Although all individuals holding a life insurance policy own an investment, they did not have the legal right to exert control over the investments inside the policy.
However, according to a recent ruling by the U.S. Tax Court, investors who exercise control over how money is invested are subject to tax on the investment income. This case was significant because it is seen as a landmark victory for the IRS in how the income from variable life insurance and annuities policies are taxed. This negates the perceived tax-advantaged benefits of such policies, and thus, life insurance policy control is shifted.
Webber v. Commissioner
In the case, Jeffrey T. Webber purchased a single premium life insurance policy on his aunt. The issuer then deposited the balance into a segregated fund to reinsure the annual risk. Webber then advised the fund manager over several years to invest the money in publicly traded stocks and private investments in which he was involved or knew to be value investments. In turn, the fund manager followed all the suggestions and invested the money in accordance with Webber's advice. As a result, the IRS ruled that Webber was subject to tax on the income generated in the segregated fund because while he did not have the legal right to provide recommendations on how to invest the money, the fund manager followed Webber's orders.
The Tax Court ruling
In the decision, the court upheld the IRS assertion by applying the investor control doctrine evidenced in Rev. Rul. 77-85. This meant that if Webber exercised control over how the money was invested in the fund, he must then be considered the owner of the fund and the income in it.
Previously, Congress had issued insurance tax rules that asserted the investor control doctrine. The way this worked was that the tax code imposed limitations on the level of influence that policy owners could contribute to their variable insurance and annuity contracts. It also required policy investment diversification. However, with the decision, the court ruled that Webber bypassed these limitations because while the fund was diversified, the fund manager invested in private funds that he or she would not have known about without Webber's recommendations.
In rendering its holding, the court rejected Webber's argument that the investor control doctrine applied solely to annuities, and not life insurance policies. Further, the court rejected his argument that he should not be subject to tax on the "inside buildup" since he was not in constructive receipt of the investment earnings. Therefore, the court drew a distinction in investor control, asserting that it is a separate doctrine that addresses a different area, and not applicable to constructive receipt.
Webber v. Commission marks the first ruling on investors and life insurance policy control in more than 30 years, but it also poses a material threat to owners of life insurance and annuity policies. If holders exert control over variable life insurance and annuity policies, then they assume control over the investments inside the policy. Thus, holders are taxed on the current investment income because they lose the deferral or elimination of tax on the inside buildup.
What this means for policy holders is that they need to assess their level of influence on their investments to ensure that the tax-deferred benefits of the policy are not in jeopardy based on the investor control doctrine or the Webber decision.