" is included in gross income. While income inherent in an annuity contract is taxed ratably over the period that it is received, income on a deferred annuity contract is not taxed as it is earned.
Therefore, investing through the medium of life insurance or annuities allows for the deferral (or in the case of life insurance held until death, the elimination) of tax on income that would be taxed currently to the investor (as interest, dividends, or capital gain) in the absence of the insurance/annuity "wrapper."
A. Qualification as Life Insurance or Annuity Contract.
In order to be entitled to the benefits described above, the product in question must qualify as a "life insurance contract" or as an "annuity contract."
Under §7702, the term "life insurance contract" is a contract "which is a life insurance contract under the applicable law." In addition to qualifying as life insurance under local law, contract must meet one of two tests: the "cash value accumulation test" or the "guideline premium and cash value corridor" test. Certain common law characteristics of life insurance also may have to be present in order for a contract to qualify as a life insurance contract.
There is no similar statutory definition of "annuity contract." However, applicable Treasury regulations provide that an annuity contract is generally a contract issued by an insurance company that is "considered to be [an] annuity contract in accordance with the customary practice of life insurance companies."
B. Variable Contracts and the "Diversification" Rules.
In addition to meeting the requirements of a life insurance or annuity contract, a "variable contract" (other than certain pension plan contracts) must meet the "diversification requirements" of §817(h), which was added to the Code in 1984. If a variable contract fails to meet the diversification requirements, it is not treated as a life insurance or annuity contract - thus resulting in taxation of the "inside build-up" on the contract to the holder - for any period during which the investments made by the accounts are not adequately diversified. Although considerably more complicated, a contract will be deemed to be adequately diversified if it invests in at least five different "investments" that are not available other than through the purchase of a life insurance or annuity contract in the stipulated percentages.2
C. The "Investor Control" Doctrine.
The "investor control" doctrine predates the 1984 enactment of the diversification rules under §817. It was developed, beginning in 1977,3 in a series of revenue rulings issued as the Internal Revenue Service's response to the marketing of variable life insurance and annuity products that allowed the contract owner to retain too much control over the investment assets underlying the contract to be consistent with the ownership of the contract by the insurer. While some considered that the 1984 legislation replaced the investor control doctrine with the relatively bright-line diversification rules codified in §817, it was clear that the Internal Revenue Service believed that the doctrine still retained its validity.4
Jeffrey T. Webber ("Taxpayer") was a venture-capital investor and private-equity fund manager, who established a grantor trust that purchased "private placement"5 variable life insurance policies insuring the lives of two elderly relatives from a Cayman Islands insurance company (hereinafter sometimes "Lighthouse"). Taxpayer and various family members were the beneficiaries of these policies. The grantor trust moved from Alaska to the Bahamas to Delaware during the period at issue.
The premium paid for each was placed in a separate account underlying the policy. The assets in these separate accounts, and all income earned thereon, were segregated from the general assets and reserves of the insurer pursuant to Cayman Islands' law, and inured exclusively to the benefit of the two insurance policies.
The money in the separate accounts was used to purchase investments in startup companies with which Taxpayer was intimately familiar and in which he otherwise invested personally and through funds he managed. Taxpayer effectively dictated both the companies in which the separate accounts would invest and all actions taken with respect to these investments. "Taxpayer expected the assets in the separate accounts to appreciate substantially, and they did."
According to the court, Taxpayer's objectives were to avoid income tax on the income and capital gains realized by the investments in the account, and, upon the deaths of the insureds, to avoid all income and estate taxation.
Lighthouse permitted the policyholder to select an investment manager from a Lighthouse-approved list. The court noted that:As drafted, the Policies state that no one but the Investment Manager may direct investments and deny the policyholder any `right to require Lighthouse to acquire a particular investment' for a separate account. Under the Policies, the policyholder was allowed to transmit `general investment objectives and guidelines' to the Investment Manager, who was supposed to build a portfolio within those parameters. The Trusts specified that 100% of the assets in the separate accounts could consist of "high risk" investments, including private-equity and venture-capital assets." Lighthouse was required to perform "know your client" due diligence, designed to avoid violation of antiterrorism and money-laundering laws, and was supposed … to ensure that "the Separate Account investments [were managed] in compliance with the diversification requirements of Code Section 817(h).
On the advice of his attorney, Taxpayer never communicated - by email, telephone, or otherwise - directly with Lighthouse or the Investment Manager. Instead, he relayed all of his directives, invariably styled "recommendations," through his legal advisors in a series of over 70,000 emails to them. For the most part these emails "recommended" investments in start-up companies in which Taxpayer either also was invested or controlled.
