When Surrender Leads to Success.
On June 30, 2015, the U.S. Tax Court concluded in Webber v. Commissioner that the owner of a private placement life insurance policy retained sufficient control and ownership over the assets held in the account underlying the policy to be treated as the actual owner for federal income tax purposes. As a result, the policyowner was taxable on the income earned by the assets during the years at issue.
The court's decision shows that simply including restrictive language in a variable life insurance policy contract that prohibits all communications between a policyowner and investment manager regarding the selection of specific investments within the underlying account is not sufficient to prevent the policyowner from being treated as the owner of the underlying assets if he or she fails -- directly or indirectly -- to adhere to these restrictions.
PPLI and the Investor Control Doctrine
Private placement life insurance (PPLI) is a form of variable universal life insurance designed for the high-net-worth market. It provides cash value appreciation based on the performance of one or more investments held within a segregated investment account underlying the policy. Properly structured, earnings and gains generated within a PPLI policy grow tax-deferred if the policy complies with Internal Revenue Code Section 7702(a). This means that the policyowner does not owe income tax on the earnings unless they are withdrawn from the policy. For this reason, PPLI is a desirable tax-advantaged vehicle for holding potentially tax-inefficient investments, such as hedge funds or non-U.S. investments (i.e., assets that produce ordinary income or short-term capital gains). In addition, proceeds payable at the insured's death are generally received free of income tax. As a result, the investment returns generated within the policy permanently escape income tax if the policy is held until death.
However, a number of requirements must be met for a PPLI policy to be respected as life insurance under U.S. federal tax law. Among these requirements is that the assets in the segregated investment account underlying the policy must be owned by the insurer -- not the policyowner.
To achieve this result, the policyowner must relinquish significant control over the investment decisions regarding the segregated account assets. While the policyowner may select the investment manager, all day-to-day investment decisions must be made by the investment manager. The policyowner must not communicate with the investment manager or in any way direct the manner in which the investment advisor should invest the segregated investment account assets. This is often referred to as the "investor control doctrine."
Beginning in the late 1970s, the IRS has issued a series of published revenue rulings and private letter rulings in an attempt to better define the parameters under which a policyowner will be treated as the owner of the underlying assets based on the level of the policyowner's control over the investments within the segregated investment account.
A policy can fail to qualify under IRC Section 7702(a) if it does not have sufficient at-risk insurance coverage built into the policy and, as a result, fails the so-called guideline premium and cash value corridor tests. Provided that the policy still constitutes a life insurance contract under applicable local law, the policyowner is taxed annually on the "income on the contract" accrued during each such taxable year. Income on the contract includes the increase in net surrender value for the contract in that year, plus the cost of life insurance protection provided under the contract during that year. Such contracts are referred to as Section 7702(g) contracts, and are treated as life insurance for all other tax purposes.
In certain cases, the life insurance company issues a Section 7702(g) policy, which freezes the net cash surrender value available to the policyowner to the lesser of premiums paid or the net cash surrender value. Under such a contract, the policyowner is not taxed annually on the increase in net surrender value because the contract essentially has a frozen cash surrender value during the lifetime of the insured.
Webber v. Commissioner
Jeffrey Webber, a venture capital investor and private equity fund manager, purchased two frozen Section 7702(a)-compliant private placement variable life insurance policies from a Cayman Islands insurance company through a grantor trust. The insurance premiums were placed in segregated accounts for the exclusive benefit of the policyholder. The policies stated that only the investment manager for the relevant segregated account could direct investments and that the insurance company could deny Webber (i.e., the indirect policyowner through his grantor trust) any right to require the insurance company or the investment manager to acquire any particular investment for the segregated account. However, Webber was allowed to communicate "general investment objectives and guidelines" and specific recommendations to the investment manager, which the investment manager was free to ignore.
Through more than 70,000 emails to or from Webber's personal attorney and accountant and the investment manager and insurance company, Webber gave "recommendations" for investments in the segregated account, and in only three instances could Webber identify a recommendation which the investment manager failed to follow. Furthermore, the funds in the segregated accounts were used to purchase investments in startup companies with which Webber was intimately familiar and in which he otherwise invested personally, and through funds that he managed. For most of the companies in which the funds were invested, Webber sat on the board and invested in each of them through his personal accounts, through IRAs and through private equity funds that he managed.
