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Private Placement Life Insurance/ Annuities: The Tangled Web of Jeffrey Webber.
Private Placement Life Insurance/ Annuities: The Tangled Web of Jeffrey Webber.
Private Placement Life Insurance/ Annuities: The Tangled Web of Jeffrey Webber.2
Steven A. Horowitz, Esq.
Partner, Horowitz and Rubenstein, LLC
By Steven A. Horowitz
INTRODUCTION TO PPLI/ PPVA AND WEBBER
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.
For the past year and two months I have been looking on with great interest at all of the articles produced by scholarly experts, regarding both the decision in Jeffrey T. Webber, as well as the true impact that it will, and should have on the private placement life insurance industry (insurance carriers, IDF Managers, Policyholders, Advisors, proponents, sales people, etc.), and the IDF managers and policy owners in particular. For most of that time, I have been of the belief that the scholars and experts in the field, who have written extensively on the decision in Webber, as well as those attorneys who write opinions, and carrier protocols, and rules about how policies should be managed in order to assure policy compliance, were correct in their interpretation of Webber and its implications. I have worked with others, to design a series of rules and one or more sets of protocols designed to be “best practices” for taxpayers and their advisors to follow in the design and administration of Private Placement Variable Life Insurance (PPVLI or PPLI) and Private Placement Variable Annuities (PPVAs).
As planners, we very often fail to recognize the fact that there is really no way that our clients will ever comprehend the magnitude of benefits which we are helping them to achieve; nor should we ever truly believe that they are up to the task of shouldering the burden, which we are putting on them, of adhering to the formalities of these transactions, which are the very reasons why they work in theory and in practice. At some point, advisors run the very real risk that we are over-designing the transaction, the guidelines and rules of which clients will never adhere to, because they do not really understand the complexity of the transaction, and the reasons why they work. At the outset of the planning process and early on in the implementation phases of our various strategies, we try to explain the practices and procedures and protocols which are to be followed in order for them to succeed.
It is very important for tax and estate planners to remember that it is adherence to formalities and compliance with both the spirit and the substance of the law and the mechanics of the techniques which is required in order for us to help our clients secure the ultimate tax savings which we hope to achieve for them. It is by no means a condemnation of our clients, or a statement meant to belittle their intelligence when we say that some planning is really just too sophisticated for certain clients to implement, because we know that they will be unable to follow the so-called playbook, guidelines, or rules which we try to make them understand that they must comply with in order for them to stay far away from trouble and reap the maximum benefit from the Plans which we which we design and plan and implement for them. At what point do our clients bend the rules and continue to bend them so far that they can’t help but compromise the integrity of the plan and thereby destroy the value we sought to obtain for them. How often do we fail to adequately impart to them just how important strict adherence the basic formalities of the transaction are in order to avoid the re-characterization of certain techniques by the Internal Revenue Service (“IRS” or “Service”)? One way or another; as tax advisors, we have to answer the basic question of whether or not our planning is, pushing the edge of the envelope, or pushing our clients over the edge and into tax problems that will cost them thousands or millions of dollars (of taxes, penalties, interest and fees to fight). In some cases, even more importantly, we have to ask the question: How high is the risk that we run of making our clients famous for generations of tax and estate planning practitioners and students to come.
Jeffrey T. Webber, Venture Capitalist enters the Tax Planning Hall of Shame by engaging in one of the most abusive misuses of life insurance planning techniques that the tax planning community has ever seen. Private Placement Variable Universal Life Insurance (referred to herein as “PPLI”) is at the center of Mr. Webber’s web of deception. His wanton misuse of the arrangement, and total disregard of the rules derived from decades of court cases and IRS published and private guidance is both remarkable and noteworthy for the plan’s outright abuse and violation of the Investor Control Doctrine. In the end, the result of both the plan and the Judge’s decision are absurdly predictable the in one hand and almost astonishing on another. The abusive Taxpayer’s plan failed and he paid tax that he had hoped to avoid, yet it was less than should have been paid and, yet to astonishment of many an expert in this area of the law, he was only required to pay interest rather than interest and penalties. From the standpoint of the insurer, the advisors, the IDF Manager (bank) and the Taxpayer, the message of the decision is clear: beware the investor control doctrine and comply with the diversification rules, and honor Robert Fink as a remarkable tax litigator of majestic proportions for convincing the judge that the taxpayer was entitled to rely on counsel who appeared to be more of an aider and abettor of an abusive tax plan.
