Under the "investment control" doctrine, the taxpayer who established a grantor trust that purchased "private placement" variable life insurance policies insuring the lives of two elderly relatives was the actual owner of the assets in the separate accounts underlying the policies.
- The premiums paid for the policies, less various expenses, were placed in separate accounts whose assets inured exclusively to the benefit of the policies.
- The money in the separate accounts was used to purchase investments in startup companies with which Webber was intimately familiar and in which he otherwise invested personally and through private-equity funds he managed. He effectively dictated both the companies in which the separate accounts would invest and all actions taken with respect to those investments.
On audit, IRS concluded that Webber retained sufficient control
and incidents of ownership over the assets in the separate accounts to be
treated as their owner for Federal income tax purposes under the "investor
control" doctrine.
The
Tax Court finding that IRS's Revenue Rulings enunciating the "investor
control" doctrine were entitled to deference and weight and concluded that
Webber was the owner of the assets in the separate accounts for Federal income
tax purposes. Accordingly, he was taxable on the income earned on those assets
during the tax years in issue.
The Court noted that the powers that Webber retained included
the power to direct investments; the power to vote shares and exercise other
options with respect to these securities; the power to extract cash at will
from the separate accounts; and the power in other ways to derive "effective
benefit" from the investments in the separate accounts.
However, the Tax Court held that Webber wasn't liable for the
accuracy-related penalties under Code Sec. 6662(a) because he relied in good
faith on professional advice from competent tax professionals.
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144 T.C. No. 17
UNITED STATES TAX COURT
JEFFREY T. WEBBER, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 14336-11. Filed June 30, 2015.
P, a U.S. citizen, established a grantor trust that purchased
“private placement” variable life insurance policies insuring the lives
of two elderly relatives. P and various family members were the
beneficiaries of these policies. The premiums paid for the policies,
less various expenses, were placed in separate accounts whose assets
inured exclusively to the benefit of the policies. The money in the
separate accounts was used to purchase investments in startup
companies with which P was intimately familiar and in which he
otherwise invested personally and through private-equity funds he
managed. P effectively dictated both the companies in which the
separate accounts would invest and all actions taken with respect to
these investments.
R concluded that P retained sufficient control and incidents of
ownership over the assets in the separate accounts to be treated as
their owner for Federal income tax purposes under the “investor
control” doctrine. See Rev. Rul. 77-85, 1977-1 C.B. 12. The powers
P retained included the power to direct investments; the power to vote
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shares and exercise other options with respect to these securities; the
power to extract cash at will from the separate accounts; and the
power in other ways to derive “effective benefit” from the
investments in the separate accounts. See Griffiths v. Helvering, 308
U.S. 355, 358 (1939).
1. Held: The IRS revenue rulings enunciating the “investor
control” doctrine are entitled to deference and weight under Skidmore
v. Swift & Co., 323 U.S. 134, 140 (1944).
2. Held, further, P was the owner of the assets in the separate
accounts for Federal income tax purposes and was taxable on the
income earned on those assets during the taxable years in issue.
3. Held, further, P is not liable for the accuracy-related
penalties under I.R.C. sec. 6662(a) because he relied in good faith on
professional advice from competent tax professionals.
Robert Steven Fink, Megan L. Brackney, and Joseph Septimus, for
petitioner.
Steven Tillem, Shawna A. Early, and Casey R. Kroma, for respondent.
LAUBER, Judge: Petitioner is a venture-capital investor and private-equity
fund manager. He established a grantor trust that purchased “private placement”
variable life insurance policies insuring the lives of two elderly relatives. These
policies were purchased from Lighthouse Capital Insurance Co. (Lighthouse), a
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Cayman Islands company. Petitioner and various family members were the beneficiaries
of these policies.
The premium paid for each policy, after deduction of a mortality risk premium
and an administrative charge, was placed in a separate account underlying the
policy. The assets in these separate accounts, and all income earned thereon, were
segregated from the general assets and reserves of Lighthouse. These assets inured
exclusively to the benefit of the two insurance policies.
The money in the separate accounts was used to purchase investments in
startup companies with which petitioner was intimately familiar and in which he
otherwise invested personally and through funds he managed. Petitioner effectively
dictated both the companies in which the separate accounts would invest and all
actions taken with respect to these investments. Petitioner expected the assets in
the separate accounts to appreciate substantially, and they did.
Petitioner planned to achieve two tax benefits through this structure. First,
he hoped that all income and capital gains realized on these investments, which he
would otherwise have held personally, would escape current Federal income taxation
because positioned beneath an insurance policy. Second, he expected that the
ultimate payout from these investments, including all realized gains, would escape
Federal income and estate taxation because payable as “life insurance proceeds.”
-4-
Citing the “investor control” doctrine and other principles, the Internal Revenue
Service (IRS or respondent) concluded that petitioner retained sufficient
control and incidents of ownership over the assets in the separate accounts to be
treated as their owner for Federal income tax purposes. Treating petitioner as having
received the dividends, interest, capital gains, and other income realized by the
separate accounts, the IRS determined deficiencies in his Federal income tax of
$507,230 and $148,588 and accuracy-related penalties under section 6662 of
$101,446 and $29,718 for 2006 and 2007, respectively.1 We will sustain in large
part the deficiencies, but we conclude that petitioner is not liable for the penalties.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found. The stipulations of
facts and the attached exhibits are incorporated by this reference. When he
petitioned this Court, petitioner lived in California.
Petitioner’s Background and Business Activities
Petitioner received his bachelor’s degree from Yale College and attended
Stanford University’s M.B.A. program. He left Stanford early to start a
1All statutory references are to the Internal Revenue Code (Code) as in
effect for the tax years in issue. All Rule references are to the Tax Court Rules of
Practice and Procedure. All dollar amounts have been rounded to the nearest
dollar.
-5-
technology consulting firm, and he later founded and managed a series of privateequity
partnerships that provided “seed capital” to startup companies. These
partnerships were early-stage investors that generally endeavored to supply the
“first money” to these entities. Separately, petitioner furnished consulting services
to startup ventures through his own firm, R.B. Webber & Co. (Webber & Co.).
Each venture-capital partnership had a general partner that was itself a partnership.
Petitioner was usually the managing director of the general partner. The
venture-capital partnership offered limited partnership interests to sophisticated
investors. These offerings were often oversubscribed.
As managing director, petitioner had the authority to make, and did make,
investment decisions for the partnerships. To spread the risk of investing in new
companies, petitioner often invested through syndicates. A syndicate is not a
formal legal entity but a group of investors (individuals or funds) who seek to
invest synergistically. Generally speaking, the syndicate’s goal was to make earlystage
investments in companies that would ultimately benefit from a “liquidity
event” like an initial public offering (IPO) or direct acquisition.
Before investing in a startup company, petitioner performed due diligence.
This included review of the company’s budget, business plan, and cashflow model;
his review also included analysis of its potential customers and competitors
-6-
and the experience of its entrepreneurs. Because petitioner, through Webber &
Co., provided consulting services to numerous startup companies, he had access to
proprietary information about them. On the basis of all this information, petitioner
decided whether to invest, or to recommend that one of his venture-capital partnerships
invest, in a particular entity. Having made an early-stage investment, petitioner
usually sought to find new investors for that company, so as to spread his
risk, enhance the company’s prospects, and move it closer to a “liquidity event.”
Having supplied the “first money” to these startup ventures, petitioner and
his partnerships were typically offered subsequent opportunities to invest in them.
These opportunities are commonly called “pro-rata offerings.” As additional
rounds of equity financing are required, a pro-rata offering gives a current equity
owner the chance to buy additional equity in an amount proportionate to his existing
equity. This enables him to maintain his current position and avoid “dilution”
by new investors. Depending on the circumstances, petitioner would accept or
decline these pro-rata offerings.
Petitioner invested in startup companies in various ways. He held certain
investments in his own name; he invested through trusts and individual retirement
accounts (IRAs); and he invested through the venture-capital partnerships that he
managed. To help him manage this array of investments, petitioner in 1999 hired
-7-
Susan Chang as his personal accountant. She had numerous and diverse responsibilities.
These included determining whether petitioner had funds available for a
particular investment; ensuring that funds were properly transferred and received;
communicating with lawyers, advisers, paralegals, and others about investments in
which petitioner was interested; and maintaining account balances and financial
statements for petitioner’s personal investments.
Because of his expertise, knowledge of technology, and status as managing
director of private-equity partnerships, petitioner served as a member of the board
of directors for more than 100 companies. As relevant to this opinion, petitioner
through various entities invested in, and served on the boards of, the following
companies at various times prior to December 31, 2007:
Company Name
Board
Member or
Officer
Petitioner Individually
or Through a Private
Equity Partnership
Invested In
Petitioner Through an
IRA Invested In
Accept Software Yes Yes Yes
Attensity Corp. Yes Yes No
Borderware Tech. Yes Yes Yes
DTL Plum Investments No Yes No
JackNyfe, Inc. Yes Yes No
Lignup, Inc. Yes Yes Yes
Links Mark Multimedia No Yes No
Lunamira, Inc. No Yes No
-8-
Medstory, Inc. No Yes No
Milphworld, Inc. No Yes No
Nextalk, Inc. Yes Yes No
Prevarex, Inc. Yes Yes No
Promoter Neurosciences No Yes No
PTRx Media, LLC Yes Yes Yes
Push Media, LLC No Yes No
RJ Research, Inc. No Yes No
Reactrix Systems, Inc. No Yes No
Renaissance 2.0 Media No Yes No
Signature Investments No Yes No
Soasta, Inc. Yes Yes Yes
Techtribenetworks, Inc. Yes Yes No
Vizible Corp. Yes Yes Yes
Weldunn Restaurant Group No Yes Yes
Webify Solutions Yes Yes No
Petitioner’s Tax and Estate Planning
By 1998 petitioner had enjoyed success in his investing career and accumulated
assets in excess of $20 million. An attorney named David Herbst, who furnished
petitioner with tax advice, recommended that he secure the assistance of an
experienced estate planner. One of petitioner’s college classmates referred him to
William Lipkind, a partner in the law firm Lampf, Lipkind, Prupis and Petigrow.
