The Investor Control Doctrine: When “Hands Off” Really Means “Hands Off”

By Gary Rand, CPA, Denver

Editor: Mark G. Cook, CPA, MBA, CGMA

In Webber, 144 T.C. No. 17 (2015), an individual, rather than the insurance company, was determined for tax purposes to be the owner of assets in segregated asset accounts that were held for the benefit of private placement variable life insurance policies. As a result, the individual was liable for tax on the income earned by those assets.

The Basics

A variable life insurance policy is a cash-value policy with an investment component allowing the owner to allocate premium dollars to a separate account comprised of stocks, bonds, funds, and other investments within the insurance company's portfolio. A private placement life insurance policy (PPLI) is a type of variable life insurance policy where the investments within each policy are customized and are not limited to the insurance company's portfolio of investments.

If the assets in the separate accounts perform well, the policy's value may substantially exceed its minimum death benefit. Upon the insured's death, the beneficiary receives the greater of the minimum death benefit or the value of the separate account, either one of which is tax-free.

The Facts

Jeffrey T. Webber, a successful private-equity investor, on the recommendation of his tax advisers, including William Lipkind, an estate-planning lawyer, purchased PPLI as one part of an overall estate plan.

In 1999, Webber contributed $700,000 to a grantor trust in which the trustee purchased two "Flexible Premium Restricted Lifetime Benefit Variable Life Insurance Policies" (the policies) from Lighthouse, a life insurance company based in the Cayman Islands. The beneficiaries of the policies were Webber's children, his brother, and his brother's children. Forms 709, United States Gift (and Generation-Skipping Transfer) Tax Return, were timely filed reporting the completed gifts. The policies insured the lives of two of Webber's relatives who were ages 77 and 79. The policies each had a minimum guaranteed death benefit of $2,720,000. After subtracting administrative fees, the premiums were allocated to separate accounts for each policy.

Lighthouse did not provide investment advice but permitted the policyholder to select an investment manager from an approved list. Webber selected Butterfield, an investment management company, and paid the company a nominal fee.

Some terms of the policies included that:

  • No one but the investment manager may direct investments;
  • The policyholder could transmit "general investment objectives and guidelines"; and
  • The policyholder was allowed to offer specific investment recommendations to the investment manager, but the investment manager was free to ignore those recommendations and was supposed to conduct independent due diligence before investing in any nonpublicly traded security.

Shortly after the premiums were paid, the accounts purchased some stock that Webber owned in three startup companies for $2,240,000. Given that he had only paid $700,000 to the accounts via premiums, Webber speculated that this transaction was an installment sale. Not long after the purchase, each of the three companies had a liquidity event, either an IPO or direct sale, which enabled the separate accounts to sell the shares at a substantial gain. Those profits were used to purchase other investments, although it is unclear how many. But the accounts held investments in 24 companies during 2006 and 2007, the years covered by the case, and at the end of 2007, the accounts had a minimum of $12.3 million in assets.

The Law, Regulations, and Limitations on PPLI and the “Investor Control” Doctrine

The investor control doctrine spans decades of revenue rulings and court cases, and a full explanation of the doctrine is beyond the scope of this item. Presented here is a synopsis.

Beginning in the late 1970s and early 1980s, the IRS took the general position that the owner of a PPLI, rather than the insurance company, was the owner of the assets in the accounts and therefore would be currently taxed on the earnings. This position was centered on the theory that, if the policyholder's incidents of ownership over the assets in the insurance company's segregated accounts became sufficiently extensive and widespread, the policyholder, rather than the insurance company, would be deemed to be the true "owner" of those assets for federal income tax purposes. In that event, the deferral or elimination of tax on the "inside buildup" would be lost.

The most crucial "incident of ownership" that emerged from the rulings and cases was the power of the policyholder to decide which specific investments the account will hold. Rev. Rul. 82-54 states that "control over individual investment decisions must not be in the hands of the policyholders."