Background To PPLI and Taxation of Life Insurance
Without doubt, the best source of guidance comes from the relevant Internal Code Sections and Treasury Regulations itself. 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 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 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.
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 7702 and 817 of the Internal Revenue Code, of 1986 as amended (the "Code), and whether the policy earnings and gains would be allowed to grow free of the burden of both federal and state income tax, or whether the insured, premium funder, or policy owner would be treated as the owner for income tax purposes, and currently taxable on those aforementioned gains and income. Were this case to be appealed, it would almost certainly be overturned as a matter of law based upon the misapplication of legal principles upon which the Tax court based its decision. However, no such appeal was taken on this case, and with quite good reason, namely: the fact that in the act of losing based upon the law, the taxpayer actually achieved a remarkably favorable result in the lower tax and the absence of penalties.
In a Well-Reasoned Opinion Judge Lauber Provides Some Potentially Valuable Guidance (Maybe???) But Likely Reached The Wrong Conclusion as a Matter of Law!
What Was Wrong with the Webber Decision?
I truly believe that the Service should have lost the case on the issue of investor control, but not because of the fact that the investor/ Taxpayer did not exercise too much control. Rather, the case should have been decided based upon the one major point of law, namely: Jeffrey T. Webber did not own the policy. The body of case law and revenue rulings, right or wrong, provides that it is the “policyholder/ owner of the contract” (See, Rev. Rul. 82-54, 1982 C.B. 11), must be the one who has exercised the excessive control over the investments within the contract. The Code provisions and historical body of tax law which govern the tax treatment of life insurance policies and annuity contracts provides in pertinent part as follows in a very clear fashion, the relevant language is as follows: the Policy Holder and owner of the contract are the parties who may not exercise an overabundance of control over the investments within the contract. As Mr. Webber was not the owner of the policy or policyholder (without application of the grantor trust rules), then the Court could not reach the conclusion that it reached without first dealing with the issue of grantor trust status (which would have made Mr. Webber the “Owner” for all federal income tax purposes), (See Rev. Rul. 85-13, 1985-1 C.B. 184).
However, Judge Lauber clearly states that the facts of Webber were so egregious that he did not need to reach to the Service’s alternative argument of Grantor Trust status causing the ownership to have been retained by Mr. Webber. I firmly believe that such a finding was and still is reversible error, because the only party who can exercise violative Investor Control over the investments made with policy assets, and thereby cause the income therefrom to be treated as their own income, is the Policy Owner/ Holder of the life insurance policy and the contract owner of a variable annuity contract. See, B.L. Dexter, Tax Terrorism: Nasty Truths About Investor Control Theory and the Accommodation of Social Security Privatization, 57 Mercer L. Rev, 553 (2005-2006). The reader should take specific note of the Section III entitled: “CRITIQUE OF THE INVESTOR CONTROL DOCTRINE” (ID. At 567-574).
In a post-Webber world, it is more difficult to argue that Investor Control no longer applies due to the diversification rules of Code Section 817(h), as that is the law of the case. The IRS benefitted because they obtained the desired result that both rules are applicable, and they got to collect some of the tax they were looking for plus interest. However, no award of penalties, will likely result in some other cases pushing the envelope in the future. The most that the service really got was the level of inaccurate and fear inspiring press which the result of this case received. The result has been a more than slight fear based chill as to what can and can’t be done in a PPLI policy and an IDF, and the severely misguided and erroneous warnings which have been written, and convey the incorrect message that: any level of direct or indirect communication between an IDF Manager and the policy holder will result in a violation of the Investor Control doctrine and will cause the policy earnings to be taxable to the policy holder rather than tax-deferred build-up inside the insurance policy. These warnings and the fear that they have inspired, has served to chill the waters of the U.S. Private Placement Life Insurance market.
THE TANGLED WEB OF JEFFREY WEBBER: GUIDANCE FOR THE TAX ADVISOR AND CLIENT
The True Holding of Webber, Its Real Message and the Appropriate Conclusions to Be Drawn.
Despite the fact that the decision is wrong on the argued and decided points of law, Webber provides the PPLI and advisory/ planning community with some long awaited guidance with respect to the Investor Control Doctrine. That guidance, along with the level of assurance that the Diversification Rules of Code Section 817(h) were not intended to dispose of the Investor Control Doctrine, in determining who the owner of the assets in a private placement variable universal life policy, or private placement variable annuity contract for income tax purposes, and who will be taxed on the income and gains produced thereby in a properly designed and managed policy/ contract.