-9-
Petitioner met with Mr. Lipkind for the first time in 1998 at Mr. Herbst’s
office. 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 petitioner that the strategy was sound. After
several followup conversations, petitioner hired Mr. Lipkind to do his estate planning
and stated his intention to purchase the private placement life insurance. Mr.
Lipkind then undertook a series of steps to implement this strategy.
The Grantor Trusts
The first step was the creation of a grantor trust, which had three iterations
between 1999 and 2008. On March 24, 1999, petitioner established the Jeffrey T.
Webber 1999 Alaska Trust (Alaska Trust), a grantor trust for Federal income tax
purposes. Mr. Lipkind recommended Alaska as the situs in part because that State
has no income tax; he was concerned that certain tax risks could arise if the trust
were formed in California, where petitioner resided. Mr. Lipkind’s firm drafted
the trust documents and customized them to petitioner’s needs.
-10-
The trustees of the Alaska Trust were Mr. Lipkind and the Alaska Trust Co.
Petitioner could remove the trustees at any time and replace them with “Independent
Trustees.” The beneficiaries 2 were petitioner’s children, his brother, and
his brother’s children. Petitioner was named a discretionary beneficiary of the
Alaska Trust, which was necessary to achieve grantor trust status.3
In 1999 petitioner contributed $700,000 to the Alaska Trust. The trustee
used these funds to purchase from Lighthouse two “Flexible Premium Restricted
Lifetime Benefit Variable Life Insurance Policies” (Policy or Policies). Petitioner
timely filed Form 709, United States Gift (and Generation-Skipping Transfer) Tax
Return, reporting this $700,000 gift. He attached to this return a disclosure
statement explaining that the Alaska Trust “purchased two variable life insurance
policies * * * for an aggregate first year’s premium of $700,000” and noting that
2Independent Trustees could include any bank or an attorney who was not
“within the meaning of section 672(c) * * * related or subordinate to the Grantor.”
3The Alaska Trust provided that “any one Independent Trustee acting alone”
may distribute to petitioner as Grantor “such amounts of the net income and/or
principal * * * as such Independent Trustee deems wise.” In determining whether
to make any such distribution, the trustee was required to take into consideration
“the Grantor’s own income and property and any other income or property which
may be available to the Grantor.” The trustee was empowered to exercise such
discretion without regard to the interest of remaindermen.
-11-
his “contributions to the Trust were completed gifts and the Trust assets will not
be includible in [his] gross estate.”
The Alaska Trust was listed as the owner of the Policies from October 28,
1999, to October 8, 2003. During 2003 petitioner became concerned about protecting
his assets from creditors because Webber & Co. was encountering financial
problems, he was going through a divorce, and he feared lawsuits from unhappy
private-equity investors following the “dot.com” crash. With the goal of achieving
asset protection, petitioner asked Mr. Lipkind to move the Alaska Trust assets
offshore. Mr. Lipkind advised against doing this because of the tax disadvantages
it could entail. Petitioner nevertheless persisted in his desire for asset protection,
and Mr. Lipkind complied with his wishes.
On October 9, 2003, Mr. Lipkind established the Chalk Hill Trust, a foreign
grantor trust organized under the laws of the Commonwealth of the Bahamas. The
Alaska Trust then assigned all of its assets, including the Policies, to the Chalk
Hill Trust. Petitioner filed a timely Form 3520, Annual Return To Report Transactions
With Foreign Trusts and Receipt of Certain Foreign Gifts, reporting this
transfer and signing the return as “owner-beneficiary” of the Chalk Hill Trust.
Petitioner was the grantor of the Chalk Hill Trust and is treated as its owner
for Federal income tax purposes. The trustee was Oceanic Bank & Trust, Ltd.; the
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U.S. protector was Mr. Lipkind; and the foreign protector was an entity from the
Isle of Man. Petitioner and his issue were the beneficiaries of the Chalk Hill
Trust. During petitioner’s lifetime the trustee had “uncontrolled discretion” to
distribute trust assets to the beneficiaries. Mr. Lipkind, as the U.S. protector,
could remove and replace the trustee at any time.
The Chalk Hill Trust was listed as the owner of the Policies from October 9,
2003, through March 6, 2008. It was thus the nominal owner of the Policies during
the tax years in issue. In early 2008 petitioner became confident that the credit
risks had passed and decided to move the trust assets back to a domestic grantor
trust. The Delaware Trust was established for that purpose, and all assets of the
Chalk Hill Trust, including the Policies, were assigned to it. The salient terms of
the Delaware Trust arrangement did not differ materially from the terms of the
prior two grantor trust arrangements. We will sometimes refer to the Alaska Trust,
the Chalk Hill Trust, and the Delaware Trust collectively as “the Trusts.”
Lighthouse
Lighthouse is a Cayman Islands class B unlimited life insurance company
established in 1996 and regulated by the Cayman Islands Monetary Authority.
Lighthouse issues annuity and variable life insurance products. During 1999 it
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issued 70 to 100 policies with a total outstanding face value of $250 to $300
million. Petitioner had no direct or indirect ownership interest in Lighthouse.
Lighthouse is managed by Aon Insurance Managers (Aon), a wholly owned
subsidiary of Aon PLC, a major insurance company headquartered in London.
Aon was responsible for the day-to-day operations of Lighthouse, including its
recordkeeping, compliance, and financial audits. Lighthouse reinsures mortality
risk arising under its policies with Hannover Rückversicherung-AG (Hannover
Re), a well-respected reinsurer. Lighthouse generally reinsures all but $10,000 of
the mortality risk on each policy, as it did with these Policies. For some elderly
insureds, such as those under petitioner’s Policies, Lighthouse reinsured virtually
100% of the morality risk.
Before issuing a policy Lighthouse would conduct an underwriting analysis
and seek medical information about the prospective insured. Where (as here) the
policyholder was not the insured, Lighthouse performed due diligence regarding
the source of funds. It also confirmed the existence of an insurable interest.
The Policies
The Policies, initially acquired by the Alaska Trust and later transferred to
the Chalk Hill Trust, insured the lives of two of petitioner’s relatives. The first
Policy insured the life of Mabel Jordan, the stepgrandmother of petitioner’s then
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wife. Ms. Jordan, who was 78 years old when the Policy was issued, died in November
2012 at age 92. The second Policy insured the life of Oleta Sublette, petitioner’s
aunt. She was 77 years old when the Policy was issued and was still alive
at the time of trial. Each Policy had a minimum guaranteed death benefit of
$2,720,000.
Each Policy required Lighthouse to establish a separate account pursuant to
section 7(6)(c) of the Cayman Islands Insurance Law to fund benefits under that
Policy. On receiving the initial premiums in 1999, Lighthouse debited against
them the first-year policy charges (a one-year mortality risk premium and one
year’s worth of administrative fees). Lighthouse kept the administrative fees and
transferred most of the mortality risk premium to Hannover Re. The remainder of
each premium was allocated to the relevant separate account. On an annual basis
thereafter, Lighthouse debited each separate account for that year’s mortality and
administrative charges. If the assets in the separate account were insufficient to
defray these charges, the policyholder had to make an additional premium payment
to cover the difference; otherwise, the policy would lapse and terminate.
The annual administrative fee that Lighthouse charged each Policy equaled
1.25% of its separate account value. There was an additional fee to cover services
nominally provided by the Policies’ “investment manager.” (As explained below,
-15-
that fee was modest.) The mortality risk charge was determined actuarially, but it
rapidly decreased as the value of the separate accounts approached or exceeded the
minimum death benefit of $2,720,000. The mortality risk charges debited to the
separate accounts during 2006-2007 totaled $12,327.
The minimum death benefit was payable in all events so long as the Policy
remained in force. If the investments in the separate account performed well, the
beneficiary upon the insured’s death was to receive the greater of the minimum
death benefit or the value of the separate account. The Policies provided that the
death benefit would be paid by Lighthouse “in cash to the extent of liquid assets
and in kind to the extent of illiquid assets (any in kind payment being in the sole
discretion of Lighthouse), or the Death Benefit shall be paid by such other arrangements
as may be agreed upon.”
The Policies permitted the policyholder to add additional premiums if necessary
to keep the Policies in force. On September 7, 2000, the Alaska Trust
made an additional premium payment of $35,046 to cover a portion of the secondyear
mortality/administrative charge. The assets in the separate accounts performed
so well that no subsequent premium payments were required. Thus, the
total premiums paid on the Policies by the Alaska Trust (and by its successor
grantor trusts) amounted to $735,046.
