On June 30, 2015, the U.S. Tax Court issued Webber v. Commissioner, 144 T.C. no. 17, an important decision applying the ‘investor control” doctrine to two non-U.S. private placement life insurance (PPLI) policies. Although the Tax Court decided the case on extreme facts raised in the case, the decision highlights the significance of the investor control doctrine in insurance planning for high-net-worth individuals and indicates that the investor control doctrine is an area of scrutiny by the Internal Revenue Service. As illustrated by the court's decision in Webber, policyholders, insurers and investment managers should each critically examine both the governing contractual language and their course of conduct when administering insurance policies and investing assets backing policies.
The policyholder in Webber established a grantor trust that purchased two PPLI policies on the lives of two of the policyholder's relatives. The policyholder was a venture-capital investor and private equity fund manager. The policies at issue in Webber otherwise met the statutory definition of “life insurance contract” under the U.S. tax law. Premiums paid for each policy were placed into separate accounts benefitting the policies.
The policyholder selected an investment manager to manage the separate accounts for each policy. The terms and conditions of the policies stated that only the investment manager could direct investments. The policyholder had no contractual right to require the insurance carrier to acquire any particular investment for a separate account, but could provide “general investment objectives and guidelines” and was permitted to offer specific investment recommendations to the investment manager. The investment manager, however, was free to ignore such recommendations.
The policyholder relayed investment directives to the investment manager of the separate account through his personal attorney and accountant. Over the term of the policy, the separate accounts held several investments, and the policyholder cited only three instances when the investment manager declined to follow the policyholder's investment recommendations. The Tax Court questioned whether the policyholder was the motivating factor behind even those three instances. The investments comprising the separate accounts were startup companies with which the policyholder was familiar through the funds he managed outside of the policy. Additionally, for most of the companies in which the separate accounts invested, the policyholder either sat on the board of the company and/or invested in the company through his personal account, individual retirement accounts and/or the private equity funds he managed.
Regarding the assets held in the separate accounts, the Tax Court found that the investment manager took no independent initiative and considered no investments other than those indirectly proposed by the policyholder. The policyholder admitted that the investment manager couldn’t have obtained access to any of those investment opportunities except through him. Although nearly 100 percent of the investments in the separate accounts consisted of non-publicly-traded securities, the policyholder provided no indication that the insurance company or investment manager engaged in independent research or meaningful due diligence with respect to any of the policyholder's investment directives. In fact, the Tax Court found that the policyholder commonly negotiated a deal directly with a third party, then recommended that the investment manager implement the deal he’d already negotiated. At times, the policyholder did so against the advice of legal counsel. Through his agents' directives to the investment manager, the policyholder:
- invested in startup companies in which he was already interested;
- lent money to those ventures;
- sold securities from his personal account to the policies’ separate accounts;
- purchased securities in later rounds of financing; and
- assigned to the separate accounts companies’ rights to purchase shares that he would otherwise have purchased himself.
Ongoing Investments Held in Separate Accounts
Further, the Tax Court held that the policyholder dictated what actions were taken with respect to ongoing investments held in the separate accounts. The Tax Court found that the investment manager took no action without signoff from the policyholder's agents, which they generally provided by telephone. These included:
- deciding how the investment manager would vote shares held in the separate accounts; responding to capital calls; and
- deciding whether to participate in bridge funding, whether to take a pro-rata share in series D financing and whether to convert promissory notes held in the separate accounts to equity.
The policyholder, through his control over the separate accounts, was also able to extract cash for his personal use without surrendering the policy or without resorting to using it as collateral for a loan. For example, the petitioner apparently sold assets to the separate accounts directly. Through his indirect investment directives, the policyholder also caused the separate accounts to lend money to a corporation he owned and sold promissory notes to the separate accounts. Finally, by following his investment recommendations, the separate account financed investments such as a winery, resort and hunting lodge, which were allegedly for the policyholder’s personal use.
The Tax Court found that the policyholder retained significant incidents of ownership over the assets in the separate accounts. Accordingly, the dividends, interest, capital gains and other income received by the separate accounts during the tax years at issue were taxable to the policyholder. However, the policyholder wasn’t held liable for accuracy related penalties of 20 percent of the income tax due because he reasonably relied on the advice of legal counsel when investing in and administering the insurance policies.
In reaching its conclusion, the Tax Court in Webber stated that a policyholder violates the investor control doctrine—and will be considered the owner of the assets in a separate account underlying a variable life insurance policy—if he has sufficient “incidents of ownership” over the assets in the separate account. The Tax Court focused its ownership analysis on the policyholder’s power to decide what specific investments will be purchased, sold, exchanged or otherwise held in the separate account. Other incidents of ownership include:
- the power to vote securities held in the separate account;
- the power to exercise other rights or options relative to those investments;
- the power to extract money from the separate account, by withdrawal or otherwise; and
- the power to derive effective benefit from the separate account assets.
Applying this analysis, the Tax Court found that the policyholder in Webber exercised sufficient control over the assets in the separate accounts to warrant inclusion of the policy assets in the policyholder's current taxable income for the tax years at issue. Even though the policy contract purported to give the investment manager absolute discretion over the assets held in the separate accounts, the Tax Court found that this restriction was disregarded in practice.
What It Means
First, not only will the IRS (and the courts) scrutinize the contractual language of a policy, but also how the policy is administered in practice. The Tax Court in Webber looked to both the substance of the agreement and the parties’ actual conduct. This highlights the importance that policyholders, investment managers and insurers should provide strong contractual language regarding the investor control doctrine and administer policies in a way which respects these contractual obligations.
Second, indirect communication with an investment manager via an intermediary is sufficient to raise investor control issues. The Tax Court found that even though the policyholder in Webber may not have directly communicated with the investment manager, he nonetheless exercised an impermissible amount of control over investment of the assets in the separate account.
Third, the Tax Court applied the investor control doctrine to non-U.S. PPLI. Although this has been the view of the IRS before, Webber is a recent application of this doctrine in this context.
Finally, in making its determination on the issue of whether the policyholder exercised sufficient control over the assets in the policy, the Tax Court afforded great deference to IRS revenue rulings regarding the investor control doctrine under applicable administrative review. The Tax Court in Webber repeatedly and explicitly referred to prior revenue rulings establishing and interpreting the investor control doctrine.