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BRIEFING CENTER
IRS Issues
Ruling on Private Placement Life Insurance Arrangement
The issue of who is considered the
owner, for income tax purposes, of assets held in the subaccounts of a
private placement variable life insurance policy was addressed recently in
Private Letter Ruling
200244001. The ruling was the result of a request (by the Bermuda and U.S.
subsidiaries of a large publicly traded life AA+ rated insurance company) to
rule specifically on a private placement variable life insurance arrangement
where the subaccounts of the life insurance policies would be invested in
hedge funds organized as partnerships the interests of which were offered in
exempt securities offerings to 100 or fewer accredited investors. This was to
be the first entry into the private placement market for this family of
insurance companies.
Variable life insurance
Variable life insurance is a type
of permanent life insurance that provides flexibility of premium payments and
death benefit coverage along with a rate of return on the savings portion of the
policy that varies depending on the performance of the underlying investments
(held in "subaccounts" for each policy). Tax-qualified variable life
insurance policies allow for tax-free buildup of investment value inside the
policy. Depending on the type of policy issued, the policyholder may have
tax-free access to the investment value by means of policy loans, and at death,
the beneficiaries of the policy receive the death benefit proceeds (less any
outstanding policy loans) free of income tax.
Among the requirements for a
variable life insurance policy to achieve tax-deferral on the buildup of
investment value, the Treasury Regulations interpreting section 817(h) of the
Internal Revenue Code (the section requiring adequate diversification of
investments) require that insurance companies not invest variable account assets
alongside the public in publicly available mutual funds. If an insurance
company wants variable account assets invested in mutual funds, the fund manager
must carve out a special "life insurance policy only" fund.
What the IRS said
In short, the IRS held in the
letter ruling that because the hedge funds in which the policy subaccounts
would be invested are available to the public and are not funds in which only
life insurance company subaccounts, then too much "investor control" exists and
thus the policies fail the
diversification rules of section 817(h) of the Internal Revenue Code. The
result is that the owner of such an insurance policy would be deemed to be the
owner of the underlying assets in the policy subaccounts and would be
taxable on the income thereof. Ouch.
What's odd about it
What first struck me as
particularly odd was not the IRS's position. Large variable life insurance
policies, particularly private placement policies which offer customized
investment choices, save policy owners billions of dollars in income tax on
policy investments each year. Congress allows them under the Internal Revenue
Code. The IRS doesn't like them. That's simple enough to understand.
What is more difficult to
understand was why the ruling was issued at all. Negative private letter
rulings are rarely issued. Private letter rulings are IRS rulings requested by
taxpayers and directed solely at the requesting taxpayer. Typically private
letter rulings are negotiated by the requesting taxpayer's counsel and IRS
counsel. If the IRS's position appears immovably contrary to the taxpayer's
position, and the taxpayer knows he is not going to get a favorable ruling, then
usually the taxpayer simply withdraws the ruling request and no ruling is
issued. However, that did not happen here. Why not?
First, we can rule out ignorance.
The firm that represented the insurance companies in this ruling is a
well-respected Washington D.C. firm with a great deal of experience in the
taxation of investment and insurance products and investment and insurance
product design. The insurance companies had to have wanted the negative ruling
to be issued.
A more cynical group believes that
the insurance companies allowed the ruling to be issued in order to sabotage other insurers who had already entered the private
placement market. If the ruling caused a stir in the high net worth client
estate planning and offshore planning community -- which it indeed has -- then
the insurers offering private placement life insurance might look foolish and
the companies that requested the ruling, now firmly on the other side of the
fence having never entered the market, would look brilliantly conservative to
potential clients and advisors.
The less cynical among us believe
that perhaps the insurance companies and their counsel wanted the ruling issued
because it would force the IRS to stake out a position which the insurance
companies could then pick apart in future litigation.
What might the ruling mean?
In any event the ruling was
issued. So, what does it mean? There appear to be three views:
Could it
mean the end of private placement policies?
How might the ruling mean the end
of private placement variable life insurance? Well, the ruling clearly calls on
insurers to require fund managers to create separate life-insurance-only mirror
funds for variable life insurance policy subaccounts. There aren't many
private placement variable life insurance policies out there. There may not be
enough demand for fund managers to agree to supply mirror funds. If not, the
market for private placement policies as hedge fund investment vehicles may dry
up.
I don't believe that this will be the case. I have talked to several small fund managers who have indicated a willingness to establish insurance-only
mirror funds for variable life insurance policies.
It might mean nothing
How could it be that the ruling
means nothing? There is a very credible argument that the whole notion of
"investor control" is inapplicable to variable policies and that only the
mechanical objective diversification rules found in the applicable treasury
regulations should apply to variable life insurance policies. The following
summary is based on the work of two prominent attorneys in the field of the
taxation of private placement life insurance products, Robert Colvin, of counsel
to Chamberlain Hrdlicka White Williams &
Martin, in Houston, and Jay Walker of J.A. Walker & Associates, P.C. in
Atlanta.
The IRS's "investor control"
argument is primarily based on the common law doctrine of "constructive
receipt." The IRS has stated in published
revenue rulings that a policy owner will be considered the owner of subaccount
assets if the owner possesses incidents of ownership in those assets.