-16-
The Policies granted certain rights to the policyholder prior to the deaths of
the insureds. Each Policy permitted the policyholder to assign it; to use it as collateral
for a loan; to borrow against it; and to surrender it. If the policyholder
wished to assign a Policy or use it as collateral for a loan, Lighthouse had the
discretion to reject such a request.
However, the Policies significantly restricted the amount of cash the policyholder
could extract from the Policies by surrender or policy loan. This restriction
was accomplished by limiting the Cash Surrender Value of each Policy to the total
premiums paid, and by capping any policy loan at the Cash Surrender Value. For
this purpose, “premiums” were defined as premiums paid in cash by the policyholder,
to the exclusion of mortality/administrative charges debited from the
separate accounts.
Thus, if the separate accounts performed poorly and the policyholder paid
cash to cover ongoing mortality/administrative charges, those amounts would
constitute “premiums” and would increase the Cash Surrender Value. By contrast,
if the separate accounts performed well and ongoing mortality/administrative
charges were debited from the separate accounts, those amounts were not treated
as premiums that increased the Cash Surrender Value, but as internal charges paid
-17-
by Lighthouse. The result 4 of this restriction was that the maximum amount the
Trusts could extract from the Policies prior to the deaths of the insureds, by surrendering
the Policies or taking out policy loans, was $735,046.
Investment Management of the Separate Accounts
Lighthouse did not provide investment management services for the separate
accounts. Rather, it permitted the policyholder to select an investment manager
from a Lighthouse-approved list. For most of 2006 and 2007 Butterfield
Private Bank (Butterfield), a Bahamian bank, served as the investment manager
for the separate accounts. The Policies specified that Butterfield would be paid
$500 annually for investment management services and $2,000 for accounting.5 In
November 2007 Experta Trust Co. (Bahamas), Ltd. (Experta), became the
investment manager. No one testified at trial on behalf of Butterfield or Experta.
We will refer to these entities collectively as the “Investment Manager.”
4For 2006 and 2007 the separate accounts paid Lighthouse $130,000 and
$161,500, respectively, to cover annual mortality/administrative charges. The
2007 charges were higher because the separate accounts’ values had increased.
5It appears that the separate accounts paid Butterfield $8,500 in overall fees
for 2006 and 2007, but there is no evidence that any amount in excess of $500 per
year was allocable to investment management. Petitioner directs the Court’s attention
to an accounting entry showing “Administrative Fees” of $20,500 paid in
2007, but there is no evidence to establish what these were paid for.
-18-
As drafted, the Policies state that no one but the Investment Manager may
direct investments and deny the policyholder any “right to require Lighthouse to
acquire a particular investment” for a separate account. Under the Policies, the
policyholder was allowed to transmit “general investment objectives and guidelines”
to the Investment Manager, who was supposed to build a portfolio within
those parameters. The Trusts specified that 100% of the assets in the separate
accounts could consist of “high risk” investments, including private-equity and
venture-capital assets. Lighthouse was required to perform “know your client”
due diligence, designed to avoid violation of antiterrorism and moneylaundering
laws, and was supposed to ensure that “the Separate Account investments [were
managed] in compliance with the diversification requirements of Code Section
817(h).”
Besides setting the overall investment strategy for a separate account, a
policyholder was permitted to offer specific investment recommendations to the
Investment Manager. But the Investment Manager was nominally free to ignore
such recommendations and was supposed to conduct independent due diligence
before investing in any nonpublicly-traded security. Although almost all of the
investments in the Policies’ separate accounts consisted of nonpublicly-traded
securities, the record contains no compliance records, financial records, or busi-
19-
ness documentation (apart from boilerplate references in emails) to establish that
Lighthouse or the Investment Manager in fact performed independent research or
meaningful due diligence with respect to any of petitioner’s investment directives.
Lighthouse created a series of special-purpose companies to hold the investments
in the separate accounts. The Lighthouse Nineteen Ninety-Nine Fund LDC
(1999 Fund), organized in the Bahamas, was created when the separate accounts
were initially established. During the tax years in issue the principal special-purpose
company was Boiler Riffle Investments, Ltd. (Boiler Riffle), likewise organized
in the Bahamas. These investment funds were owned by Lighthouse but were
dedicated exclusively to funding death benefits under the Policies through the
separate accounts. These special-purpose vehicles were not available to the
general public or to any other Lighthouse policyholder.
The “Lipkind Protocol”
Mr. Lipkind explained to petitioner that it was important for tax reasons that
petitioner 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, petitioner followed
the “Lipkind protocol.” This meant that petitioner never communicated--by
email, telephone, or otherwise--directly with Lighthouse or the Investment Mana-
20-
ger. Instead, petitioner 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 petitioner’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
petitioner: “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.
Investments by the Separate Accounts
In April 1999, shortly after the Alaska Trust initiated the Policies, the 1999
Fund purchased from petitioner, for $2,240,000, stock that petitioner owned in
three startup companies: Sagent Technology, Inc., Persistence Software, Inc., and
Commerce One, Inc. Petitioner was unsure how the 1999 Fund could have paid
him $2,240,000 for his stock when the Alaska Trust at that point had paid premiums
toward the Policies of only $700,000 (before reduction for very substantial
first-year mortality charges). He speculated that he might have made an installment
sale.
-21-
Petitioner testified that he expected the stock in these three companies to
“explode” in value. They did. Not long thereafter, each company had a “liquidity
event”--either an IPO or direct sale--that enabled the separate accounts to sell the
shares at a substantial gain. Those profits were used to purchase other investments
for the separate accounts during the ensuing years.
During 2006-2007 Boiler Riffle was the special-purpose entity through
which petitioner effected most of his investment objectives for the Policies.6 (In
their email correspondence, petitioner and Mr. Lipkind often refer to Boiler Riffle
as “BR” or “br,” and various parties refer to petitioner as “Jeff.”). Petitioner
achieved his investment objectives by entering into transactions directly with
Boiler Riffle and by offering through his intermediaries “recommendations” about
assets in which Boiler Riffle should invest.
The net result of this process was that every investment Boiler Riffle made
was an investment that petitioner had “recommended.” Apart from certain brokerage
funds, virtually every security that Boiler Riffle held was issued by a startup
company in which petitioner had a personal financial interest, e.g., by sitting on its
6Boiler Riffle had 5,000 shares of stock outstanding, and its Register of
Members showed 2,500 shares as “owned” by each Policy. Since an insurance
policy cannot own property, the Court interprets this reference to mean that half of
the assets held by Boiler Riffle were dedicated respectively to each Policy.
-22-
board, by investing in its securities personally or through an IRA, or by investing
in its securities through a venture-capital fund he managed. The Investment
Manager did no independent research about these fledgling companies; it never
finalized an investment until Mr. Lipkind had signed off; and it performed no due
diligence apart from boilerplate requests for organizational documents and “know
your customer” review. The Investment Manager did not initiate or consider any
equity investment for the separate accounts other than the investments that petitioner
“recommended.” The Investment Manager was paid $500 annually for its
services, and its compensation was commensurate with its efforts.
The 70,000 emails in the record establish that Mr. Lipkind and Ms. Chang
served as conduits for the delivery of instructions from petitioner to Lighthouse
and Boiler Riffle. The fact that Boiler Riffle invested almost exclusively in startup
companies in which petitioner had a personal financial interest was not serendipitous
but resulted from petitioner’s active management over these investments.
The following table shows the startup companies in which Boiler Riffle held
investments at year end 2006 and 2007, the form of those investments, and whether
petitioner invested in the same entities outside of the Policies:
-23-
Company Equity
Convertible Debt/
Promissory Note
Petitioner Invested In
Outside Policies
Accept Software 2006 & 2007 2007 Yes
Attensity Corp. 2006 & 2007 --- Yes
Borderware Tech. 2006 & 2007 2006 & 2007 Yes
DTL Plum Investments 2006 & 2007 --- Yes
JackNyfe, Inc. 2007 --- Yes
Lignup, Inc. 2006 & 2007 2007 Yes
Links Mark Multimedia --- 2007 Yes
Lunamira, Inc. 2007 --- Yes
Medstory 2006 --- Yes
Milphworld, Inc. --- 2007 Yes
Nextalk, Inc. 2007 --- Yes
Prevarex, Inc. 2007 --- Yes
Promoter Neurosciences 2007 --- Yes
PTRx Media, LLC 2006 & 2007 2007 Yes
Quintana Energy 2006 & 2007 --- Yes
Push Media, LLC 2006 & 2007 --- Yes
RJ Research, Inc. --- 2007 Yes
Reactrix Systems, Inc. 2006 & 2007 --- Yes
Renaissance 2.0 Media 2006 & 2007 --- Yes
Signature Investments --- 2006 & 2007 Yes
Soasta, Inc. 2007 --- Yes
Techtribenetworks, Inc. 2006 & 2007 2006 & 2007 Yes
Vizible Corp. 2006 & 2007 --- Yes
Welldunn Restaurant Group 2006 & 2007 --- Yes
-24-
Though Mr. Lipkind was careful to insulate petitioner from direct communication
with the Investment Manager, he frequently represented to the personnel of
target investments that he and petitioner 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
petitioner wished Boiler Riffle to invest.
