Steve Leimberg's Estate Planning Email Newsletter - Archive Message #564

Date:

24-Jul-03 12:06 AM

From:

Steve Leimberg's Estate Planning Newsletter

Subject:

Rev. Rulings 2003-91 and 92 - Private Placement Variable Life

 

LISI Commentator Bob Colvin of Chamberlain, Hrdlicka, White, Williams & Martin in Houston burned the midnight oil to provide us with this extensive and introspective analysis of Rev. Rulings 2003-91 and 92.

The rulings triggered frantic calls from several major newspapers (sharks smelling blood in the waters?) when the Treasury announced yesterday that it and the IRS issued these rulings "to curtail the abusive use of life insurance and annuity contracts to avoid current taxation on investment earnings."

The rulings – which from a glance at the headlines of the IRS announcement threatened to be an entirely new and devastating approach - promulgated by the Treasury to inhibit the use of standard insurance contracts – in reality are much less life threatening than they appear. They focus only on the much more narrow field of private placement variable life and annuity contracts "'wrapped' around other investments" (most notably direct hedge fund investments) and the issue of who will be considered the owner for income tax purposes of the underlying investments." In other words, will the "tax protective wrapper" of life insurance/annuities be available – or will the owner be taxed currently on returns from the underlying investments?

Here's Bob Colvin's carefully considered analysis:

EXECUTIVE SUMMARY:

Rev. Rul 2003-91, a generally positive ruling, concludes with the generally accepted principle that Holders (contract owners) of life insurance contracts and variable annuities are permitted to freely allocate investments among a limited menu of insurance dedicated funds previously established exclusively for investment by insurance carriers or through insurance products.

Rev. Rul. 2003-92 crosses into more hostile territory by ruling that Holders are not permitted to direct that separate account funds be invested into “nonregistered” partnerships which accept investments from persons other than insurance or annuity contracts (thus discouraging direct investment into hedge funds). The basic holding of this second ruling is directly contrary to the long standing regulations under Code section 817(h) with respect to the required diversification of variable contract separate accounts.

FACTS:

Yesterday, the IRS issued companion Revenue Rulings 2003-91 & 2003-92 addressing the hotly debated issue of “investor control” in variable contracts with its sights set squarely on the increasingly popular private placement insurance market.

The Treasury press release states these rulings “will curtail the purchase of life insurance and annuity contracts primarily for tax avoidance purposes.”

THE ISSUE

The long standing debate has been over the degree of specificity by which a variable contract owner (called a “Holder” in the rulings) is permitted to allocate assets of the underlying separate account supporting their policy to specific investments or investment funds. In particular, these rulings address the controversial issue of when can the Holder direct that his/her account be invested into certain publicly available funds.

THE BASIC HOLDINGS

Rev. Rul 2003-91 is couched in more positive tones by concluding with the generally accepted principle that Holders are permitted to freely allocate among a limited menu of insurance dedicated funds previously established exclusively for investment by insurance carriers or through insurance products.

Rev. Rul. 2003-92 crosses into more hostile territory by ruling that Holders are not permitted to direct that separate account funds be invested into “non-registered” partnerships which accept investments from persons other than insurance or annuity contracts. The basic holding of this ruling is directly contrary to the long standing regulations under section 817(h) with respect to the required diversification of variable contract separate accounts.

REGS VERSUS REVENUE RULINGS

In particular, regulations section 1.817-5(f)(ii) and –5(g)(ex. 3) are generally considered to expressly permit the Holder to request investment of their separate account funds into otherwise publicly available partnerships (such as hedge funds) - provided the fund is not “registered” under federal or state securities law.

There is a debate within the SEC at this time that many expect to result in required registration of private investment partnerships such as hedge funds. If enacted, then the controversy of these revenue rulings will, at least in part, be muted for the majority of private placement insurance Holders. If registered, then it is generally clear the hedge funds must be insurance dedicated to permit direct allocation by the Holder.

BLATENT DISREGARD OF REGULATIONS:

It is this author’s personal belief the rulings are seriously lacking in technical support, internally inconsistent, contrary to the clear language of long standing regulations, and unlikely to prevail if challenged in court. But then, I would not want one of my clients to be the one fitting the bill for that battle.

It is disturbing to the insurance industry and many legal practitioners that the IRS would so blatantly disregard its own regulations. It is particularly disconcerting in this case where the regulations have been of long standing duration (since 1986) and were promulgated pursuant to Congressionally mandated criteria.