Generally, under these revenue rulings, in order for the insurance company to be
considered the owner of the assets in a subaccount, control over individual
investment decisions must not be directly or indirectly in the hands of the policy owner.
There were a few revenue rulings
issued in the early 1980s and another in 1999 in which the IRS staked out its
argument. In the one case (Christofferson) dealing with the issue
(in the context of a variable annuity) in 1984, the IRS won its argument that
the taxpayers had enough control over the policy to render the income in the
subaccount taxable to them.
There is, however, a fundamental difference between
a
life insurance policy and an annuity. In order for a policy owner to
realize the full value of the investment subaccount under an insurance contract
before death, he must give up the right to a substantial death benefit. In contrast, the owner of an annuity
policy can surrender it
and receive the full value of the investment subaccount (less surrender
charges), but without having to give up any substantial rights other than the
right to receive income beyond his life expectancy; however, that right is
practically fungible - he can purchase that right again at any time from any
insurer. On the other hand, if he gives up insurance coverage, he may not
be able to get that coverage again for reasons of health or age.
Since the mini-flurry of activity in the early
1980s, Internal Revenue Code Section 817(h) was enacted and accompanying
regulations were issued. Code Section 817(h) and the Section 817
regulations provides that the investments of each subaccount underlying a
variable life insurance contract must be adequately diversified in accordance
with Treasury regulations in order for the policy to qualify as an annuity or
life insurance policy. There are fairly simple mechanical rules that are
applied to determine if a subaccount is adequately diversified.
Following the enactment of Section 817(h) and
the issuance of the 817 regulations, investor control rules may be applicable no
longer for the following reasons:
- Congress intended that the Section 817
regulations would address issues of diversification and investor control; the
regulations do address diversification, but do not address investor control
(in the explanation to the temporary IRC Section 817 diversification
regulations, Treasury noted that it would issue guidance under Section 817(d)
on investor control issues in final regulations. Final regulations have
never been issued under IRC Section 817(d)).
- Section 817(h)(2) provides that a subaccount will be considered "diversified" if it satisfies the diversification requirements applicable to regulated
investment companies (RICs) which permit the taxpayer to
invest up to 50% of the assets of a segregated account in companies controlled
by the taxpayer as long as no single investment in controlled companies exceeds
25% of the total value of the segregated account. Therefore, a certain degree of
investor control appears to be expressly permitted by Congress.
- The partnership look-through rules found in
the Section 817(h) regulations expressly refer to permitted investment in a
partnership "if the partnership interest is not registered under a Federal or
State law regulating the offering or sale of securities."
Indeed, the Code and regulations practically
invite
investment in private partnerships and in other investments over which the
policy owner may have some control.
However, in Rev. Rul. 99-44 the IRS
reasserted its view that investor control is still an issue, and clearly, in PLR
200244001, it is staking out that position once again. So, even if the
argument seems like a good one - and it is quite logical and sensible given the
current state of the law - one must be prepared to do battle with the IRS.
Although the IRS has not litigated the investor
control issue since 1984 (despite the explosive growth of variable annuity and
variable life insurance products), the issuance of PLR 200244001 may be the
harbinger of litigation to come.
It simply might mean proceed with caution
So, is there a middle ground that allows us to
use private placement variable life insurance in planning for our clients and
that allows us all to sleep well at night? I think so.
The IRS has issued a favorable ruling (PLR
9433030) on a private placement variable corporate-owned life insurance ("COLI")
arrangement in which, among other things, no employee would communicate directly
or indirectly with the insurer or investment advisor about the investments, the
owner could not select the investments to be made and the owner could not change
the pre-established investment guidelines. Quite conservative, but it
worked.
Furthermore, the IRS has ruled in the past (PLR
9839034 and PLR 9851044) that variable contracts can invest in public mutual
funds under "fund of funds" arrangements (as contrasted with direct investment
in otherwise publicly available funds, such as the privately offered hedge fund
partnership interests involved in PLR 200244001). Shares of such funds of funds
must be offered solely to insurance company subaccounts. A variable
contract that invests in such a fund of funds should not fail for investor
control issues merely because the fund of funds invests in publicly available
funds. Unless a policyowner is prepared to do battle with the IRS on this
issue, the solution will have to be that investment advisors associated with the
subaccounts will have to establish mirror funds solely for variable subaccounts.
Because the amounts invested in most private placement policies are substantial,
the annual costs incurred by an investment advisor to set up and run a mirror
fund (perhaps $5,000 to $10,000 annually) should not dissuade an advisor from
participating in a private placement arrangement.
So, within specific parameters, private
placement policies are acceptable to the IRS, even when the issue of investor
control is accepted as a given. PLR 9433030 provides a reasonable set of
guidelines for private placement policy structures and PLR 9839034 and PLR
9851044 provide guidelines for achieving specific investment objectives using
funds of funds to access publicly available funds.
For more information on private placement
life insurance and annuities please contact Chris Riser at
criser@riserlaw or (404) 634-0750.
If any reader has specific issues with an in-force or contemplated policy with
regard to investor control or diversification, I would be happy to refer you to
highly competent counsel in Houston or Atlanta. Please contact me for
further information.
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