Accept Software. Petitioner invested in Accept Software personally and
through funds he managed and was a member of its board of directors. In January
and June 2006 he communicated directly with its representatives, prior to any
consultation with the Investment Manager, and committed to have Boiler Riffle
purchase its series B equity round shares. Petitioner made a personal financial
commitment to officers of Accept Software and then directed Boiler Riffle to
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finance that commitment. In December 2006 Mr. Lipkind emailed a staff person
at Butterfield and informed her that petitioner wished to make this investment: “It
is most strongly recommended that BR go forward with this. If there are any questions,
please call.” The Investment Manager duly complied with this recommendation.
In mid-2007 Accept Software offered its shareholders a chance to participate
in a bridge financing. Petitioner initially indicated that he wished Boiler Riffle
to participate for its “pro-rata amount,” and this instruction was relayed to the
Investment Manager. Later, Mr. Lipkind thought petitioner had changed his mind
and emailed a staff person at Butterfield: “An issue has now arisen with respect to
going as high as ‘pro-rata.’ Have papers been sent in? If not, hold. I should get
matter cleared up by tomorrow. If papers went in already, I will deal with it at
Company level.” The staff person responded: “I have not sent the paper work as
yet [and] I will hold until I h[ear] f[rom] you.” Petitioner ultimately decided to
take his pro-rata share, and Boiler Riffle obediently made that investment.
PTRx Media. Petitioner invested in PTRx personally and through funds he
managed and was a member of its board of directors. In March 2006 petitioner
told Mr. Lipkind that he wanted Boiler Riffle to invest $50,000 in PTRx’s series B
financing. On March 31, 2006, Mr. Lipkind emailed Ms. Strachan of Butterfield
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as follows: “Boiler Riffle should participate in the attachments for Series B to the
tune of $50,000, the same amount it did on Series A. I assume you will process
same.” Boiler Riffle purchased the PTRx stock.
PTRx later offered a series D financing, and Mr. Lipkind asked petitioner
whether Boiler Riffle should participate. Petitioner responded: “[PTRx is] doing
great [and] they should be break even by the end of the year. They have just hired
a killer sales guy. We cut a great deal this morning with a bank. * * * I would do
pro-rata at the minimum.” Mr. Lipkind emailed the Investment Manager and
“strongly recommended that Boiler Riffle * * * participate at least to their prorata.”
Boiler Riffle duly purchased its pro-rata share of the series D financing.
WellDunn Restaurant Group. Petitioner invested in WellDunn personally
and through a fund he managed. On September 1, 2006, Mr. Lipkind emailed Ms.
Strachan at Butterfield as follows: “We recommend WellDunn as an investment
for Boiler Riffle. WellDunn had hoped that BR would invest $250,000, but I advised
them it was unlikely that the investment would exceed $150,000. Until they
indicate that is OK, it is unnecessary to proceed.”
WellDunn subsequently acquiesced in the reduced investment amount and
Mr. Lipkind sent a follow-up email to Ms. Strachan: “Please proceed with BR
investing $150,000 in this deal.” Mr. Lipkind then informed his contact at Well-
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Dunn: “I have * * * instructed Kimberly to proceed and to deal directly with you.
BR’s investment should now proceed quickly and smoothly.” On September 13,
2006, Boiler Riffle invested $150,000 in WellDunn.
JackNyfe Inc. Petitioner invested in JackNyfe personally and through a
fund he managed and was on its board of directors. On August 27, 2007, petitioner
informed Mr. Lipkind that he had structured a $1.2 million financing for Jack-
Nyfe that would be effected in $200,000 tranches. He told Mr. Lipkind that “the
participants in these financings will be br and others. * * * br should consider to
be on point for the first $400,000.” On September 6, 2007, Ms. Chang sent Mr.
Lipkind wire instructions that Boiler Riffle was to use when making its initial
$200,000 investment.
Mr. Lipkind forwarded these wire instructions to a staff person at Butterfield
but noted: “I am still reviewing certain documents so that I have not given a
green light recommendation yet.” On September 10, 2007, Mr. Lipkind completed
his document review and emailed the Investment Manager with instructions that
“we proceed.” On September 18, 2007, Mr. Lipkind sent a follow-up email instructing
the Investment Manager to get the investment in JackNyfe done “ASAP”
because “Jeff wanted to close this tranche as soon as possible.” Boiler Riffle
followed Mr. Lipkind’s instructions and invested $200,000 in JackNyfe.
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Lignup, Inc. Petitioner invested in Lignup personally and through a fund he
managed and was on its board of directors. On December 16, 2005, without approval
from the Investment Manager, petitioner committed to Lignup’s representatives
that Boiler Riffle would invest $300,000 in the company. In late December
2005 Mr. Lipkind followed up with a “recommendation” to the Investment Manager.
Boiler Riffle made the desired investment in the desired amount.
After instructing Boiler Riffle to invest in Lignup, petitioner directed what
actions Boiler Riffle should take in its capacity as a Lignup shareholder. On May
19, 2006, Mr. Lipkind relayed petitioner’s instructions that Boiler Riffle consent
to an amendment of Lignup’s certificate of incorporation, but that it reject participation
in a subsequent financing round. Mr. Lipkind told the Investment Manager
to “[k]indly process” petitioner’s instructions, and it did so.
As a shareholder in his own right, petitioner had the opportunity to subscribe
for pro-rata offerings of Lignup shares, but on certain occasions he assigned
his rights to Boiler Riffle. On June 1, 2006, Ms. Chang told Mr. Lipkind that “Jeff
would like Boiler Riffle to take his pro rata of 74,743 shares of Lignup Series B
stock.” Mr. Lipkind passed this recommendation on to the Investment Manager,
and Boiler Riffle purchased the shares. Six months later, Mr. Lipkind noted that
“Jeff in all of his incarnations” would take his pro-rata share of a subsequent
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Lignup offering and would assign part of his share to Boiler Riffle. Mr. Lipkind
said, “Full speed ahead on this one,” and a staff person from Butterfield replied
that this could “get done next week.”
Techtribenetworks, Inc. Petitioner invested in Techtribenetworks personally
and through funds he managed and was on its board of directors. In early 2006
he lent the company $50,000 in exchange for a promissory note. Later that year he
sold that promissory note to Boiler Riffle for $50,000. In early 2007 petitioner
advanced an additional $200,000 to Techtribenetworks. At petitioner’s request,
Boiler Riffle then lent Techtribenetworks $200,000 so that it could reimburse
petitioner for the funds he had invested several months previously.
The $200,000 note Boiler Riffle received from Techtribenetworks was convertible
into its series B stock. When a “B” financing round was announced later
in 2007, Mr. Lipkind instructed Boiler Riffle to invest $250,000. A staff person
from Butterfield asked whether Boiler Riffle should convert the $200,000 note and
add $50,000 in cash, or whether it should invest $250,000 of new money on top of
the note. Mr. Lipkind directed that Boiler Riffle do the former, and it did.
Quintana Energy. On September 19, 2006, Mr. Lipkind emailed a representative
of Quintana Energy stating: “Our entity, Boiler Riffle, a Bahamian corporation,
would like to invest an aggregate of $600,000. In addition, Jeff’s IRA
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would like to invest $200,000.” The following week, Mr. Lipkind emailed that
individual and others stating: “For very important reasons, please do not, in any
communication with me concerning Quintana and Boiler Riffle, include Jeff
Webber as a copy.” On September 22, 2006, Boiler Riffle made a substantial
investment in Quintana Energy.
In January 2007 Quintana Energy issued a capital call to its shareholders.
On January 22, 2007, a Butterfield staff person emailed Mr. Lipkind asking him to
“confirm whether Boiler Riffle is interested in the Quintana capital call for Jan.
30th.” Mr. Lipkind responded, “Yes. BR should honor the capital call.” Boiler
Riffle evidently did so.
Signature Investments RBN. In 2006 petitioner wanted Boiler Riffle to
invest $500,000 in Longboard Vineyards, LLC (Longboard), a California winery.
(Petitioner had previously owned a winery himself.) He began negotiations
directly with Longboard without consulting the Investment Manager. Because
Longboard was a pass-through entity for Federal income tax purposes, Mr.
Lipkind advised petitioner that “it is tax inefficient for it to be owned by Boiler
Riffle.”
On Mr. Lipkind’s advice, petitioner accordingly organized Signature Investments
RBN, Inc. (Signature), a domestic C corporation of which he was the presi-
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dent and beneficial owner, and capitalized it with $50,000 of his own funds. Petitioner
then made arrangements for Boiler Riffle to lend $450,000 to Signature,
with the plan that Signature would then lend $500,000 to Longboard. Longboard
was experiencing financial difficulty at this time, but petitioner assured Mr. Lipkind
that the loan from Signature “brings everything in compliance” and “the bank
is in the loop.”
Petitioner’s personal attorneys reviewed the operating agreement for Longboard,
made comments on it, and worked with Longboard’s representatives to
draft the promissory note. During these negotiations petitioner asked that the note
from Longboard to Signature act as security for the note from Signature to Boiler
Riffle. Longboard’s representative told Mr. Lipkind that “this would probably be
okay if Boiler is owned or controlled by Webber.” Mr. Lipkind responded: “Boiler
Riffle is 100% owned by two variable life insurance policies * * * both of
which are owned by a Trust of which Jeff [Webber] is the Settlor and a discretionary
beneficiary.” This explanation satisfied Longboard.
