Jeffrey T. Webber is a venture capital and private-equity fund manager. Seeking, like the rest of us, to mitigate the taxes on his investments, Webber ended up in 1998 in the offices of an estate planner by the name of William Lipkind. As the U.S. Tax Court would later relate:
Mr. Lipkind laid out a complex estate plan that involved a grantor trust and the purchase of private placement life insurance policies from Lighthouse. He explained that private placement insurance is a type of variable life insurance that builds value in a separate account. (The details of this strategy are discussed more fully below.) Mr. Lipkind acknowledged that this tax-minimization strategy had certain tax risks, but he orally assured [Webber] that the strategy was sound.
Webber settled an Alaska Trust, taxed to Webber as a grantor trust. Alaska was chosen in an attempt to avoid California state taxes. Alaska Trust Company and Lipkind were chosen as the Trustee, and Webber was made the Trust Protector and given the powers to remove and replace them at any time. Webber's children, brother, and brother's children were the beneficiaries of the Alaska Trust.
Webber settled the Alaska Trust with his contribution of $700,000. One of the trustees then purchased two private-placement life insurance (PPLI) policies on the lives to two elderly relatives (age 77 and 78 years respectively) from Lighthouse Capital Insurance Co. (Lighthouse) in the Cayman Islands. Webber and other family members were the beneficiary of these policies.
Lighthouse is managed by AON Insurance Managers, and was responsible for Lighthouse's day-today operations and regulatory compliance. Lighthouse typically reinsures all but $10,000 of the mortality risk on each of its policies through Hannover Re, a large reinsurance company -- here, because the insureds were elderly, Lighthouse reinsured 100% of the mortality risk with Hannover Re -- each policy had a minimum guaranteed death benefit of $2.72 million.
Lighthouse took Webber's premiums and, after deducting their administrative charge and a mortality risk premium, (which was done against the policies assets' each year as well) placed the balance of the funds into separate accounts for each policy. These accounts were segregated away from Lighthouse's other assets and reserves. The policies were designed so that upon the death of an insured, the beneficiaries would receive a "distribution in kind" of the assets held by Lighthouse.
Because the investment return on the assets inside the policies was so high, there was no need for additional premium payments, other than a $35,046 charge in 2000 to cover the second-year mortality and administrative charges.
Nominally, Butterfield Private Bank in the Bahamas provided "investment management" for the separate accounts for only a $500 annual fee -- which it is so low shall be explained shortly -- and a $2,000 annual accounting expense.
In reality, Butterfield didn't really manage anything, but instead Lighthouse created a number of special-purpose companies in the Bahamas through which the assets were actually invested.
Who really managed the moneys for the separate accounts of the PPLI policies? Webber, of course. But that brings to us what the Court referred to as:
The “Lipkind Protocol ”
Mr. Lipkind explained to [Webber] that it was important for tax reasons that [Webber] not appear to exercise any control over the investments that Lighthouse, through the special-purpose companies, purchased for the separate accounts. Accordingly, when selecting investments for the separate accounts, [Webber] followed the “Lipkind protocol.” This meant that [Webber] never communicated—by email, telephone, or otherwise—directly with Lighthouse or the Investment Manager. Instead, [Webber] relayed all of his directives, invariably styled “recommendations,” through Mr. Lipkind or Ms. Chang.
The record includes more than 70,000 emails to or from Mr. Lipkind, Ms. Chang, the Investment Manager, and/or Lighthouse concerning [Webber]’s “recommendations” for investments by the separate accounts. Mr. Lipkind also appears to have given instructions regularly by telephone. Explaining his lack of surprise at finding no emails about a particular investment, Mr. Lipkind told [Webber]: “We have relied primarily on telephone communications, not written paper trails (you recall our ‘owner control’ conversations).” The 70,000 emails thus tell much, but not all, of the story.
Indeed, one of the first thing that Webber started to do was moving those his existing holdings which he expected to rapidly appreciate into the separate accounts, and thus the tax-free wrapper of the PPLI policies. Soon after the policies were in place in 1999, Webber transferred $2.24 million in stock into the PPLI policies (a curiosity in itself since the policies had so far received only $700,000 in premiums).
