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 This means that the policyowner does not owe income tax on the earnings unless they are withdrawn from the policy.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.