After getting Longboard’s signoff on the security agreement, Mr. Lipkind
instructed his associate to send the draft promissory note to the Investment Manager
“explaining the transaction which is contemplated and ‘recommend’ and seek
their approval both for the loan and the form of the note. Thereafter, please co-
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ordinate * * * to get this thing done.” On November 11, 2006, Boiler Riffle lent
Signature $450,000 in exchange for its note, and on December 18, 2006, Signature
lent Longboard $500,000 in exchange for its note. Longboard’s note to Signature
was subordinated to the winery’s outstanding bank loans.
Boiler Riffle made two additional loans to Signature the following year. In
September 2007 Longboard required more capital, and petitioner arranged a
$100,000 loan from Boiler Riffle through Signature to the winery. Ms. Chang
asked Mr. Lipkind “to request that Boiler Riffle proceed with its consideration of a
$100,000 advance to Signature.” As soon as Mr. Lipkind’s staff drafted the note
and petitioner had signed it, Ms. Chang requested that it “be presented to Boiler
Riffle to fund along with wire instructions.” Boiler Riffle promptly complied.
Later that month Boiler Riffle lent Signature another $80,000. As Ms.
Chang explained to Mr. Lipkind, this loan had nothing to do with the winery:
“Jeff needs to borrow from Boiler Riffle $80,000 as soon as possible for a deposit
on the Canada Maximas lodge, to be purchased through Wild Goose Investments.”
Boiler Riffle promptly complied.
Philtap Holdings Ltd. In April 2006 petitioner wanted to invest in Post
Ranch Investments Limited Partnership (Post Ranch), which was developing a
luxury property in Big Sur, California. Without prior approval from the Invest-
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ment Manager, petitioner began negotiations directly with Post Ranch’s representatives.
On April 4, 2006, Ms. Chang informed Mr. Lipkind of the status:
“Jeff wants to invest in an LP that will be a part owner of a luxury resort in Big
Sur * * *. We thought Jeff could purchase 250K interest through his IRA, but
there are a number of hurdles. * * * Would you * * * be able to make such an
investment happen by early next week?” She later followed up: “Since [Jeff]
insists on making this investment and it is not a wise use of onshore dollars at this
time given existing capital commitments and the bank’s liquidity requirements, he
is looking towards Boiler Riffle.”
After reviewing Post Ranch’s offering materials, Mr. Lipkind advised petitioner
against making this investment: “When one adds up the various and conflicting
roles of the promoters, one concludes there is virtually no way in law to
protect oneself adequately. Thus, you are giving your money to these promoters
and praying to God that they treat their LPs fairly.” Although Mr. Lipkind warned
that “a reasonably prudent investor with no personal knowledge or relationship
with the promoters would take a pass,” petitioner decided to invest anyway.
Mr. Lipkind then passed petitioner’s “recommendation” on to the Investment
Manager. He was told that Boiler Riffle had $250,000 available but that
Lighthouse preferred to have the investment made by an entity other than Boiler
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Riffle. Mr. Lipkind then instructed the Investment Manager to form a new entity
“ASAP” to complete the deal. The Investment Manager followed Mr. Lipkind’s
instruction and set up a new company, Philtap Holdings, Ltd. (Philtap), which was
owned by Lighthouse. On April 19, 2006, Philtap invested $250,000 in Post
Ranch as petitioner had instructed.
Webify Solutions. Petitioner and two other investors provided the initial
seed money to Webify Solutions (Webify), and petitioner served on its board of
directors. In October 2002 Webify issued petitioner warrants to purchase 250,000
shares of its common stock for 5 cents per share. Petitioner wanted Boiler Riffle
to acquire these warrants from him and Mr. Lipkind conveyed this “recommendation”
to the Investment Manager. On March 31, 2003, Boiler Riffle purchased
the warrants from petitioner for $3,085. He reported this sale on a 2003 gift tax
return, attaching an appraisal supporting the $3,085 value. In 2004 Boiler Riffle
exercised the warrants and purchased 250,000 shares of Webify for $12,500.
Petitioner was aware that International Business Machines (IBM) might be
interested in Webify, and he recommended that Boiler Riffle make additional
Webify investments. In a series of transactions during 2002-2004, Boiler Riffle
purchased $412,500 of Webify convertible debentures and entered into an agreement
to purchase series B preferred stock for an amount in excess of $400,000. In
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July 2006 IBM agreed to purchase Boiler Riffle’s aggregate investment in Webify
for more than $3 million. Of this sum, $2,731,087 was paid in 2006, and the
remainder was put into escrow to indemnify IBM against certain risks. An additional
$212,641 was paid to Boiler Riffle from the escrow in 2007, and the remaining
balance was apparently paid in 2008. As shown on Butterfield’s financial
records, Boiler Riffle’s aggregate basis in its Webify investment was $838,575.
Milphworld, Inc. While acknowledging that Lighthouse implemented “the
vast bulk” of his instructions, petitioner contends that it demurred to his recommendation
to buy shares of Milphworld. This was supposedly because Lighthouse
thought the company’s name had a derogatory connotation. There is no documentary
evidence of such reluctance, and Boiler Riffle in fact invested in Milphworld.
Petitioner initially suggested the Milphworld investment in August 2006,
but SEC restrictions apparently prevented Boiler Riffle from acquiring its stock.
To get around these restrictions, petitioner made loans to Milphworld and arranged
to have Boiler Riffle purchase its promissory notes from him. A staff person
from the Investment Manager emailed Mr. Lipkind: “Kindly advise if we are
to proceed with the Milphworld investment in Boiler Riffle.” Mr. Lipkind responded,
“[Y]es.” In February 2007 Boiler Riffle purchased from petitioner six
Milphworld promissory notes with an aggregate face value of $186,600.
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Lehman Brothers Fund. Besides investing in startup companies that petitioner
“recommended,” Boiler Riffle placed funds in money-market and other
investment vehicles offered by brokerage firms. Petitioner cites a Lehman Brothers
fund as another of his recommendations that the Investment Manager supposedly
rejected. There is no record support for this contention; in fact, the record
establishes the opposite.
In May 2006, without prior approval from the Investment Manager, Mr.
Lipkind emailed a broker at Lehman Brothers regarding that firm’s Co-Investment
Partners fund (CIP), inquiring how they might “splice this investment into an appropriate
place in Jeff’s universe.” Two days later Mr. Lipkind emailed Butterfield,
stating: “We recommend Boiler Riffle sign up for a $1,000,000 investment”
in CIP. One week later, Mr. Lipkind emailed petitioner to confirm that Boiler
Riffle had made this investment. Later in 2006 CIP issued a capital call. On
November 7, 2006, Mr. Lipkind emailed Ms. Strachan: “This is a Jeff Webber/BR
investment. I assume you will take care of the capital call.” There is no evidence
that the Investment Manager failed to do so.7
Petitioner cites only 7 one other occasion on which the Investment Manager
allegedly declined to implement an investment recommendation that petitioner had
made, concerning a company called Safeview. The Investment Manager apparently
pointed out to petitioner a “due diligence” issue concerning this company--the
(continued...)
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Mr. Lipkind’s Tax Advice
After explaining the mechanics of private placement life insurance at their
1998 meeting, Mr. Lipkind noted that there were certain Federal tax risks associated
with this tax-minimization strategy. He told petitioner that he had reviewed
pertinent IRS rulings, relevant judicial precedent, and opinion letters from several
U.S. law firms. These opinion letters, issued by Powell Goldstein, Rogers &
Wells, and other firms, addressed the U.S. tax consequences of Lighthouse private
placement life insurance products generally. James A. Walker, Jr., the author of
the Powell Goldstein opinions, later became outside general counsel for Lighthouse.
Mr. Lipkind had lengthy discussions with Mr. Walker about the Lighthouse
products and the tax risks associated with them.
Three of these opinion letters specifically addressed the “investor control”
doctrine. They stated that “investor control is a factual issue and uncertain legal
area” but concluded that the Lighthouse policies as structured would comply with
7(...continued)
State of California had issued a complaint against one of its principals--but petitioner
himself made the final decision not to invest. On July 12, 2007, Mr. Lipkind
accordingly emailed the Investment Manager: “I want Safeview Investment
to be ‘on hold’ until I recommend further.” Later in 2007 petitioner again suggested
an investment in Safeview. The record contains no evidence that the
Investment Manager opposed the investment at that time.
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U.S. tax laws and avoid application of this doctrine. Mr. Lipkind told petitioner
that he concurred in these opinions.
Acknowledging the risk that the IRS would challenge the strategy, Mr. Lipkind
concluded that the “investor control” doctrine would not apply because petitioner
would not be in “constructive receipt” of the assets held in the separate
accounts. While assuring petitioner that the outside legal opinions supported this
conclusion, Mr. Lipkind did not provide a written opinion himself. Mr. Herbst
approved the Lighthouse transaction but did not provide a written opinion either.
