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A Tax Strategy Gone Wrong

What does it mean to control an asset?

The answer is sometimes complicated and always of great interest to the Internal Revenue Service. In a recent Tax Court case, a taxpayer found himself on the wrong side of this question.

Jeffrey T. Webber, the taxpayer, is a venture capital investor and a private equity fund manager. He established a trust to purchase private placement variable life insurance policies from a Cayman Islands-based insurance company, Lighthouse Capital Insurance Co. Webber and various members of his family were the beneficiaries of these policies, which insured the lives of two of Webber’s elderly relatives. The trust was designed to be a grantor trust, meaning Webber was responsible for paying taxes on the trust’s income.

Private placement insurance is a vehicle that builds value in separate accounts, rather than as part of a collective asset pool under the insurer’s direct control. Such insurance is sold only through private placement offering and is generally marketed to accredited investors. These insurance policies typically require sizable initial investments but can serve as powerful estate-planning tools because the value of the investments within the insurance policies can grow income tax-free, and additionally pass to heirs free of estate and gift taxes in most situations upon an insured’s death.

Since the insurance takes the form of variable life policies, it does not offer a fixed benefit or require a fixed premium. Instead, the policyholder, in this case the trust, transfers cash or securities to the insurer. These premium deposits, after the deduction of charges for mortality risk and administrative costs, are invested to fund the policies as the investments grow. If the investments perform well, future fees and premiums are simply deducted from the existing accounts. If the investments perform poorly, the policyholder may be required to pay additional premiums to cover the yearly fees. Upon an insured’s death, beneficiaries receive the minimum death benefit or the underlying account’s value, whichever is greater.

Variable life policies with underlying asset accounts must also be “adequately diversified” to secure the full extent of the favorable U.S. tax treatment generally extended to life insurance. The accounts in this case met the diversification requirements under federal regulations, so the beneficiaries, including Webber, were well-positioned to benefit from this somewhat complex estate-planning arrangement.

During the period at issue in the case, the policyholder was permitted to select an investment manager from a list of entities approved by Lighthouse. The trust appointed Butterfield Private Bank to serve as the investment manager for the accounts established to underlie these insurance policies. Butterfield, which is based in the Bahamas, received $500 annually for its services.

If this rate seems low, the Tax Court thought so, too; in the court filings, it was noted that the investment manager’s “compensation was commensurate with its efforts” — which is to say that the investment manager did very little in the way of actually managing the investments at issue.

This might not have been a problem if the investments had been simple and straightforward. Instead, nearly all consisted of nonpublic securities and other private investments in startups or enterprises in which Webber held a personal financial interest. As the court filing put it, “[Webber] expected the assets in the separate accounts to appreciate substantially, and they did.” Normally, such a high-risk strategy would have required a great deal of research and care. In this instance, that research clearly did not come from the investment manager.

Yet Webber and his tax attorney, William Lipkind, based their tax strategy on the assumption that the taxpayer exerted no direct control over the accounts structured this way. At Lipkind’s urging, Webber took care never to make direct contact with the investment manager, communicating his investment “recommendations” through Lipkind, who also served as trustee for the trust that owned the insurance accounts, or through his personal accountant.

These recommendations, according to the court, included more than 70,000 emails containing directions about the accounts, all of which the investment manager followed with only cursory due diligence and no evidence of independent research. Nor did the investment manager invest in anything other than Webber’s recommendations as communicated through Lipkind. For his part, Lipkind communicated largely by phone, again in the name of removing the appearance of Webber’s control over the assets.

This is where the “investor control doctrine” becomes critical. The reason that Webber never contacted the investment manager directly was that he believed this separation would be enough to establish that he did not have control of the assets. As long as the investor lacks control in such situations, both the investment growth and the death benefits from the policies would theoretically come to him tax-free.

The IRS concluded, however, that Webber retained sufficient control of the assets to be treated as their owner for federal tax purposes, even though the insurance company nominally owned them during the years in question. Therefore, dividends, interest, capital gains and other income received by the company holding the accounts should have been included in Webber’s gross income. The Tax Court upheld the IRS’ position in Webber v. Commissioner.

The investor control doctrine was essentially the hinge on which the court’s opinion turned. If a policyholder gains too much control over the assets in the policy’s account, the major tax benefit of tax-free appreciation on the investments is lost. The investor will then be taxed on investment income as it is realized. Clearly, it was in Webber’s interest to attempt to support the argument that investor control did not apply.

Webber agreed to the tax-planning strategy to attempt to avoid taxation, after all. The crux of the strategy Lipkind suggested rests on using life insurance to defer or eliminate tax on income earned within the insurance “wrapper.” As it was planned, the structure would have given Webber a two-pronged benefit: First, all income and capital gains realized on investments within the insurance policy would escape current federal income taxation at the time they were realized, and second, the ultimate realized gains, when paid out, would escape taxation as a result of their character as life insurance proceeds.

If Butterfield had indeed been an independent investment manager working without Webber’s input, it might have come out that way. Lipkind based the strategy on his understanding of several related IRS rulings and opinions from U.S. law firms addressing the tax consequences of private placement insurance products from Lighthouse in a general sense. Several of these law firms specifically addressed the investor control doctrine; according to the court filing, Lipkind believed that it would be enough that Webber was not in “constructive receipt” of the assets — that is, he did not have unfettered control of when the insurance policies’ benefits would be paid.

However, it was clear that Webber effectively retained full control of which investments were purchased and when. In addition, the court noted that he retained other benefits, such as directing the investment manager to take specific actions in its capacity as a shareholder or deriving what the court termed “effective benefit” from the underlying assets.

Attempting to structure one’s affairs to minimize tax burden is not a crime, and when Lipkind proposed the strategy to Webber he characterized it as potentially risky but basically sound, according to the court documents. Webber timely reported his gifts to the trust, attaching a disclosure that the trust had purchased the insurance policies using the gifted assets. He also properly reported the trust assets’ transfer to a foreign grantor trust when moving them offshore, as well as the transfer when subsequently moving them back into a domestic account. In other words, he made no effort to hide his estate plan from the IRS and, as he testified, believed the strategy would successfully withstand the agency’s scrutiny.

Therefore, the fact that the structure did not work is not evidence that Webber thought he was skirting the law, as the Tax Court recognized. The court declined to impose the accuracy penalties that the IRS originally pursued on the grounds that Webber had sought and reasonably relied upon the advice of a tax professional. And the tax authorities left the transfer tax component of the plan alone. Webber was, however, deemed responsible for paying the tax on the income realized in the insurance policies’ accounts in the two years for which he was audited. The IRS determined that the total for those two years came to $655,818. Even without the penalties, it was undoubtedly a painful result for the taxpayer.

Webber v. Commissioner thus serves as an effective, if qualified, warning. Simply because your name is not on an asset, do not assume that you do not control it. The IRS certainly will not make this assumption on your behalf.