Regulations are issued under more rigid oversight standards, including the requirement for public notice and comment, that is noticeably lacking when a mere revenue ruling is published. The courts have generally recognized this distinction by providing a significantly higher degree of deference to properly promulgated regulations than to less thoughtfully scrutinized revenue rulings.

Despite what could be argued to be less than thorough analysis supporting these rulings, the insurance industry must now address their impact and properly adjust to their effect.

Therefore, let’s consider certain of the statements, conclusions and innuendos embodied in the rulings.

ATTEMPTED TIE-IN TO EXISTING REGULATIONS

Albeit arguably contrary to the regulations, the rulings make a point to justify issuance of these rulings based on the preamble to the section 817 regulations first proposed back in 1986. In particular, the rulings quote:

The temporary regulations …do not provide guidance concerning the circumstances in which investor control of the investments in a segregated asset account may cause the investor, rather than the insurance company, to be treated as the owner of the assets in the account…..Guidance on this and other issues will be provided in regulations or revenue rulings under section 817(d), relating to the definition of variable contracts. [Emphasis added.]

Those of us active in the field have been waiting on this investor control messiah to join us for the past 17 years. However, the recent rulings are surely to spark divisive sects among true believers since the “good book” of the IRS has told us to expect this coming in the form of “regulations or revenue rulings under section 817(d).”

To the further confusion of mere mortals, both rulings were surprisingly issued under Code Section 61(a) rather than Section 817(d) as prophesized.

61 – 817 – WHAT'S THE DIFFERENCE AND WHY DOES THIS MATTER?

Section 61(a) versus 817(d)? Well, first it will leave the more “purist” believers waiting for the “true” word on this issue in the context of the diversification rules as promised.

On a more analytical basis, section 61(a) is about the most general provision in the Internal Revenue Code; which gives rise to the question of why an issue of this importance is not better suited for one of the many insurance specific provisions in the Code?

It is a basic premise of statutory interpretation that a provision specifically directed at the issue generally controls over the more general statements. So we are left with mere conjecture as to why sections 817, 72, or any of the other insurance specific provisions were considered unworthy to form the basis for this analysis.

It is also interesting to note that Code section 61(a) appears to be the latest weapon of choice in attacking insurance related issues within the IRS. For example, section 83 presented some uncomfortable problems in reaching the “right” result as they dismantled split dollar as we know it so the “go to” section for reinforcements was section 61(a). The IRS seems to be fishing lately with a very broad net.

REGURGITATED ANNUITY RULINGS

The two new rulings go through the standard mantra of reciting the familiar old investor control revenue rulings and, of course, the Christoffersen case, while casually pointing out these were all “prior to enactment of section 817”.

However, the new rulings fail to directly address the longstanding debate over whether enactment of the diversification rules of section 817 were intended by Congress to replace the prior hodge podge of investor control rulings. Nevertheless, I think the IRS position is clear since the facts forming the basis for the rulings expressly state the contracts comply with the regulations section 1.817-5(b)(1) diversification requirements.

Of particular significance is that each of the cited rulings and the Christoffersen case focused exclusively on investor control in the context of annuities; whereas the present rulings leap without any segue or analysis to the conclusion that the rules are (or should be) the same for life policies. Without digressing into a lengthy discourse on the obvious differences between life policies and annuities, it is interesting that in all the years of concern over the investor control issue there has never been any revenue ruling, notice or case specifically addressing this issue in the context of life policies. Until now, annuities have attracted all the attention. Suffice it to say this author believes there are significant unresolved issues concerning how the constructive receipt doctrine applies to annuities as compared to life policies.

PARTNERSHIPS MAKE THEIR DEBUT

It is furthermore very interesting the IRS has never before issued any revenue ruling or notice addressing the unique application of these principles to partnerships. The only guidance for taxation of partnerships within variable contracts has been found in regulations section 1.817-5(f)(ii) and -5(g)(ex. 3) cited above. As noted, these regulations expressly authorize direct investment into partnerships provided they meet the “non-registered” requirement. The two new rulings specifically state the partnerships therein are all non-registered. It is surprising that such a dramatic change in policy towards non-registered partnerships would be presented in a mere revenue ruling rather than through the more thoughtful regulatory hearings process.

SO WHAT STILL WORKS?

