Tax Court Holds that Owner of Variable Life Insurance Policy is Taxable on ‘Inside Buildup’ based on Investor Control
In the first judicial decision on investor control in thirty years, the IRS scores a landmark victory that poses a material threat to owners of variable life insurance policies and the perceived tax deferral benefits of such policies.
The facts of Webber v. Comm’r, 144 T.C. 17 (June 30, 2015), involve an all-too-common structure. Mr. Webber settled and funded an asset protection trust, which used gifted monies to purchase variable life insurance policies. Premiums paid on the policies were kept by the insurance company in separate accounts. Over a period of the years, the taxpayer made a series of recommendations to the insurance company regarding how the monies in the separate accounts should be invested. Although the policies in Webber purported to give the insurance company and its investment managers “complete discretion” to select investments, the Tax Court found that the restriction meant nothing in practice. Ultimately the level of control proved too significant, and the Tax Court found that the taxpayer should be treated as the owner of the separate account assets based on the investor control doctrine. That doctrine states that if the policyholder’s incidents of ownership over the assets inside the policy become sufficiently comprehensive, the holder rather than the insurance company is treated as the true owner of those assets for federal income tax purposes. In that event, a major benefit of the insurance policy – i.e., the deferral or elimination of tax on the “inside buildup,” is lost and the holder is taxed currently on investment income as it is realized.
In rendering its holding, the Tax Court rejected the taxpayer’s argument that the investor control doctrine only applied to annuities and not life policies. The Tax Court further rejected the taxpayer’s argument that he should not be taxed on the inside buildup since he was not in “contrastive receipt” of the investment earnings. The Court found that investor control is a separate doctrine that addresses a different problem than constructive receipt.
The Webber decision serves as a warning to all holders of variable life policies that exert influence over the investments inside the policy. The time is now for policyholders to professionally assess their level of control and take action to insure that the purported tax deferral benefits of such policies are not in danger based on the investor control doctrine and the Webber decision. A copy of the Webber decision can be viewed here: http://www.ustaxcourt.gov/InOpHistoric/WebberDivision.Lauber.TC.WPD.pdf