Federal officials have completed regulations that could discourage wealth advisors from wrapping clients stakes in “alternative investments” such as hedge funds inside life insurance and annuity segregated accounts.
The Internal Revenue Service has ruled that, in many cases, it will treat a hedge fund wrapped in a life insurance policy or annuity contract as a single investment holding, rather than “looking through” the hedge fund to count the many different holdings within the hedge fund and measure the percentage of assets in each holding.
The change affects hedge funds and other investments managed by partnerships that are not registered for sale to ordinary investors with the U.S. Securities and Exchange Commission.
The IRS does create an important exception: It will continue to count the number of investment holdings bundled inside a “nonregistered partnership,” rather than counting the partnership as a single investment holding, if the partnership is available only through life or annuity segregated accounts.
Completion of the new rule means that wealthy taxpayers who have used “private placement life insurance” policies to cut taxes on hedge fund investments may be violating federal life insurance and annuity portfolio diversification requirements.
The final rule will “prevent taxpayers from turning otherwise taxable investments in hedge funds and other entities into tax-deferred or tax-free investments by purchasing the investments through a life insurance or annuity contract,” according to the U.S. Treasury Department, the parent of the IRS.