PPLI’s Basic Premise and Value as an Estate and Income Tax Planning Tool
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 beneficiaries receive the greater of the minimum death benefit or the value of the separate account, either one of which is tax-free. As the investment power of the market for high net worth and ultra- high net worth individuals has grown over the past two decades, professional advisors of all disciplines (legal, accounting, investment and insurance, etc.) are more frequently asked about tax – advantaged structures for passive investments and interests in real estate, whether passive or active. A life insurance policy that is tax compliance for US tax purposes, can serve to accomplish the myriad of goals of the high net worth and ultrahigh net worth clients. However, there are issues which need to be understood and dealt with from the diversification to investor control to onshore solicitation to pricing and investment flexibility. Some of these will be addressed dependent upon the selection of the carrier, who will best be judged based upon ongoing service in compliance matters related to the policy. 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.
Control or No Control over Investment Decisions
According to the Court, Webber’s planning attorney and advisor, William D. Lipkind designed and implemented 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 Right but Very Wrong
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 Regulation D financings; 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.
Most policy cash values are accessed in a “customary way”, by borrowing, or partial surrender of the policy up to basis. 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 of which Webber served.
The Evolution of the Investor Control Doctrine
Beginning in the late 1970s and early 1980s, the IRS took the general position that the owner of a PPLI, rather than the insurance company, was the owner of the assets in the accounts and therefore would be currently taxed on the earnings. This position was centered on the theory that, if the policyholder's incidents of ownership over the assets in the insurance company's segregated accounts became sufficiently extensive and widespread, the policyholder, rather than the insurance company, would be deemed to be the true "owner" of those assets for federal income tax purposes. In that event, the deferral or elimination of tax on the "inside buildup" would be lost.
The most crucial "incident of ownership" that emerged from the rulings and cases was the power of the policyholder to decide which specific investments the account will hold. Rev. Rul. 82-54 states that "control over individual investment decisions must not be in the hands of the policyholders."
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, notwithstanding the fact that these court decisions and general principles were developed prior to the enactment of Code Section 817 in 1984 and the issuance of the Treasury Regulations in 1989, as amended in 2005 and 2008.
This "[I]nvestor [C]ontrol" position of the IRS is primarily based on the theory that where the policyholder who can dictate investment decisions and control day-to-day buying, selling, trading or holding strategies, then that policyholder is in "constructive receipt" of the earnings within the segregated investment account, a point which Judge Lauber summarily dismisses in his opinion. Moreover, the IRS position is somewhat based on the premise that the policy issuer is acting in a capacity of being the “alter ego” of the policyholder and, as “a mere conduit” for carrying out the investment directions given by that policyholder. 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 (See, Rev. Rul. 77-85, 1977-1 C.B. 12; Rev. Rul. 82-54, Supra and Rev. Rul. 2003-91 2003-2 C.B. 347). 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 Sections 817(h) and 72(e), we believe that a more conservative approach to PPVLI is recommended for client use. In order to take a conservative, protective position on this issue, the recommended policy design is for the PPVLI policy to be established with an independent investment advisor or Fund Manager (such as the IDF manager) who will control and direct all investments made within the segregated policy investment account. The use of a pass-through entity such as an Insurance Dedicated Fund (IDF) partnership or LLC (taxed as a partnership for federal income tax purposes), which qualifies for the look-through rule treatment discussed above, may be the most appropriate structure for the policy.
An example of the IRS position as far as the maintained applicability of the Investor control doctrine is Revenue Ruling 2003-91 (2003-2 C.B. 347). This ruling presents guidance on the investor control doctrine by presenting a factual scenario in which a variable contract holder does not have control over segregated account assets sufficient to be deemed the owner of the assets. In this manner, this ruling presents a “safe harbor” from which taxpayers may operate. The situations in 2003-91 asks: “Under the facts set forth below, will the holder of a variable contract be considered to be the owner, for federal income tax purposes, of the assets that fund the variable contract? Will income earned on those assets be included in the income of the holder in the year in which it is earned? (See Facts of Rev. Rul. 2003-91 below).