For their work preparing Trust documents and all other work for petitioner,
Mr. Lipkind and his colleagues charged time at their normal hourly rates. Neither
Mr. Lipkind nor his firm received from petitioner any form of bonus or other remuneration
apart from hourly time charges. Neither Mr. Lipkind nor his firm received
compensation of any kind from Lighthouse or the Investment Manager.
IRS Examination and Tax Court Proceedings
The IRS examined petitioner’s timely filed 2006 and 2007 Federal income
tax returns. Initially, petitioner directed his staff to produce all documents and
other information that the IRS requested. He declined, however, to let the IRS
interview Ms. Chang, and respondent therefore issued an administrative summons
for her testimony. Petitioner’s attorneys moved to quash this summons contending
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(among other things) that IRS personnel had made false statements about
petitioner to third parties. IRS representatives eventually interviewed Ms. Chang.
After the examination the IRS advanced a variety of theories to support its
determination that petitioner was taxable on the income that Boiler Riffle derived
from the investments it held for the Polices’ separate accounts. These theories
included the contention that the Lighthouse structure lacked economic substance
or was a “sham”; that Boiler Riffle was a “controlled foreign corporation” (CFC)
whose income was taxable to petitioner under section 951 through the Chalk Hill
Trust; and that petitioner should be deemed to own the assets in the separate
accounts under the “investor control” doctrine. The parties have stipulated that
Boiler Riffle had the following items of book income and expense during 2006
and 2007:
Item 2006 2007
Realized gain $1,913,237 $28,379
Unrealized gain 0 82,562
Unrealized loss (21,555) 0
Dividends/interest 78,595 214,799
Loan interest 0 210,741
Miscellaneous/other income 40 212,641
Total income 1,970,317 749,122
Policy mortality/admin. charges 130,000 161,500
Bank service charges 2,172 6,157
Butterfield bank fees 8,500 0
-40-
Administration fees 0 20,500
Government fees and taxes 350 1,871
Miscellaneous/other expense 1,163 454
Total expense 142,185 190,482
Net income per books 1,828,132 558,640
Boiler Riffle had total assets of $7.2 million and $12.3 million at the end of
2006 and 2007, respectively. The separate accounts appear to have held other
assets, owned by Philtap or other special-purpose entities, but the record does not
reveal the amounts of those other assets. The IRS issued petitioner a notice of
deficiency on March 22, 2011. He timely sought review in this Court.
OPINION
I. Burden of Proof
When contesting the determinations set forth in a notice of deficiency, the
taxpayer generally bears the burden of proof. See Rule 142(a); Welch v. Helvering,
290 U.S. 111, 115 (1933). If a taxpayer introduces “credible evidence with
respect to any factual issue,” the burden of proof on that issue will shift to the
Commissioner if certain conditions are met. Sec. 7491(a)(1). “Credible evidence
is the quality of evidence which, after critical analysis, the court would find sufficient
upon which to base a decision on the issue if no contrary evidence were submitted.”
Higbee v. Commissioner, 116 T.C. 438, 442 (2001) (quoting H.R. Conf.
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Rept. No. 105-599, at 240-241 (1998), 1998-3 C.B. 747, 994-995). To qualify for
a shift in the burden of proof, the taxpayer must (among other things) have
“cooperated with reasonable requests by the Secretary for witnesses, information,
documents, meetings, and interviews.” Sec. 7491(a)(2)(B). The taxpayer bears
the burden of proving that all of these requirements have been satisfied. See Rolfs
v. Commissioner, 135 T.C. 471, 483 (2010), aff’d, 668 F.3d 888 (7th Cir. 2012).
As explained below, infra p. 66, petitioner did not introduce “credible
evidence” on the central factual issues in this case. Nor did he fully cooperate
with respondent’s reasonable discovery requests. He rejected respondent’s request
to interview Ms. Chang, forcing the IRS to issue a summons; when the summons
was issued, petitioner’s attorneys moved to quash it. An interview with Ms.
Chang could reasonably have led, and did lead, to relevant evidence. See Polone
v. Commissioner, T.C. Memo. 2003-339, aff’d, 479 F.3d 1019 (9th Cir. 2007). By
seeking to block respondent’s access to Ms. Chang, petitioner failed to “cooperate[]
with reasonable requests by the Secretary for witnesses, * * *, meetings, and
interviews.” See sec. 7491(a)(2)(B); see Rolfs, 135 T.C. at 483. The burden of
proof thus remains on him.8
8In any event, whether the burden has shifted matters only in the case of an
evidentiary tie. See Polack v. Commissioner, 366 F.3d 608, 613 (8th Cir. 2004),
(continued...)
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II. Tax Treatment of Life Insurance and Annuities
The Policies in this case are a form of private-placement variable life insurance.
Private-placement insurance is sold exclusively through a private-placement
offering. These policies are marketed chiefly to high-net-worth individuals who
qualify as accredited investors under the Securities Act of 1933. See 15 U.S.C.
sec. 77b(a)(15) (2006); 17 C.F.R. sec. 230.501(a) (2006).
Variable life insurance is a form of cash value insurance. Under traditional
cash value insurance, the insured typically pays a level premium during life and
the beneficiary receives a fixed death benefit. Under a variable policy, both the
premiums and the death benefit may fluctuate. The assets held for the benefit of
the policy are placed in a “segregated asset account,” that is, an account
“segregated from the general asset accounts of the [insurance] company.” Sec.
817(d)(1). The policy does not earn a fixed or predictable rate of return but a
8(...continued)
aff’g T.C. Memo. 2002-145. In this case, we discerned no evidentiary tie on any
material issue of fact. See Payne v. Commissioner, T.C. Memo. 2003-90, 85
T.C.M. (CCH) 1073, 1077 (“Although assignment of the burden of proof is
potentially relevant at the outset of any case, where * * * the Court finds that the
undisputed facts favor one of the parties, the case is not determined on the basis of
which party bore the burden of proof, and the assignment of burden of proof
becomes irrelevant.”).
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return dictated by the actual performance of the investments in this separate
account.
If the assets in the separate account perform well, the premiums required to
keep the policy in force may be reduced as the account buildup lessens the insurer’s
mortality risk. If those assets perform extremely well, as was true here, the
value of the policy may substantially exceed the minimum death benefit. Upon the
insured’s death, the beneficiary receives the greater of the minimum death benefit
or the value of the separate account.
Life insurance and annuities enjoy favorable tax treatment. Under section
72, earnings accruing to cash value and annuity policies--often referred to as the
“inside buildup”--are not currently taxable to the policyholder (and generally are
not taxable to the insurance company). The cash value of the policy thus grows
more rapidly than that of a taxable investment portfolio. The policyholder may
access this value, often on a tax-free basis, by withdrawals and policy loans during
the insured’s lifetime. See sec. 72(e). If the contract is held until the insured’s
death, the insurance proceeds generally are excluded from the beneficiary’s
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income under section 101(a). With proper structuring, the death benefit will also
be excluded from the estate tax. See sec. 2042.9
A variable contract based on a segregated asset account “shall not be treated
as an annuity, endowment, or life insurance contract for any period * * * for which
the investments made by such account are not, in accordance with regulations prescribed
by the Secretary, adequately diversified.” Sec. 817(h)(1). Under these regulations,
a separate account is “adequately diversified” if no more than 55% of
the total value is represented by any one investment; no more than 70% of the total
value is represented by any two investments; no more than 80% of the total value
is represented by any three investments; and no more than 90% of the total value is
represented by any four investments. Sec. 1.817-5(b)(1), Income Tax Regs. The
separate accounts underlying the Policies invested in dozens of startup companies
in which petitioner was interested. Respondent does not contend that the separate
accounts fail the section 817(h) asset-diversification requirements.
Under section 7702(9 a), a contract is considered to be “life insurance” for
Federal income tax purposes only if it meets certain tests. See infra pp. 78-81.
Respondent does not contend that the Policies fail any of the section 7702(a)
requirements.
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III. The “Investor Control” Doctrine
A. Background
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 has its roots in Supreme Court jurisprudence
dating to the early days of the Federal income tax. Section 1 imposes a tax on the
taxable income “of” every individual. Construing the predecessor provision of the
Revenue Act of 1926, ch. 27, 44 Stat. 9, the Court stated in Poe v. Seaborn, 282
U.S. 101, 109 (1930): “The use of the word ‘of’ denotes ownership.” The
principle thus became early established that, “in the general application of the
revenue acts, the tax liability attaches to ownership.” Blair v. Commissioner, 300
U.S. 5, 12 (1937). And “ownership” for Federal tax purposes, as the Court stated
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in Griffiths v. Helvering, 308 U.S. 355, 357-358 (1939), means ownership in a
real, substantial sense:
We cannot too often reiterate that “taxation is not so much
concerned with the refinements of title as it is with actual command
over the property taxed--the actual benefit for which the tax is paid.”
Corliss v. Bowers, 281 U.S. 376, 378 (1930). And it makes no
difference that such “command” may be exercised through specific
retention of legal title or the creation of a new equitable but
controlled interest, or the maintenance of effective benefit through
the interposition of a subservient agency. * * *
In Corliss, 281 U.S. at 377, the taxpayer transferred assets to a trust,
directing the trustee to pay the income to his wife for life, but reserving the power
to modify or revoke the trust at any time. In an opinion by Justice Holmes, the
Court held the taxpayer taxable on the trust income even though he did not receive
the income or hold title to the assets that generated it. The Court reasoned: “The
income that is subject to a man’s unfettered command and that he is free to enjoy
at his own opinion may be taxed to him as his income, whether he sees fit to enjoy
it or not.” Id. at 378.