"The Investment Manager did no independent research about these fledgling companies; it never finalized an investment until [the attorney] had signed off; and it performed no due diligence apart from boilerplate requests for organizational documents and `know your customer' review. The Investment Manager did not initiate or consider any equity investment for the separate accounts other than the investments that [Taxpayer] `recommended.' The Investment Manager was paid $500 annually for its services, and its compensation was commensurate with its efforts."
On these facts, the court found that Taxpayer's life insurance arrangement violated the "investor control doctrine," in that Taxpayer, as opposed to the insurer, had sufficient "incidents of ownership over the policies in the separate account to make him the "owner" of the assets underlying the policies for tax purposes.
"The critical `incident of ownership' that emerges from these [IRS's above-cited] rulings is the power to decide what specific investments will be held in the account … [as well as] the powers to vote securities in the separate account; to exercise other rights or options relative to these investments; to extract money from the account by withdrawal or otherwise; and to derive, in other ways, what the Supreme Court has termed `effective benefit' from the underlying assets." [Citation omitted.]
In summary, the IRS's rulings enunciating the investor control doctrine consistently over a period of nearly 40 years deserve deference,6 and were not supplanted by the diversification rules under §817(h). The final regulations issued under §817 "do not provide guidance concerning the extent to which policyholders may direct the investments of a segregated asset account without being treated as the owners of the underlying assets."7
The Tax Court refused to imposed accuracy-related penalties under §6662, however, finding that Taxpayer reasonably relied on the (orally-delivered) advice of professional tax counsel. The Court also noted that "the outer limits of the [investor control] doctrine were not definitively marked when Mr. Lipkind [the attorney] rendered his advice in 1998."
The Webber case should (assuming that it is upheld on any appeal) put an end to the argument that the diversification rules and associated regulations were meant to supplant the much older investor control doctrine. It also should be an object lesson in how not to leave an evidentiary trail (over 70,000 emails!) indicating that one has in fact exercised such control over the investment of the assets in a separate account.
For more information, in the Tax Management Portfolios, see Lee and Wilkey, 827 T.M., Life Insurance — A Practical Guide for Evaluating Policies, and in Tax Practice Series, see ¶1170, Life Insurance and Social Security Benefits.
3 See, e.g., Rev. Rul. 77-85, 1977-1 C.B. 12; Rev. Rul. 80-274, 1980-2 C.B. 27; Rev. Rul. 81-225, 1981-2 C.B. 1; and Rev. Rul. 82-84, 1982-1 C.B 11. Rev. Rul. 81-225 was modified, with respect to certain retirement plan accounts, by Rev. Proc. 99-44, 1999-2 C.B. 598. Rev. Proc. 99-44 in turn clearly re-stated the IRS' position that "[s]atisfying the diversification requirements … does not prevent a contract holder's control of the investments of a segregated asset account from causing the contract holder, rather than the insurance company, to be treated as the owner of the assets in the account." See alsoChristoffersen v. United States, 749 F.2d 513 (8th Cir. 1984), rev'g 578 F. Supp. 398 (N.D. Iowa 1984).
More recently, the IRS issued Rev. Rul. 2003-91, 2003-2 C.B. 347, and Rev. Rul. 2003-92, 2003-2 C.B. 350, dealing with the diversification rules – and, to some extent, the investor control doctrine - in the context of non-registered partnerships (or hedge funds). Rev. Rul. 2003-92 "clarifies and amplifies" Rev. Rul. 81-225.
4 Final regulations concerning diversification standards were issued in 1989. T.D. 8242, 1989-1 C.B. 215. Following their issuance, the IRS continued to issue both public and private rulings invoking the "investor control" doctrine to determine ownership of assets in segregated asset accounts. See, e.g., Rev. Ruls. 2003-91 and 2003-92; PLRs 201105012, 200420017, and 9433030. See also CCA 200840043. In PLR 9433030, the Commissioner explained: "[T]he final regulations do not provide guidance concerning the extent to which policyholders may direct the investments of a segregated asset account without being treated as the owners of the underlying assets."
5 Private placement life insurance policies are marketed chiefly to high-net-worth individuals who qualify as accredited investors under the Securities Act of 1933. See 15 U.S.C. sec. 77b(a)(15) (2006); 17 C.F.R. sec. 230.501(a) (2006).
7 The court also rejected Taxpayer's alternative arguments, including arguments based on the doctrine of "constructive receipt" and §7702(g) which sets forth specific circumstances when a policyholder will be deemed to be taxable on the income and gains underlying a policy.
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