The Service analyzed the law regarding Section 61(a) which provides that the term “gross income” means all income from whatever source derived, including gains derived from dealings in property, interest and dividends. A long standing doctrine of taxation provides that “taxation is not so much concerned with the refinements of title as it is with actual command over the property taxed—the actual benefit for which the tax is paid.” Corliss v. Bowers, 281 U.S. 376 (1930). The incidence of taxation attributable to ownership of property is not shifted if the transferor continues to retain significant control over the property transferred, Frank Lyon Company v. United States , 435 U.S. 561 (1978); Commissioner v. Sunnen , 333 U.S. 591 (1948); Helvering v. Clifford , 309 U.S. 331 (1940), without regard to whether such control is exercised through specific retention of legal title, the creation of a new equitable but controlled interest, or the maintenance of effective benefit through the interposition of a subservient agency. Christoffersen v. U.S., 749 F.2d 513 (8th Cir.), rev'g 578 F. Supp. 398 (N.D. Iowa 1984). (Emphasis Added).
As a class, the United States supreme court cases relied on by the service in Revenue Ruling 2003 – 91 are somewhat off point and appear to bear it tangentially, at best, on the proper determination of basic asset ownership. For example, Corliss v. Bowers, supra concerned a taxpayer who created a trust, directing that the trust pay income to his wife for the duration of her lifetime. Because the taxpayer retained the right to revoke the trust at any time, the Court concluded that he (and not his wife) should be taxed on trust income. So, while the court mentioned the impact of a taxpayer having command over property, such dicta cannot be elevated to the status of a holding, much less a “long standing doctrine of taxation”. In articulating its final conclusions in Corliss, the court essentially restated the long-standing prohibition of anticipatory assignments of income. Likewise, the services reliance on other assignment of income places, Commissioner v. Sunnen and Helvering v. Clifford, is misplaced. Indeed it is in that Justice Murphy emphasized in the first sentence of the court’s opinion: that “the problem of the federal income tax consequences of intra-– family assignments of income is brought into focus again… The court further noted that it is in the realm of intra-– family assignments and transfers and Helvering v Clifford and similar authorities have peculiar applicability. When a taxpayer purchases an annuity contract with the intent of using it as an investment vehicle is the taxpayer attempting to assign income to the insurance company, or does the taxpayer have command over investment earnings in the same way that a parent controls income assigned to a child? (Citation) Hardly! Such an approach is shortsighted. Classic income assignment antics seek to effect a permanent shift of income from one person to another in order to achieve a more desirable tax results. However an investment focused annuity may offer a tax deferral, the whole point of such a product is to ensure that the contract purchaser can ultimately get the earnings out and into his or her pocket, an event which will invariably trigger taxation vis-à-vis the taxpayer (See Dexter, Supra). The result is somewhat different with variable universal life insurance, in so far as if the earnings are allowed to remain within the contract until death of the insured, the tax deferral is technically permanent. Moreover, the ability of the policy owner to borrow from the cash value of a non-MEC contract, allows for the access of some of the earnings from the policy tax-free during life.
Even in terms of the illegitimate use of a conduit to achieve a particular result, the service cannot rely on cited president referring to Frank Lyon Co. v. United States, the service, once again, highlights what appears to be convenient dicta without bringing forth the essence of the court’s final holding. Rather than accepting the services argument at the Frank Lyon Company had been used as a conduit, the court held that where… There is a genuine multiple party transaction with economic substance… The government should honor the allocation of rights and duties effectuated by the parties. In the end, the court reaffirmed the notion that while some transactions may appear to treat one party has a conduit the existence of true economic substance dictates that notions of a conduit be dismissed for tax purposes. See, 435 U. S. 561 (1978); and ID at 583-584. There is more theoretical support for the investor control doctrine in Christoffersen, than there is any United States Supreme Court precedent. Notwithstanding that fact, the community of advisors, and even Judge Lauber in Webber, gives the imprimatur of the Supreme Court, as the basis for its decision.