Private placement variable life will survive yet this latest attack on the insurance industry. Don’t forget our recently injured comrades split dollar, 419A plans, COLI and 412(i) plans to name a few. (In spite of attack and injury, all of these remain viable when used properly, albeit a bit embarrassed by all the recent unwanted attention with respect to overly aggressive and some downright abuses of these legitimate techniques.)

Here are some common formats of private placement variable life - from the most conservative - to something more aggressive:

1. Insurance dedicated fund. These are funds that restrict participation solely to investors entering through the purchase of an insurance or annuity contract and would exclude the majority of hedge funds in the market. This is the preferred model in the eyes of the IRS as it encourages the insurance industry to move exclusively to this format.

2. Independent asset allocators. The rulings do not expressly address these structures yet certain comments raise concerns. For example, yesterday’s rulings state “All decisions concerning the choice of Advisor… and any subsequent changes thereof, are made by [the insurance company] in its sole and absolute discretion. Holder may not communicate directly or indirectly with [the insurance company] concerning the selection or substitution of Advisor….” Does this prohibit the common practice in the industry by which a prospective Holder requests that a particular independent Advisor become qualified by the carrier to manage their separate account? Carriers are often introduced to a particular money manager by a prospective policy purchaser. However, would such an introduction prohibit that particular policy holder from allocating their separate account to that Advisor?

3. Direct hedge fund investments. This is exactly where the IRS bullet is aimed in the rulings. Although LTR 200244004 was issued last year as the initial volley in this battle, a large number of practitioners continued to believe the above cited regulations clearly permit direct investments into nonregistered partnerships such as hedge funds. Despite such personal beliefs, the market reality has evolved such that most carriers have over the past year reluctantly adopted the IRS position by refusing to permit direct investment into hedge funds.

4. Damn the torpedoes!!! There continues to be a proliferation of strategies promoted, whether based on thoughtful analysis or reckless disregard, that push the envelope to varying degrees and sometimes over the edge. These rulings will simply further isolate those planners and carriers.

SO WHERE DOES THAT LEAVE US?

1. The IRS will claim its analysis in PLR 20024404 has finally been vindicated, although it should be noted the same IRS group that issued these two revenue rulings also issued the PLR. It sounds good anyway (at least to them).

2. Regs versus revenue rulings? For the deep pocket willing to take on that battle for the rest of the industry, we will be cheering you on (from the sidelines).

3. Many carriers issuing private placement policies have already reluctantly adjusted to the PLR 20024404 so these latest rulings may simply reinforce that they made the correct business decision. However, most carriers continue to believe the asset allocator model is perfectly acceptable and these latest rulings may affect their level of confidence in this structure as well. Possibly, the IRS will throw us a bone and indorse this technique.

4. These rulings will effectively remove the huge marketing advantage recently enjoyed by hedge funds over their mutual fund brethren. As noted above, SEC registration of hedge funds will likely eliminate this distinction in the near future anyway.

5. The rulings appear to permit practically “day trading” of funds with separate accounts provided that all the investment choices meet the insurance dedicated requirements. Is this the bone they threw us?

A new wave of creativity will surely find a way around some of these latest obstacles. Private placement is here to stay and will continue to play an important role in planning for high net worth families who demand greater pricing efficiency.

"I'M SORRY, THE NUMBER YOU HAVE CALLED…"

As a final note, I attempted to call the author of the ruling at the IRS but was told the entire IRS group has moved and their phones have been disconnected (I'm not kidding).

Try giving that explanation to the IRS next time they challenge one of your opinion letters taking a position contrary to these rulings!!!

HOPE THIS HELPS YOU HELP OTHERS!!!

Bob Colvin

Edited by Steve Leimberg

CITE AS:

Steve Leimberg's Estate Planning Newsletter # 564  Copyright 2003 LISI (Leimberg Information Services, Inc.) To Access LISI Archives or Join LISI: http://www.leimbergservices.com

CITES:

IRS PRESS RELEASE JS-591: JULY 23, 2003; Rev. Rul. 2003-91; Rev. Rul. 2003-92; Reg. Section 1.817-5(d)(1); Reg. Section 1.817-5(f)(ii); Reg. Section 1.817-5(g)(ex. 3); IRC Section 61(a); IRC Section 817; Christoffersen v. United States, 749 F.2d 513 (8th Cir.), rev’g 578 F.Supp. 398 (N.D. Iowa 1984); LTR 200244004;  Tax Planning With Life Insurance (800 950 1216).

 

 



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