In Helvering v. Clifford, 309 U.S. 331 (1940), the taxpayer contributed securities
to a trust, directing himself as trustee to pay the income to his wife for a
five-year period. At the end of five years, the trust was to terminate and the
corpus would revert to the taxpayer. The trust instrument authorized the taxpayer
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to vote the shares held by the trust and to decide what securities would be bought
or sold. The trust instrument also afforded him “absolute discretion” to determine
whether income should be reinvested rather than paid out.
Speaking through Justice Douglas, the Court noted that the taxpayer’s
control over the securities remained essentially the same before and after the trust
was created. “So far as * * * [the taxpayer’s] dominion and control were
concerned,” the Court reasoned, “it seems clear that the trust did not effect any
substantial change.” Clifford, 309 U.S. at 335. The Court was not concerned that
the taxpayer could not “make a gift of the corpus to others” or “make loans to himself”
for five years. This “dilution in his control,” in the Court’s view, was “insignificant
and immaterial, since control over investment remained.” Ibid. The
Court’s conclusion that the taxpayer effectively retained the attributes of an owner,
and should be treated as the owner of the trust assets for Federal tax purposes, was
based on “all considerations and circumstances” in the case. Id. at 336.10
Appellate decisions fo 10 llowing these cases are well illustrated by N. Trust
Co. v. United States, 193 F.2d 127 (7th Cir. 1951). The taxpayer purchased shares
of stock, which were placed in escrow with a trust company until he made
payment in full. The taxpayer directed how to vote the escrowed shares, and any
dividends paid reduced the balance due the seller. The Court of Appeals for the
Seventh Circuit held that the taxpayer was in substance the owner of the shares,
even though he was not the title owner, so that the dividends paid on the escrowed
stock were taxable to him. Id. at 131.
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Drawing on the principles of these and similar cases, the IRS developed the
“investor control” doctrine in a series of revenue rulings beginning in 1977. On
the basis of 38 years of consistent rulings in this area, respondent urges that his
position deserves deference under Skidmore v. Swift & Co., 323 U.S. 134, 140
(1944). We are 11 not bound by revenue rulings; under Skidmore, the weight we
afford them depends upon their persuasiveness and the consistency of the
Commissioner’s position over time. See PSB Holdings, Inc. v. Commissioner,
129 T.C. 131, 142 (2007) (“[W]e evaluate the revenue ruling under the less
deferential standard enunciated in Skidmore v. Swift & Co.”). We thus consider
the rulings at hand under the “power to persuade” standard enunciated in
Skidmore.12
11In United States v. Mead Corp., 533 U.S. 218 (2001), the Supreme Court
recognized that there are various types of agency pronouncements that may be entitled
to different levels of deference, and that Skidmore deference, the lowest level
of deference, has continuing vitality under Chevron U.S.A., Inc. v. Natural
Res. Def. Council, Inc., 467 U.S. 837 (1984). See Mead Corp., 533 U.S. at 234
(“Chevron did nothing to eliminate Skidmore’s holding that an agency’s interpretation
may merit some deference whatever its form, given the ‘specialized experience
and broader investigations and information’ available to the agency” (quoting
Skidmore, 323 U.S. at 139)); ADVO, Inc. v. Commissioner, 141 T.C. 298, 322
n.18 (2013).
12Appeal of the instant case, absent stipulation to the contrary, would lie to
the Court of Appeals for Ninth Circuit. See sec. 7482(b)(1)(A). That Court has
not decided whether revenue rulings are entitled to Chevron or Skidmore defer-
(continued...)
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B. Evolution of the Doctrine
In Revenue Ruling 77-85, 1977-1 C.B. 12, a taxpayer purchased an investment
annuity contract from an insurance company. The initial “premium,” less
various charges, was deposited into a separate account held by a custodian. The
custodian invested the funds in accordance with the taxpayer’s directions but only
in assets from an approved list. At a certain date in the future--the “annuity
starting date”--the assets in the separate account would fund an annuity, which
would make monthly payments to the taxpayer based on the performance of the
underlying assets.
Prior to the annuity starting date, the policyholder exercised significant control
over the assets in the separate account. By issuing directions to the custodian,
the taxpayer had de facto power “to sell, purchase or exchange securities”; to “invest
and reinvest principal and income”; to vote the shares; and to exercise “any
other right or option relating to [the] assets.” 1977-1 C.B. at 13. The taxpayer
could also make “a full or partial surrender of the policy” and receive cash equal to
12(...continued)
ence. See Taproot Admin. Servs., Inc. v. Commissioner, 679 F.3d 1109, 1115
n.14 (9th Cir. 2012), aff’g 133 T.C. 202 (2009); Bluetooth SIG, Inc. v. United
States, 611 F.3d 617, 622 (9th Cir. 2010). Because respondent urges only
Skidmore deference, we need not decide how the Ninth Circuit would resolve this
question.
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the value of the account less applicable charges. After the annuity starting date,
the taxpayer continued to exercise investment control over the account, but he
could no longer surrender the policy.
The policy in Revenue Ruling 77-85 was meant to qualify as a “variable
contract” based on a “segregated asset account” within the meaning of section
817(d) (then section 801(g)). But for this treatment to be available, the IRS noted,
“the insurance company must be the owner of the assets in the segregated accounts.”
1977-1 C.B. at 14. The IRS concluded that the taxpayer possessed such
significant incidents of ownership over those assets that he should be considered
their owner for Federal tax purposes. The fact that the assets were titled in the
custodian’s name did not alter this analysis because, in the Commissioner’s view,
“[t]he setting aside of the assets in the custodial account * * * [was] basically a
pledge arrangement.” Id. at 14-15. The IRS noted:
When property is held in escrow or trust and the income therefrom
benefits, or is to be used to satisfy the legal obligations of, * * *
[another] person * * * , such person is deemed to be the owner
thereof, and such income is includible in that person’s gross income,
even though that person may never actually receive it.
On the basis of this analysis, the IRS concluded in Revenue Ruling 77-85,
that “the assets in the custodial account are owned by the individual policyholder,
not the insurance company.” 1977-1 C.B. at 15. Therefore, “any interest, divi-
51-
dends and other income received by the custodian on securities and other assets
held in the custodial accounts are includible in the gross income of the
policyholder under section 61 * * * for the year in which they are received by the
custodian.” Id.
The IRS reached the same conclusion three years later where an annuity
contract was supported by a separate account held by a savings and loan association.
Rev. Rul. 80-274, 1980-2 C.B. 27. The funds in the separate account were
“invested in a certificate of deposit for a term designated by the depositor,” who
had the right to “withdraw all or a portion of the cash surrender value of the contract
at any time prior to the annuity starting date.” 1980-2 C.B. at 28. The IRS
concluded that the policyholder/depositor should be considered the owner of the
assets because he possessed “substantial incidents of ownership in an account
established by the insurance company at * * * [his] direction.” Ibid.
Subsequent rulings address situations in which separate accounts
supporting variable contracts invest, not in securities selected directly by the
policyholder, but in shares of mutual funds with their own investment manager. In
Revenue Ruling 81-225, 1981-2 C.B. 13, the IRS considered four scenarios in
which the mutual fund shares were available for purchase by the general public
wholly apart from the annuity arrangement. The policyholder had the right
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initially to designate the fund in which the separate account would invest, and the
right periodically to reallocate his investment among the specified funds.
In these four scenarios, the IRS concluded that the insurance company was
“little more than a conduit between the policyholders and their mutual fund
shares.” 1981-2 C.B. at 14. Because the “policyholder’s position in each of these
situations [wa]s substantially identical to what his or her position would have been
had the mutual fund shares been purchased directly,” the IRS concluded that the
policyholder had sufficient investment control to be considered the shares’ owner
for Federal tax purposes. Id. The IRS reached the opposite conclusion in the fifth
scenario, where investments in the mutual fund shares were controlled by the
insurance company and the fund’s sole function was “to provide an investment
vehicle to allow * * * [the insurance company] to meet its obligations under its
annuity contracts.” Id. Because these shares were not available to the general
public but were “available only through the purchase of an annuity contract,” id. at
13, the IRS considered the insurance company to be the true owner of these
assets.13
13The IRS likewise treated the insurance company as the owner where the
separate account invested in shares of mutual funds that were “closed” to the
general public. See Rev. Rul. 82-55, 1982-1 C.B. 12, 13. On the other hand, the
IRS treated the policyholder as the owner of a separate account supporting a
(continued...)
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In Revenue Ruling 82-54, 1982-1 C.B. 11, the segregated account underlying
the variable policies comprised three funds that invested respectively in
common stocks, bonds, and money-market instruments. The insurance company
was the investment manager of these funds, and the funds were not available for
sale to the general public. Policyholders had the right to allocate or reallocate
their investments among the three funds.
“[I]n order for the insurance company to be considered the owner of the
mutual fund shares,” the IRS reasoned, “control over individual investment decisions
must not be in the hands of the policyholders.” 1982-1 C.B. at 12. Under
this standard, the IRS concluded that the insurance company owned the assets in
the separate account:
[T]he ability to choose among broad, general investment strategies
such as stocks, bonds or money market instruments, either at the time
of the initial purchase or subsequent thereto, does not constitute
sufficient control over individual investment decisions so as to cause
ownership of the private mutual fund shares to be attributable to the
policyholders.