Control or No Control Over Investment Decisions

Lipkind recommended the PPLI structure to Webber and provided insulation to avoid direct contact between Webber and Butterfield so that Webber would not appear to exercise any control over the investments. However, the evidence reflected extensive communications between Webber, the lawyer, and the personnel of every target investment. This communication showed that, in no uncertain terms, Webber was in control of all investment decisions.

The court noted the following:

  • Webber recommended every investment made by the accounts;
  • Virtually every security the accounts held was issued by a startup company in which Webber had a personal financial interest;
  • The investment manager did no independent research or due diligence about these "fledgling" companies, aside from boilerplate document requests; and
  • The investment manager was paid $500 annually for its services.

The Court’s Analysis and Conclusion

Whether a taxpayer has retained significant incidents of ownership over assets is determined on a case-by-case basis, taking into account all of the relevant facts and circumstances. The core incident of ownership is the power to select investment assets by directing the purchase, sale, and exchange of particular securities. Other incidents of ownership include the power to vote securities and exercise other rights relative to those investments; the power to extract money from the account by withdrawal or other means; and the power to derive "effective benefit" from the underlying assets. The court determined that Webber enjoyed all of these powers over the assets in the accounts.

The court specifically determined the following:

1. Power to direct investments:

  • Webber enjoyed an unfettered ability to select investments by directing the investment manager to buy, sell, and exchange securities;
  • Although the policies purported to give the investment manager complete discretion to select investments, in practice this restriction meant nothing; and
  • The investment manager acted merely as a rubber stamp for Webber's "recommendations," which were found to have been equivalent to directives.

2. Power to vote shares and exercise other options:

  • Webber repeatedly directed what actions the accounts would take for their ongoing investments: The investment managers took no action without a signoff from Lipkind or Susan Chang, who was Webber's personal accountant and agent; and
  • Numerous examples of Webber exercising these powers were provided, including:

    a.A vote concerning an amendment to a certificate of incorporation and participation in a second round of financing;

    b.How the accounts should respond to capital calls;

    c.Direction regarding whether the accounts should participate in bridge financing;

    d.Direction regarding whether the accounts should take their pro rata share of a series D financing; and

    e.Direction whether the accounts should convert promissory notes to equity.

3. Power to extract cash:

  • Shortly after the policies were initiated, Webber sold shares of startup companies to the accounts for $2,240,000. As startup companies, these shares would have sold on the open market, if one even existed, at a substantial discount;
  • Webber extracted cash by directing the investment manager to lend $450,000 to his corporation for an investment he wished to make;
  • In 2006, Webber extracted $50,000 by directing the investment manager to purchase a promissory note from him from an investee company;
  • In 2007, Webber extracted $186,600 from the accounts by directing the investment manager to purchase from him promissory notes from an investee company; and
  • In 2007, Webber extracted $200,000 from the accounts by directing the investment manager to lend that amount to an investee company, which enabled that company to repay its $200,000 promissory note to him.

4. Power to derive other benefits:

  • Webber used the accounts to finance personal investments, including a winery, a resort in Big Sur, Calif., and a Canadian hunting lodge;
  • The account investments mirrored or complemented the investments in his personal portfolio and the portfolios of the private-equity funds he managed; and
  • Webber regularly used the separate accounts synergistically to bolster his other positions.

Citing the investor control doctrine and other principles, the IRS concluded that Webber retained sufficient control and incidents of ownership over the assets in the separate accounts so as to be treated as their owner for federal income tax purposes. The court sustained the assessed tax deficiencies. The court, however, held that Webber was not liable for related penalties, since he relied on professional advice.

Observations

When structuring and implementing PPLI policies, it is important to understand the investor control doctrine, its history, and the acceptable level of involvement in investment decisions.

EditorNotes

Mark Cook is a partner with SingerLewak LLP in Irvine, Calif.

For additional information about these items, contact Mr. Cook at 949-261-8600 or mcook@singerlewak.com.

Unless otherwise noted, contributors are members of or associated with SingerLewak LLP.

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