Rev. Rul. 81-225, 1981-2 C.B. 12, concludes that investments in mutual fund shares to fund annuity contracts are considered to be owned by the purchaser of the annuity if the mutual fund shares are available for purchase by the general public. Rev. Rul. 81-225 also concludes that, if the mutual fund shares are available only through the purchase of an annuity contract, then the sole function of the fund is to provide an investment vehicle that allows the issuing insurance company to meet its obligations under its annuity contracts and the mutual fund shares are considered to be owned by the insurance company. Finally, in Rev. Rul. 82-54, 1982-1 C.B. 11, the purchaser of certain annuity contracts could allocate premium payments among three funds and had an unlimited right to reallocate contract value among the funds prior to the maturity date of the annuity contract. Interests in the funds were not available for purchase by the general public, but were instead only available through purchase of an annuity contract. The Service concludes that the purchaser's ability to choose among general investment strategies (for example, between stock, bonds, or money market instruments) either at the time of the initial purchase or subsequent thereto, does not constitute control sufficient to cause the contract holders to be treated as the owners of the mutual fund shares. (Emphasis added)
In Christoffersen v. U.S., the Eighth Circuit considered the federal income tax consequences of the ownership of the assets supporting a segregated asset account. The taxpayers in Christoffersen purchased a variable annuity contract that reflected the investment return and market value of assets held in an account that was segregated from the general asset account of the issuing insurance company. The taxpayers had the right to direct that their premium payments be invested in any one of six publicly traded mutual funds. The taxpayers could reallocate their investment among the funds at any time. The taxpayers also had the right upon seven days’ notice to withdraw funds, surrender the contract, or apply the accumulated value under the contract to provide annuity payments. The Eighth Circuit held that, for federal income tax purposes, the taxpayers, not the issuing insurance company, owned the mutual fund shares that funded the variable annuity. The court concluded that the taxpayers “surrendered few of the rights of ownership or control over the assets of the sub-account,” that supported the annuity contract. Christoffersen, 749 F.2d at 515. According to the court, “the payment of annuity premiums, management fees and the limitation of withdrawals to cash [did] not reflect a lack of ownership or control as the same requirements could be placed on traditional brokerage or management accounts.” Id. at 515-16. Thus, the taxpayers were required to include in gross income any gains, dividends, or other income derived from the mutual fund shares.
Section 817 of the Code was enacted by Congress as part of the Deficit Reduction Act of 1984 (Pub. L. No. 98-369), (the “1984 Act”), and provides rules regarding the tax treatment of variable life insurance and annuity contracts. Section 817(d) defines a “variable contract” as a contract that provides for the allocation of all or part of the amounts received under the contract to an account that, pursuant to State law or regulation, is segregated from the general asset accounts of the company and that provides for the payment of annuities, or is a life insurance contract. In the legislative history of the 1984 Act, Congress expressed its intent to deny life insurance treatment to any variable contract if the assets supporting the contract include funds publicly available to investors: The conference agreement allows any diversified fund to be used as the basis of variable contracts so long as all shares of the funds are owned by one or more segregated asset accounts of insurance companies, but only if access to the fund is available exclusively through the purchase of a variable contract from an insurance company. . . . In authorizing Treasury to prescribe diversification standards, the conferees intend that the standards be designed to deny annuity or life insurance treatment for investments that are publicly available to investors . . . H. R. Conf. Rep. No. 98-861, at 1055 (1984).
Section 817(h)(1) provides that a variable contract based on a segregated asset account shall not be treated as an annuity, endowment, or life insurance contract unless the segregated asset account is adequately diversified in accordance with regulations prescribed by the Secretary. If a segregated asset account is not adequately diversified, income earned by that segregated asset account is treated as ordinary income received or accrued by the policyholders.
In Rev Rul 82-54, (1982-1 C.B. 11), the Service held that holder of a variable contract will not be considered to be the owner, for federal income tax purposes, of the assets that fund the variable contract. Therefore, any interest, dividends, or other income derived from the assets that fund the variable contract is not included in the holder's gross income in the year in which the interest, dividends, or other income is earned. This Revenue Ruling has been misread, misapplied and misinterpreted by many tax practitioners insofar as the nature of the warning signs that seem to prohibit any kind of contact between the Policyholder and either the Investment Advisor, the Carrier or the IDF Manager (“the Managers”). The Ruling does not prohibit any form of contact or interaction between the Policyholder and the Managers. Rather, what the revenue ruling does say, is that if the transferor retains “significant control” over the property transferred, and then proceeds to list a series of instances where the transferor has legal control and active decision making ability over the asset; if that is the case, the Ruling provides, that based upon all the fact and specifics of the situation, how to determine what level and extent of control would be deemed “significant control”. As such we are not talking about the mere conversation or communication between the parties, but rather about what significant legal power and control over the asset is in the hands of the Policyholder. The Service cites this Revenue Ruling for the proposition and conclusion that the purchaser's ability to choose among general investment strategies (for example, between stock, bonds, or money market instruments) either at the time of the initial purchase or subsequent thereto, does not constitute control sufficient to cause the contract holders to be treated as the owners of the mutual fund shares.
