The Investor Control Doctrine: Alive and Well
Some thought the investor control doctrine had little bite left, but the tax court on June 30 ruled that doctrine still has some sharp teeth. In Webber v. Commissioner 144 TC No. 17 (June 30, 2015), the tax court concluded that because the taxpayer had sufficient control over the assets held in separate accounts of variable life insurance policies, the taxpayer was the tax owner of the assets and was taxable on the income earned on those assets.
Investor Control Doctrine
The Internal Revenue Service first established the investor control doctrine in Rev. Rul. 77-85, 1977-1 CB 12, providing that the policy holder of an annuity contract issued by a life insurance company must currently include in income the amounts of interest and dividends or other income received by the custodian of the investment account created in conjunction with the contract and over which the policyholder has investment control Through public and private rulings, the Internal Revenue Service over the years has continued to develop the investor control doctrine and in 2003 expanded it to cover variable life insurance policies.
In Rev. Rul. 2003-91, 2003-2 CB 347, variable life insurance contracts were funded by assets in a separate account, which was then divided into 12 subaccounts. Each subaccount followed a specific investment strategy. The policyholder could allocate funds among the subaccounts but investment decisions in each subaccount were made by the insurance company or the investment manager in their sole and absolute discretion. The Internal Revenue Service concluded that based on the facts and circumstances, the insurance company, and not the policyholder, was the owner of the assets in the separate accounts for federal income tax purposes. By issuing Rev. Rul. 2003-91, the Internal Revenue Service took the position that in applying the investor control doctrine annuity and life insurance contracts will be treated similarly.
The Court Case
In Webber, the taxpayer was a venture capitalist that made his investments through his own name, his IRA and through various venture capital partnerships. As part of his estate planning, he formed a grantor trust that purchased two variable life insurance policies insuring the lives of two elderly relatives with various family members as the beneficiaries of the policies. The policies were acquired from a non-U.S. insurance company and the premiums paid were placed into separate accounts to fund the policies. The taxpayer was advised by his estate planner that the Internal Revenue Service could assert that the taxpayer was the owner of the assets in the separate accounts if it was determined that the taxpayer had sufficient control over the investment of the assets held in the separate accounts.
The insurance company did not manage the investments of the separate accounts, but rather the policyholder was supposed to pick an investment manager from an approved list of managers supplied by the insurance company. The policies provided that no one except the investment manager could direct the investments and denied the policyholder any right to require the insurance company to acquire any investment. The tax court, however, found that these restrictions were not followed.
Instead of the investment manager making the investment decisions with respect to the policies, the tax court found that the investments made by the separate accounts were made on “recommendations” by the taxpayer and each investment was made into a company that he had some financial interest in. By using the assets in the separate accounts the taxpayer first hoped that all income and capital gains realized on the investments, which he would otherwise have held personally, would escape current federal income taxation because they would be held through a life insurance policy. Second, the taxpayer expected that the ultimate payout from the investments, including all realized gains, would escape federal income and estate taxation because they would be payable as life insurance proceeds.
The tax court found that the taxpayer “enjoyed the unfettered ability to select investments for the separate accounts by directing the investment manager to buy, sell and exchange securities and other assets in which he wished to invest.” Not surprising, the tax court found that pursuant to the investor control doctrine, the taxpayer was the owner of the assets held in the separate accounts and he was taxable on all income earned on those assets during the years in questions. Because the taxpayer reasonably relied on advice from his tax advisors regarding the policies, he was able to avoid accuracy related penalties.
The use of life insurance policies can be an effective estate planning tool, but insurance companies, policy holders, and their advisors must understand the implications of the investor control doctrine in order to ensure the desired tax results. Because of the fact specific nature of the investor control doctrine, it is hard to establish where the line is that causes a policyholder to be treated as the tax owner of the assets in a separate account, but the doctrine, as shown in Webber, is very much alive.