Moreover, through his agents' directives to the investment manager, Webber lent money to ventures in which he was already interested in, sold securities from his personal account to the policies' segregated accounts, purchased securities in later rounds of financing and assigned to the segregated accounts rights to purchase shares that he would have otherwise purchased himself. In addition, Webber directed how the investment manager should vote shares held in the segregated account in its capacity as a shareholder; how the investment manager should respond to capital calls; whether the investment manager should participate in bridge financing; and whether the investment manager should convert a promissory note to equity. Webber also extracted cash or other benefits from the segregated accounts in numerous other ways.
Based on the powers retained by Webber, including the power to direct investments, vote shares and exercise options with respect to the shares, and particularly the determination that Webber and his grantor trust could extract cash at will from the segregated accounts in several ways to derive effective benefits from the investments in the segregated accounts, the Tax Court concluded that Webber retained sufficient control and incidents of ownership over the assets in the segregated accounts to be treated as the owner of the assets for U.S. federal income tax purposes. The court expressly found that the IRS's long history of revenue rulings articulating the investor control doctrine were entitled to deference. Accordingly, all of the dividends, interest, capital gains and other income realized by the segregated accounts during the years at issue were includible in Webber's gross income.
Importantly, the Tax Court rejected Webber's contention that he could not be taxed on the income realized by the assets within the segregated account because he was not in constructive receipt of the income. Pursuant to the "constructive receipt" doctrine, a taxpayer is subject to tax on income that he has not actually received if the income is credited to his account, set apart for him or otherwise made available so that he has access to it at any time. Because the court determined that Webber should be treated as the actual owner of the segregated account assets, the court further concluded that he should also be treated as actually receiving the income from the assets. Therefore, resorting to "constructive receipt" was not necessary.
In addition, the Tax Court rejected the argument that Webber should only be taxed under Section 7702(g) since he was found to be the owner of the segregated account assets; because the cash surrender value was frozen, this income inclusion under Section 7702(g) would have been minimal. The Tax Court stated that it would be illogical to treat Webber as the owner of the segregated account assets on the one hand, and then tax the income earned on those assets as though they were owned by the insurance company, which is a prerequisite for taxation under Section 7702(g).
It should be noted, however, that the court declined to impose accuracy-related penalties on Webber, on the grounds that he had reasonably relied on the advice of his professional tax advisor.
Why Webber Matters
PPLI continues to be an extremely powerful income tax and estate planning tool, where tax inefficient investments can grow on a tax-deferred or completely tax-free basis depending on whether the policy is held until the death of the insured. However, as the Tax Court in Webber made clear, it is not only imperative that the contract contain specific language regarding the investor control doctrine, it is equally imperative that the policyowner, insurance company, investment manager and all of their agents and representatives act in a manner that respects the contractual restrictions. Indirect and direct communications between the policyowner, insurance company and investment manager are sufficient to raise issues under the investor control doctrine.
While the egregious facts of the Webber case made the result predictable, it serves as a useful reminder that the investor control doctrine remains relevant almost 40 years after it was first advocated by the IRS. It also demonstrates that it is critically important for clients considering a PPLI policy to consult a professional legal advisor with experience in every aspect of PPLI products.
The Tax Court resolved the issues regarding the interplay of investor control with the "constructive receipt" doctrine and Section 7702(g). Essentially, constructive receipt and Section 7702(g) become inapplicable if the investor control doctrine applies to a policyowner.
In its fiscal year 2016 budget proposal, the Obama administration recommended reporting for life insurance companies on each policy whose cash value is invested in a segregated investment account. According to the Treasury Department, "reporting will enable the IRS to identify more easily which variable insurance contracts qualify as insurance contracts under current law and which contracts should be disregarded under the investor control doctrine." Although this proposal was not included in the provisions of the Bipartisan Budget Act of 2015, it would be extremely unfortunate if Congress ultimately decided in subsequent legislation to eliminate the tax benefits achieved through the purchase of PPLI policies because policyowners begin to push the envelope too far and fail to respect the separateness of the policy and the assets within the segregated account underlying the policy.