The Revenue Ruling even goes so far to say, that the policy holder, can have some degree of actual legal control over the asset. The policy holder has the right to demand that the asset manager sell one fund, and to buy from another fund, at the policy holders control and discretion. And the policy holder can exercise this right every thirty days, in the case in question. And this level of actual and tangible legal control, does not meet the threshold to constitute “significant control”, and it is therefore not a problem. The Service concludes that the purchaser's ability to choose among general investment strategies (for example, between stock, bonds, or money market instruments) either at the time of the initial purchase or at a point subsequent thereto, does not constitute control sufficient to cause the contract holders to be treated as the owners of the mutual fund shares.
This Revenue Ruling has been described as a Safe Harbor because Facts of the Ruling as represented by the Taxpayer in order to obtain the favorable ruling from the Service happened to be one in which the policyholder didn’t have the ability to exert any control. In the analysis provided by the Service, the facts involved are repeated. They are not restated by the Service as a legal ruling or application of law. Rather, the restatement of the fact that there is absolutely no decision making control on the part of the taxpayer is merely a restatement of facts of the specific case under discussion in the Ruling. “Holder may not select or direct a particular investment to be made by either the Separate Account or the Sub-accounts. Holder may not sell, purchase, or exchange assets held in the Separate Account or the Sub-accounts.
While it is true that Webber was an egregious set of facts vis-à-vis the all-consuming nature of Jeffrey Webber’s control over the decisions with regard to the policies there at issue. Despite that fact, it is quite clear that the case law and Treasury Pronouncements on this subject all say that "the policyholder must not have the ability to direct the investments made within the insurance dedicated fun, or the policy itself". Based upon the literal wording of the statute and the regulations that were published by the treasury department, with regard to section 817 of the Internal Revenue Code is clear that the judge cannot possibly have reached the conclusion that he reached and be justified based upon the law. Rather, the only way in which the judge can have reached this conclusion, would be to have addressed the argument made by the service that the policy was owned by a grantor trust of which Mr. Webber would be the owner of the assets of the trusts for all purposes of the income tax. See Rev. Rul. 85-13, 1985-1 C.B. 184 and Bernard and Joyce Madorin, Petitioners v. Commissioner of Internal Revenue, Respondent, 1985 TC 667; But See Estate of Rothstein, 735 F.2d 704, 2nd Cir.(1984).
However, Judge makes it clear that in his view of the tax law and as the basis for his opinion, “the existence of the over 70,000 emails" are so egregious that he need not reach the issue of whether or not the grantor trust argument (which was the alternative argument of the Internal Revenue Service in the case), and was more than sufficient, along with the other myriad of instructions which were given by Jeffrey T. Webber to William Lipkind and in- turn given to Susan Chang who passed them on to the IDF Manager, Bank of Butterfield, to justify the determination that the Non-policyholder had too much control and exercised too much control over the investments within the policy.
What is clear from this case, is that there is a "public policy" objective which is the basis for the decision in the case of Jeffrey Weber. The decision was made based upon the fact that the investor in this case exercised extreme amounts of control over the policies investments and that the IDF manager played no role, other than that of a rubberstamp with respect to The decision as to the making of investments within the policy. This conclusion reached by Judge Lauber is directly inapposite to the actual wording of the statutes, the case law in the insurance area and the revenue rulings, private letter rulings, chief counsel memoranda, and the tax deferred investing model which is at the center of this debate. The reality is that if the Service and Treasury believe that there is an abuse in the insurance area, and the regulations they cannot be fixed by a judicial decision, regardless of how egregious the facts were in the case. What is of extreme interest in this case is the fact that the judge would reach too so much of an extensive analysis of the investments and of the underlying facts of the case without actually ever reading the law. The truth is that Judge Lauber probably would have provided the insurance world a far greater clarification and much more benefit by analyzing the law of agency. The Judge could easily have found that Mr. Lipkind and the trustee and the IDF Manager were nothing more than the mere agents of Jeffrey T. Webber (which it is obvious that they were). However, rather than reach to either the grantor trust ownership theory (which could have been argued against as a matter of state property law), or he could have used agency principles. However, he instead chose to strangle the body of rulings and case law to reach the conclusion that he wanted to reach and find that the Investor Control Doctrine can be violated even by a non-policy owner. The effect of this decision is to put fear into the PPLI and PPVA marketplace, and thereby chill the waters of aggressive sales practices.
