Tax Court: “Investor control” doctrine

Tax Court: “Investor control” doctrine

The U.S. Tax Court today issued an opinion that sustained deficiencies determined by the IRS with respect to a taxpayer who purchased “private placement” variable life insurance policies and used the income and capital gains realized on the investments in the separate accounts to invest in startup companies.

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The case is: Webber v. Commissioner, 144 T.C. No. 17 (June 30, 2015)

 

Read the 92-page opinion [PDF 303 KB]

Summary

The taxpayer, a venture-capital investor and private-equity fund manager, established a grantor trust that purchased “private placement” variable life insurance policies insuring the lives of two elderly relatives. The policies were purchased from a Cayman Islands insurance company, and the taxpayer and his family members were listed as the beneficiaries.

The premiums paid for each policy, after deduction of a mortality risk premium and an administrative charge, were placed in a separate account underlying the policy. The assets in these separate accounts, and all income earned on those accounts, were segregated from the general assets and reserves of the insurance company.

The separate accounts purchased investments in startup companies which, as the Tax Court noted, the taxpayer was intimately familiar with, and also in which he invested personally and through funds he managed.

As noted by the Tax Court, the taxpayer effectively dictated both the companies in which the separate accounts would invest and all actions taken with respect to these investments. The taxpayer expected the assets in the separate accounts to appreciate substantially (and the court found that they did).

The Tax Court explained that the taxpayer had planned to achieve two tax benefits through this structure:

  • First, that all income and capital gains realized on these investments (that otherwise the taxpayer would have held personally), would escape current federal income taxation because they were positioned within an insurance policy
  • Second, that the ultimate payout from these investments, including all realized gains, would escape federal income and estate taxation as “life insurance proceeds”
The IRS cited the “investor control” doctrine and other principles, and concluded that the taxpayer had retained sufficient control and incidents of ownership over the assets in the separate accounts to be treated as their owner for federal income tax purposes. The IRS thus treated the taxpayer as having received the dividends, interest, capital gains, and other income realized by the separate accounts, and determined deficiencies of over $507,000 for 2006 and over $148,000 for 2007. The IRS also imposed accuracy-related penalties under section 6662.
The Tax Court upheld the deficiency determinations for the most part but concluded that the taxpayer was not liable for the penalty assessments.

KPMG observation

“Investor control” determinations are very fact-specific. In this case, the Tax Court analyzed the relevant facts in great detail, and agreed with the IRS on these facts. The court applied Skidmore deference to the IRS’s “investor control” rulings, noting in particular that the IRS has enunciated consistent principles over a substantial time span—i.e., 38 years.

For those who have been wondering, this case shows that the “investor control” doctrine is still relevant to life and annuity product design.

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