IRS Limits Use Of Life Hedge Fund Wrappers

By Allison Bell

Federal officials have completed regulations that could discourage wealth advisors from wrapping clients’ stakes in "alternative investments" such as hedge funds inside life insurance and annuity segregated accounts.

The Internal Revenue Service has ruled that, in many cases, it will treat a hedge fund wrapped in a life insurance policy or annuity contract as a single investment holding, rather than "looking through" the hedge fund to count the many different holdings within the hedge fund and measure the percentage of assets in each holding.

The change affects hedge funds and other investments managed by partnerships that are not registered for sale to ordinary investors with the U.S. Securities and Exchange Commission.

The IRS does create an important exception: It will continue to count the number of investment holdings bundled inside a "nonregistered partnership," rather than counting the partnership as a single investment holding, if the partnership is available only through life or annuity segregated accounts.

Completion of the new rule means that wealthy taxpayers who have used "private placement life insurance" policies to cut taxes on hedge fund investments may be violating federal life insurance and annuity portfolio diversification requirements.

The final rule will "prevent taxpayers from turning otherwise taxable investments in hedge funds and other entities into tax-deferred or tax-free investments by purchasing the investments through a life insurance or annuity contract," according to the U.S. Treasury Department, the parent of the IRS.

Congress enacted the life and annuity portfolio diversification requirements in 1984, to discourage taxpayers from using variable annuities and variable life policies primarily as investment vehicles, according to a discussion of the new regulation written by an IRS team led by James Polfer, an IRS financial institutions and products specialist.

The diversification requirements are complicated, but, in most cases, they require portfolios to include at least 5 different investment holdings, so that no single holding accounts for more than 25% of the portfolio assets, according Arthur Bell, head of a Hunt Valley, Md., firm that advises hedge funds on tax and accounting issues. In the real world, most portfolios include far more than 5 separate holdings, to prevent fluctuations in holding values from pushing any single holding over the 25% limit, Bell says.

The final regulations appear to affect a relatively small group of advisors and insurers doing business in the private placement life insurance market, experts interviewed say.

Laurie Lewis, vice president for taxes and retirement security at the American Council of Life Insurers, Washington, says, "We didn’t have any problems with the fundamental changes to the regulation."

The Managed Funds Association, Washington, had no immediate reaction to the final regulation. But, in general, "there wasn’t a strong interest coming out of the hedge fund industry on this," says Bell, who is the MFA treasurer.

One angry advisor responded to a regulation draft released in July 2003 by asking whether the IRS had the authority to make the change. Some other members of the public responded to the draft regulation by asking the IRS to grandfather in existing life insurance policies and annuity contracts. The IRS rejected that request, but it will give taxpayers until Dec. 31 to cope with the new diversification rules. Back in July 2003, the IRS had suggested that it might give taxpayers only 2 quarters of the year to comply, according to Polfer’s team.

In theory, a wealthy taxpayer might be able to comply with the new diversification rules by bundling stakes in many different hedge funds in a life or annuity portfolio. So far, though, advisors have not set up many, if any, such portfolios, in part because of concerns about costs, Lewis says.