The purchase of a private placement life insurance policy has become an attractive strategy to allow tax-free accumulation of investment income. These policies, usually written by life insurance companies located outside the United States, often in Bermuda or the Cayman Islands, are used to avoid the U.S. scheme for taxing the investment income of life insurance companies. The taxpayer pays large premiums for the policy. A small portion of the premiums is used to cover the mortality risk under the policy, which the company generally reinsures with a much larger insurance company, and the insurer’s administrative charges. The insurance company deposits the excess premiums into a separate account and uses them to purchase investments. The income produced by these investments is not subject to U.S. taxes.
Upon the death of the insured, his beneficiary is entitled to receive the greater of the face amount of the policy or the balance of the investment account, either of which free of U.S. tax under IRC Section 101. After the policy has been in force for a few years, the balance of the investment account may be greater than the face amount of the policy, which also eliminates any mortality risk in the policy.
In order for this arrangement to work as intended, the insurance company must be treated for tax purposes as the owner of the investments in the separate policy account. If the taxpayer is treated as the owner of the investments, he will be taxed currently on realized investment income and gains. Central to this determination the amount of control the taxpayer can exert over the investments – too much taxpayer control results in the taxpayer being treated as the owner of the investments.
After a period of uncertainty, the IRS issued a revenue ruling in 2003 intended to serve as a “safe harbor” for taxpayers entering into these kinds of insurance arrangements. In Rev. Rul. 2003-91, the insurance company maintained 12 different investment funds that each followed a specific investment strategy. The taxpayer was permitted to allocate the investment account balance among the funds and to change his allocation periodically. He was not permitted to choose specific investments for any account, make recommendations for investments or have any contact with the investment officer for an account regarding the selection of specific investments. Under these circumstances, the IRS ruled that the insurance company would be treated as the owner of the assets in the investment account. Many private placement policies have subsequently been issued that are designed to operate in compliance with Rev. Rul. 2003-91.
In Webber v. Commissioner (Tax Court, June 30, 2015), the taxpayer pushed the envelope a bit too far. The taxpayer was a private equity investor who purchased a large private placement life insurance policy from a Cayman Islands insurance company. Over the next several years, the money in the investment account was used to purchase investments in several startup companies the taxpayer recommended to the policy investment advisor. In some cases, the taxpayer actually sold positions in companies that he held to the insurance company for the policy account. In many cases, private equity or venture capital funds that the taxpayer managed also took positions in these same companies.
While the taxpayer recommended the investments acquired by the insurance company, he conveyed his recommendations through intermediaries rather than directly to the policy’s investment advisor. In all, he sent 70,000 emails to the intermediaries regarding investment recommendations.
Upon audit, the IRS determined that the taxpayer should be treated as the owner of the assets due to the level of influence he exerted over the policy investments. The Tax Court agreed, finding that, although the terms of the policy did not permit the taxpayer to select or recommend investments, in substance he did so by way of his communications with the investment advisor through the intermediaries. As a result, the taxpayer was subject to tax on the realized income and gains from the investments during the audit years.
Nothing in the court’s opinion in the Webber case should be taken as calling into question private placement life insurance arrangements that operate in compliance with the requirements of Rev. Rul. 2003-91. A taxpayer should still be able to allocate the balance of the investment account among funds offered by the insurance company and reallocate the balance periodically, as long as the taxpayer is not permitted to recommend specific investments for any of the funds. He also cannot communicate with the investment advisor either directly or, as we learned from Webber, indirectly.