In Situation 1 of Ruling 2003-91, 2003-2 C.B. 347, the facts are as follows: IC is a life insurance company subject to tax under § 801 of the Internal Revenue Code. In states where it is authorized to do so, IC offers variable life and variable annuity contracts that qualify as variable contracts under § 817(d) (“Contracts”). The assets that fund the Contracts are segregated from the assets that fund IC's traditional life insurance products. IC maintains a separate account (“Separate Account”) for the assets funding the Contracts, and the income and liabilities associated with the Separate Account are maintained separately from IC's other accounts. The Separate Account is divided into various sub-accounts (“Sub-accounts”). Each Sub-account's assets and liabilities are maintained separately from the assets and liabilities of other Sub-accounts. Interests in the Sub-accounts are not available for sale to the public. Rather, interests in the Sub-accounts are available solely through the purchase of a Contract. IC engages an independent investment advisor (“Advisor”) to manage the investment activities of each Sub-account. Each Sub-account will at all times meet the asset diversification test set forth in § 1.817-5(b)(1) of the Income Tax Regulations. Twelve sub-accounts were then currently available under the Contracts, but the Insurance Company had the power to increase or decrease the number at any time. However, there were never to be more than twenty Sub-accounts available under the Contracts. Each Sub-account offered a different investment strategy. The currently available Sub-accounts included a bond fund, a large company stock fund, an international stock fund, a small company stock fund, a mortgage backed securities fund, a health care industry fund, an emerging markets fund, a money market fund, a telecommunication fund, a financial services industry fund, a South American stock fund, an energy fund and an Asian markets fund.
An individual (“Holder”) would purchase a Life Insurance Contract (“LIC”). At the time of purchase, Holder specifies the allocation of premium paid among the then available Sub-accounts. Holder may change the allocation of premiums at any time, and Holder could transfer funds from one Sub-account to another. Holders were permitted one transfer between Sub-accounts without charge per thirty-day (30) period. Any additional transfers during this period were subject to a fee assessed against the cash value of LIC. There was no arrangement, plan, contract, or agreement between Holder and IC or between Holder and Advisor regarding the availability of a particular Sub-account, the investment strategy of any Sub-account, or the assets to be held by a particular sub-account. Other than Holder's right to allocate premiums and transfer funds among the available Sub-accounts as described above, all investment decisions concerning the Sub-accounts were required to be made by IC or Advisor (being the manager of an insurance dedicated fund (IDF), or an investment account manager/ advisor, in their sole and absolute discretion. Specifically, Holder could not select or recommend particular investments or investment strategies. Moreover, the taxpayer represented (based upon the requirements of the Service and with no statutory or Case authority for the requirement) that represented that the Holder could not communicate directly or indirectly with any investment officer of the Insurance Company, or its affiliates or with Advisor, or the IDF Manager regarding the selection, quality, or rate of return of any specific investment or group of investments held in a Sub-account. A representation was made that the Holder had no legal, equitable, direct, or indirect interest in any of the assets held by a Sub-account. Rather, it was represented that the Holder had only a contractual claim against the Insurance Company to collect cash from it in the form of death benefits, or cash surrender values under the Contract. All decisions concerning the choice of Advisor or the choice of any of the Insurance Company’s investment officers that are involved in the investment activities of Separate Account or any of the Sub-accounts, and any subsequent changes thereof, are made by IC in its sole and absolute discretion. Holder may not communicate directly or indirectly with IC concerning the selection or substitution of Advisor or the choice of any IC's investment officers that are involved in the investment activities of Separate Account or any of the Sub-accounts. In Situation 2, the facts were the same as Situation 1 except that Holder purchased an annuity Contract (“Annuity”).
“OH WHAT A TANGLED WEB WE WEAVE WHEN FIRST WE PRACTICE TO DECEIVE…” Scottish poetry derived from Canto VI, XVII.
Published on September 20, 2016 By: Steve Horowitz
Oct 10, 2016
Sept 20th, 2016
April 20th, 2016
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