Webber testified that he expected this stock to "explode" in value, and it did, resulting in huge (nontaxable) gains inside the PPLI policies. Indeed, this seems to have set the pattern how the PPLI policies would be operated, i.e., Webber would make a recommendation to purchase certain stocks, the PPLI policies through their special purpose companies would make the buy, and then the separate accounts would soar in value as the stocks were taken public or otherwise subject to a liquidity event.
The 70,000 emails in the record establish that Mr. Lipkind and Ms. Chang served as conduits for the delivery of instructions from [Webber] to Lighthouse and Boiler Riffle [a special purpose company owned by the separate accounts]. The fact that Boiler Riffle invested almost exclusively in startup companies in which [Webber] had a personal financial interest was not serendipitous but resulted from [Webber]’s active management over these investments.
* * *
Though Mr. Lipkind was careful to insulate [Webber] from direct communication with the Investment Manager, he frequently represented to the personnel of target investments that he and [Webber] controlled Boiler Riffle and were acting on its behalf. Indeed, he often referred to Boiler Riffle as “Jeff’s wallet.” (Ms. Chang once suggested that the target companies change their email protocol “in order to maintain the appearance of separation.”) “When Butterfield gets something with respect to Boiler Riffle,” Mr. Lipkind told one target company, “they always solicit my views before doing anything.” “While it [may] sound complex,” he told another company, “the process does move quite rapidly. Besides, Butterfield will do nothing unless and until both I and Lighthouse sign off.” We set forth below a representative sample of communications among Mr. Lipkind, Ms. Chang, Lighthouse, the Investment Manager, and the startup companies in which [Webber] wished Boiler Riffle to invest.
In essence, the money in the Lighthouse PPLI accounts was used to invest in numerous companies in which Webber was intimately familiar, and that he himself variously invested in directly or indirectly. Effectively, Lighthouse ended up investing in what Webber wanted to invest in outside the PPLI policies. There was an appearance of separation between Webber and the "investment decisions" made by Butterfield, but it was little more than Kabuki Theatre.
Instead of making big investment gains in his own name and paying taxes on those gains, through the PPLI policies Webber was able to basically bury the gains within the tax-free orbit of the life insurance policies. Ultimately, Webber expected to receive all the money back with little or no tax when his elderly relatives passed away, as the tax-free proceeds of life insurance.
This brings us to 2003, when Webber's investment business was struggling and he was going through a divorce. At that time, Webber asked Lipkind to move the trust assets offshore for asset protection purposes. Lipkind counseled Webber not to do this because of possible negative tax consequences, but Webber persisted, and Lipkind soon thereafter formed a Bahamas Trust, called the Chalk Hill Trust, and transferred all the assets from the Alaska Trust to the Bahamas Trust.
Webber was also the settlor of the Chalk Hill Trust, and Lipkind served as its domestic protector. An entity from the Isle of Man served as the foreign protector. The Trustee was Oceanic Bank & Trust, Ltd., and, at least according to the trust documents, had "uncontrolled discretion" to distribute assets to the beneficiaries.
By 2008, Webber's liability concerns had abated and he wanted the trust assets moved back onshore. Thus, a new Delaware Trust was created, and all the assets of the Bahamas' Chalk Hill Trust was assigned to the new Delaware Trust, which basically had the same terms as the previous two trusts.
Suffice it to say that the IRS was not impressed, and ruled that Webber had "retained sufficient control and incidents of ownership over the assets in the separate accounts" such that the taxable activity of the accounts for U.S. federal income tax purposes should pass to Webber, who then appealed the IRS's assessment to the U.S. Tax Court.
The Court first noted that private placement variable life insurance policies are sold exclusively to qualifying accredited investors. Under Internal Revenue Code section 72, the investment returns within a life insurance policy are not taxable to either the insurance company or the policyholder, although the latter may borrow on a tax-free basis against the cash value of the policy. When the insured dies, then under IRC section 72(e), the death benefit of the policy passes to the beneficiary without income taxation.
But on the other hand, the Court noted:
The preceding discussion assumes that the insurance company owns the investment assets in the separate account. The “investor control” doctrine posits that, if the policyholder’s incidents of ownership over those assets become sufficiently capacious and comprehensive, he rather than the insurance company will be deemed to be the true “owner” of those assets for Federal income tax purposes. In that event, a major benefit of the insurance/annuity structure—the deferral or elimination of tax on the “inside buildup”—will be lost, and the investor will be taxed currently on investment income as it is realized.
