Tax News
“Investor Control” doctrine shuts down investment manager’s private placement insurance planning
July 01, 2015
Webber v. Comm’r, 144 T.C. No. 17 (2015) is an approximately 100 page Tax Court opinion that tells the tale of a sophisticated private placement insurance planning gone wrong. It is a tale of a well-structured planning with various controls and policies foot falling on the facts. Private placement variable life insurance is a tax planning tool used by many high-net worth individuals, including hedge fund and private equity managers. Typically the manager would pay a premium upfront and fund the insurance in segregated account through which it would acquire various speculative investments, including the manager’s own investment funds. The tax benefit is based on classifying the arrangement as insurance. This treatment affords tax deferral and possibly, avoiding tax altogether if a death benefit is paid out to the  beneficiaries. On the flip side, distributions from this product would generally be taxed at ordinary income rates and potentially could be subject to excise tax if distributions are made before the age of 59 1/2.
Offering this product to investment managers presents a specific problem. The problem is the “investor control” doctrine. The doctrine provides that if the policyholder’s incidents of ownership over the assets held in the segregated account become sufficiently capacious and comprehensive, he rather than the insurance company will be deemed to be the true “owner” of those assets for Federal income tax purposes.  In that event, a major benefit of the insurance structure--the deferral or elimination of tax on the “inside buildup”--will be lost, and the investor will be taxed currently on investment income as it is realized. Why does this present a problem for investment managers? It is a problem because investment managers want the segregated account to be invested in the portfolio companies and funds which they manage. The manager would pick the investments held in the account and in the same time sit on the board of the portfolio company, do the due diligence, vote the securities held in the account and so on. The line between the investment choices made by the insurance company and the policyholder is often blurred.

Mr. Webber found firsthand how technical and unforgiving this doctrine could be. Admittedly, Mr. Webber hired competent advisors, had policies and protocols in place, properly reported the transaction, and covered all angles as far as documents go. However, the facts stacked against Mr. Webber’s position.  Although the various policies purported to give the insurance company complete discretion to select investments, this restriction meant nothing in practice. Virtually all of the securities held in the insurance account were of companies in which Webber had personal interest through its funds or his IRAs. The insurance company took no independent initiative and considered no investments other than those proposed by Webber. The record overwhelmingly demonstrated that the taxpayer directed all investments. Furthermore, no due diligence or independent research was conducted by the insurance company. All of these functions were performed by Webber.  A number of other facts and circumstances contributed to the Court’s final decision.  We would not cover them in detail here, but we highly recommend that readers go through the entire opinion. It offers a rare insight into the inner workings of private placement insurance planning and it offers a road map of what not to do if you want to reach your intended tax goal.  One additional thing that is worth noting is that the IRS did not succeed in whacking the taxpayer with a Sec. 6662 accuracy penalty. Fortunately for the taxpayer, he hired a competent counsel and genuinely trusted counsel’s advice after full disclosure. Counsel specifically considered the "investor control" doctrine and provided competent advice regarding the same.

The opinion can be found here.
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Tags: investor control doctrine, private placement insurance, investment manager