US Tax court clarifies use of investor control rules – Lessons from the Webber case

Our readers are keenly aware that BFI’s been in the business of providing tailored, comprehensive and solid wealth planning and management solutions to investors for well over 20 years now. In many instances, and as just one example, a compliant tax structure is carefully put in place for investors to be able to optimize their taxation.

What some don’t realize is that once the final product is ready, it requires an ongoing, joint effort to keep it compliant and doing the job it’s intended to do. No one wants to realize when it’s too late that what they did 2 years ago isn’t holding up any longer today.

In the case of US clients, one of the most effective planning tools we’ve been able to use over the years is Private Placement Life Insurance and Annuities, or “PPLI” as it is often referred to. But in order for PPLI to do its job during the US investor’s lifetime, there are some key points to remember:

1) It must be properly reported on an annual basis
2) Investor control doctrine must always be followed
3) Certain investment diversification must be met; and
4) Tax needs to be paid if and when it comes due.

Today, we are going to discuss the second point above. The investor control rulings generally maintain that if a policyholder retains too much control over the assets supporting the PPLI contract, the policyholder will be treated as the owner of the assets for federal tax purposes.

For those investors who already have PPLI in place, or for those interested in this venue for jurisdictional diversification, we would like to share an important and recent US Tax Court decision in connection with the investor control.

The case is rather relevant as it is the first ruling of this type since 1984. It highlights the analysis the IRS gave to the principle of “investor control”, as well as the importance of working with an advisor that knows and understands these rules regarding your long-term planning needs.  

In Webber v. Commissioner, the taxpayer, a venture-capital investor and private-equity fund manager, established a grantor trust that purchased offshore PPLI life insurance policies on the lives of two elderly relatives. The policies themselves where not the problem, but instead the investment “micromanagement” exercised by Mr. Webber.

Before discussing the importance of the case and what happened, let’s take a few steps back to explain PPLI.

PPLI is not like the traditional retail type of life insurance you buy from a local broker. PPLI is a private placement investment vehicle available to qualified purchasers (broadly meaning that you own certain wealth and have knowledge about investments) and that provide a number of benefits to such investors, such as asset protection, access to international assets not generally available to US investors, compliant tax benefits, amongst other.

PPLI requires a separate account be set up for the benefit of each policy. This separate account is owned by the insurance company for the benefit of the policy; the account is not owned by the policyholder, this is key to understand the owner control doctrine.

The money in the account is protected from the creditor claims of the insurance company, and the funds are solely for the benefit of the policy. While a small portion of the amount deposited goes to actually pay for the insurance risk and administrative charges, the remaining funds are invested to produce growth and income.

In the late 70’s, the IRS created the Investment Control principle through a series of revenue rulings. As the name implies, the test is used to determine if a policyholder exhibits a certain amount of control of the assets in the separate account (which as stated above, belongs to the insurance company, not to the policyholder) so that income in the policy’s account is taken as owned by the policyholder and taxed as income in their hands.

Back to Webber v. Commissioner

Mr. Webber set up the policies correctly, being sure to use policies that complied with the US IRC requirements for such policies. These types of policies generally have very low premiums compared to the risk, meaning the policyholder can afford to put more into the account for investments. Mr. Webber took full advantage of that.

As mentioned before, and we would like to make a strong point about this, the issue here were not the policies themselves, but the test of the owner control doctrine. While Mr. Webber never directly communicated with the investment advisor designated for the separate accounts for the two policies, some 70,000 e-mails indicated that Mr. Webber had relayed his investment instructions to the investment advisor, through his tax advisor.

In addition, the investments were in companies that Mr. Webber invested in, either personally or through hedge funds he managed. Some of the investments were in companies where Mr. Webber served on the board of directors. He also used the investments to fulfill obligations he took on to invest in the companies. But ultimately, the investment advisor failed to properly perform their due diligence on the investments to see this connection in the background.

Ultimately, the Tax Court in Webber stated that a policyholder violates the investor control doctrine, and thereby is considered the direct owner of the assets, if they have “sufficient incidents of ownership” over the assets in the policies’ separate accounts. In doing so, they found Mr Webber had indeed had enough control of the assets in the account, warranting inclusion of the policy assets into his taxable income.

To Mr. Webber’s credit, he was up front with the IRS about his planning, properly reporting the movement of the policies and the trust which helped him to avoid the 20% penalty that was to be assessed. He did, however, end up owing $650K in income tax on the account earnings, that he could have saved, had he worked with qualified advisors.

What are the lessons to be learned?

First, a properly structure PPLI works, whether it’s onshore or offshore. The issue in this case was not the policies themselves. They were clearly set up correctly and the IRS had no issue with the structures. To us, it shows us that PPLI, when structured correctly, still stands up today just as it has for years. It still ranks as one of the best structures for US investors being able to invest offshore.

But, for PPLI to work, you need to set it up correctly, from the start. PPLI, as effective a tool as it is, clearly has a few moving parts. Just being able to trust an insurance company to set this up for you alone will not fit the bill. You need to work with someone that knows how to set up the structure and who has a network of banks, asset managers, lawyers, accountants, etc. that know PPLI and how to keep the structure compliant.

And in the maintenance of the policy for the long-term, it is critically important, as the Webber case showed, to have an investment advisor that is looking out for your best interest. They need to understand the rules that apply as well, have systems in place to ensure owner control doctrine is being kept, and know how to handle the sometimes delicate rules of working with US investors.

BFI has worked with US investors for over 20 years, and has gained particular expertise in the area of PPLI, which properly structured and maintained, can be a powerful asset protection and income tax saver. Should you have a foreign PPLI structure in place already, or would like to start one, contact us. We’ll be happy to review your situation and work together in adjusting or creating a PPLI plan that meets your diversification needs, and more importantly, remains compliant in order to accomplish the benefits sought.

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