* * *
The “investor control” doctrine posits that, if a policyholder has sufficient “incidents of ownership” over the assets in a separate account underlying a variable life insurance or annuity policy, the policyholder rather than the insurance company will be considered the owner of those assets for Federal income tax purposes. The critical “incident of ownership” that emerges from these rulings is the power to decide what specific investments will be held in the account.
With the Investor Control Doctrine, the courts have usually looked away from how the assets are legally titled, but instead focused on who is actually controlling the assets -- substance controls over form -- and each case is unique.
Of course under these facts, and I'm shortcutting the Tax Court's opinion quite a bit here, Webber was D.O.A. The record was clear that Webber had effectively directed the making of nearly every investment:
Although nearly 100% of the investments in the separate accounts consisted of nonpublicly-traded securities, the record contains no documentation to establish that Lighthouse or the Investment Manager engaged in independent research or meaningful due diligence with respect to any of [Webber]’s investment directives. Lighthouse exercised barebones “know your customer” review and occasionally requested organizational documents. But these activities were undertaken to safeguard Lighthouse’s reputation, not to vet [Webber]’s “recommendations” from an investment standpoint.
* * *
It was not uncommon for [Webber] to negotiate a deal directly with a third party, then “recommend” that the Investment Manager implement the deal he had already negotiated. Through directives to the Investment Manager, [Webber] invested in startup companies in which he was interested; lent money to these ventures; sold securities from his personal account to the Policies’ separate accounts; purchased securities in later rounds of financing; and assigned to Boiler Riffle rights to purchase shares that he would otherwise have purchased himself. Without fail, the Investment Manager placed its seal of approval on each transaction.
* * *
Among the hundreds of investments that the separate accounts made, [Webber] cites only three occasions on which the Investment Manager supposedly declined to follow his recommendations. With respect to two of these investments—a Lehman Brothers fund and Milphworld—the record shows precisely the opposite. Boiler Riffle invested more than $1 million in the Lehman Brothers CIP Fund after Mr. Lipkind expressed the desire to “splice this investment into an appropriate place in Jeff’s universe.” Boiler Riffle invested in Milphworld by purchasing from [Webber] six Milphworld promissory notes with an aggregate face value of $186,600. And while Lighthouse initially discerned a “reputational risk” regarding Safeview, it was [Webber], not the Investment Manager, who put this investment on a temporary hold. There is no evidence that the Investment Manager ever refused to implement one of [Webber]’s “recommendations.”
Thus, Webber lost because he had exercised control over the assets in the PPLI policies' separate accounts. But, throwing him a bandage, the Tax Court refused to assess accuracy-related penalties against Webber because he had reasonably relied upon Lipkind's advice.
ANALYSIS
Private Placement Life Insurance has proven to be popular for high net worth individuals for many reasons, not the least of which is that by taking the life insurance agents and their commissions out of the middle, the PPLI policies can become much more efficient than those which are commercially available.
The problem is that PPLI is subject to abuse, of which the IRS is well aware. Here, the abuse came in the form of Webber exercising what amounted to de facto direct control over the policies' assets.
But to step back, what Webber really accomplished was to move a portion of his investment business into the PPLI policies, so that the policies would soak up the income taxation instead of Webber himself. In the early 2000s, and to some extent even now, some tax attorneys set up such abusive PPLI arrangements for precisely that tax sheltering effect.
The income tax-free nature of life insurance policies has traditionally existed to provide heirs with money to live on upon the family breadwinner's death, not to shelter income against taxes. Unfortunately, anything that has a tax-free component is subject to abuse, and frankly will be abused. Better guidance from the IRS is needed to delineate the lines between the proper use of life insurance and the abusive use of life insurance, and some of these more aggressive arrangements should be made so-called "listed transactions" (a/k/a presumed tax shelters).
As with other advanced tax strategies, persons who are considering them should both (1) seek the review and advice of truly independent tax counsel, and (2) obtained an unqualified opinion letter as to the propriety of the strategy. I'm not sure that such is necessary with "plain vanilla" PPLI arrangements, but certainly it is once the arrangement leaves the whitebread varietal.
Finally, any strategy that requires winks-and-nods to make it work is probably not a good one from the outset.
Trust me on that one.
CITE
Webber v. CIR, 144 T.C. 17 (June 30, 2015). Full Opinion at http://goo.gl/PSWZH4
Full article at http://onforb.es/1MhccVJ and http://goo.gl/gDRlnj