In Revenue Ruling 2003-91, 2003-2 C.B. 347, a life insurance company
offered variable life insurance and annuity contracts. The contracts were funded
13(...continued)
variable life insurance policy where the account invested in hedge funds that were
available for sale to the general public, albeit only to “qualified investors.” See
Rev. Rul. 2003-92, 2003-2 C.B. 350.
-54-
by assets held in a separate account divided into 12 subaccounts. Each subaccount
followed a specific investment strategy keyed to market sector or type of security
(e.g., money-market, large company growth, telecommunications, international
growth, or emerging markets). None of these funds was available for sale to the
general public, and all of them met the asset diversification requirements of
section 1.817-5(b)(1), Income Tax Regs.
The policyholder had the right to change the allocation of his premiums
among subaccounts at any time and transfer funds among subaccounts. All
investment decisions regarding the subaccounts, however, were made by an independent
investment manager engaged by the insurance company. The IRS stated
its assumptions that: (1) the policyholder “cannot select or recommend particular
investments” for the subaccounts; (2) the policyholder “cannot communicate directly
or indirectly with any investment officer * * * regarding the selection * * *
of any specific investment or group of investments”; and (3) “[t]here is no
arrangement, plan, contract, or agreement” between the policyholder and the
insurance company or investment manager regarding “the investment strategy of
any [s]ub-account, or the assets to be held by a particular sub-account.” Rev. Rul.
2003-91, 2003-2 C.B. at 348.
-55-
In short, although the policyholder had the right to allocate funds among
the subaccounts, all investment decisions regarding the particular securities to be
held in each subaccount were made by the insurance company or its investment
manager “in their sole and absolute discretion.” 2003-2 C.B. at 348. Under these
circumstances, the IRS concluded that the insurance company would be treated as
owning the assets in the separate accounts for Federal income tax purposes. The
IRS indicated that this ruling was intended to “present[] a ‘safe harbor’ from
which taxpayers may operate.” 2003-2 C.B. at 347.
C. Deference
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. As the
Commissioner stated in Revenue Ruling 82-54, 1982-1 C.B. at 12, “control over
individual investment decisions must not be in the hands of the policyholders.”
Other “incidents of ownership” emerging from these rulings include the powers to
vote securities in the separate account; to exercise other rights or options relative
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to these investments; to extract money from the account by withdrawal or
otherwise; and to derive, in other ways, what the Supreme Court has termed
“effective benefit” from the underlying assets. Griffiths, 308 U.S. at 358.
We believe that the IRS rulings enunciating these principles deserve deference.
The rulings are grounded in long-settled jurisprudence holding that formalities
of title must yield to a practical assessment of whether “control over investment
remained,” Clifford, 309 U.S. at 335, and that ownership for tax purposes
follows “actual command over the property taxed.” N. Trust Co. v. United States,
193 F.2d 127, 129 (7th Cir. 1951) (quoting Griffiths, 308 U.S. at 355-358). These
revenue rulings span a 38-year period and reflect a consistent and well-considered
process of development. After stating bedrock principles in Revenue Ruling 77-
85, the IRS examined more complex scenarios corresponding to newer products
being offered in the financial markets. The Commissioner’s consideration of these
scenarios appears nuanced and reasonable, resolving particular fact patterns favorably
or unfavorably to taxpayers in light of the bedrock principles initially set
forth. Cf. Sewards v. Commissioner, __ F.3d __, 2015 WL 2214705, at *3-*4 (9th
Cir. Apr. 10, 2015) (affording “substantial deference” to interpretation of regulations
“adopted by the IRS in Revenue Rulings issued over the last 40 years”),
aff’g 138 T.C. 320 (2012).
-57-
The “investor control” doctrine reflects a “body of experience and informed
judgment” that the IRS has developed over four decades. Skidmore, 323 U.S. at
140; Fed. Express Corp. v. Holowecki, 552 U.S. 389, 299 (2008); see Kasten v.
Saint-Gobain Performance Plastics Corp., 563 U.S. __, __, 131 S. Ct. 1325, 1335
(2011) (“The length of time the agencies have held * * * [these views] suggests that
they reflect careful consideration[.]”). As evidenced by the absence of litigation in
this area during the past 30 years, these rulings have engendered stability and longterm
reliance through the private ruling process and otherwise. See Taproot Admin.
Servs., Inc. v. Commissioner, 133 T.C. 202, 212 (2009) (history of consistent
private letter rulings based on published ruling favors a finding of deference under
Skidmore), aff’d, 679 F.3d 1109 (9th Cir. 2012).14 The relative expertise of the IRS
in administering a complex statutory scheme and its longstanding, unchanging
policy regarding these issues amply justify deference to the IRS under Skidmore.
See Alaska Dep’t of Envtl. Conservation v. EPA, 540 U.S. 461, 488-492 (2004).
Our decision to afford Skidmore deference to these rulings is supported by
the unanimous opinion of the U.S. Court of Appeals for the Eighth Circuit in
14These revenue rulings have formed the basis for numerous private letter
rulings. See, e.g., Priv. Ltr. Rul. 201105012 (Feb. 4, 2011); Priv. Ltr. Rul.
200420017 (May 14, 2004); Priv. Ltr. Rul. 9433030 (Aug. 19, 1994); Priv. Ltr.
Rul. 8820044 (May 20, 1988).
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Christoffersen v. United States, 749 F.2d 513 (8th Cir. 1985), rev’g 578 F. Supp.
398 (N.D. Iowa 1984). The taxpayers there purchased from a life insurance company
a variable annuity policy supported by a separate account. The initial “premium,”
less various charges, was invested at the taxpayers’ direction in a mutual
fund. Prior to the annuity starting date, the taxpayers could withdraw all or part of
their investment on seven days’ notice, but they were limited to withdrawing cash.
Finding that the taxpayers had “surrendered few of the rights of ownership or
control over the assets of the sub-account,” the Court of Appeals for the Eighth
Circuit held that they were “the beneficial owners of the investment funds” even
though the insurance company “maintain[ed] the shares in its name.”
Christoffersen, 749 F.2d at 515 (citing Clifford, 309 U.S. 331). In the court’s view,
“[t]he payment of annuity premiums, management fees and the limitation of
withdrawals to cash, rather than shares, d[id] not reflect a lack of ownership or
control.” Id. at 515-516. Quoting Corliss, 281 U.S. at 378, the court reasoned that
“taxation is not so much concerned with the refinements of title as it is with the
actual command over the property taxed.” Christoffersen, 749 F.2d at 515. And
citing Griffiths, 308 U.S. at 358, the court found it immaterial that the taxpayers’
command over these assets was exercised by means other than the “specific
retention of legal title.” Christoffersen, 749 F.2d at 515. The court accordingly
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ruled that the “Christoffersens, and not * * * [the insurance company], own the
assets of the sub-account.” Id. at 516.
The only other case that has considered these matters is the District Court
opinion in Inv. Annuity, Inc. v. Blumenthal, 442 F. Supp. 681 (D.D.C. 1977),
rev’d, 609 F.2d 1 (D.C. Cir. 1979). The District Court held Revenue Ruling 77-85
invalid, but its opinion has no precedential force. It was reversed because, under
the Anti-Injunction Act and the tax exception to the Declaratory Judgment Act, the
District Court lacked jurisdiction to consider the case ab initio. See Inv. Annuity,
Inc., 609 F.2d at 10 (remanding with instructions “to dismiss the complaint for
lack of jurisdiction”).
In any event, we agree with the Eighth Circuit’s assessment in Christoffersen,
749 F.2d at 514: “[W]e cannot endorse the approach of the district court in
the Investment Annuity case.” The District Court, ruling in 1977, was troubled by
what it regarded as the novelty of the position the IRS enunciated in Revenue
Ruling 77-85. As of today, the Commissioner has enunciated that position consistently
for 38 years. The District Court appeared to believe that Revenue Ruling
77-85 had been undermined by an IRS private letter ruling, erroneously issued a
few months later, that was inconsistent with the published ruling. See Priv. Ltr.
Rul. 7747111 (Aug. 29, 1977). This private letter ruling was revoked as soon as
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this error came to the Commissioner’s attention. See Priv. Ltr. Rul. 7805020
(Sept. 13, 1977). For these reasons, and because the District Court gave insufficient
weight to relevant Supreme Court precedent, we find its opinion
unpersuasive.
In sum, we conclude that the IRS revenue rulings enunciating the “investor
control” doctrine are entitled to weight under Skidmore. Over four decades, they
have reasonably applied well-settled principles of Supreme Court jurisprudence to
a complex area of taxation. In any event, the legal framework urged by respondent
is consistent with prior case law, and we would adopt it regardless of deference.
D. Ownership of the Separate Account Assets
The investments in the separate accounts were titled to the 1999 Fund,
Boiler Riffle, Philtap, and other special-purpose entities owned by Lighthouse but
pledged to the Policies. Lighthouse, rather than petitioner, thus nominally owned
these assets during the tax years in issue. Respondent contends that petitioner,
under the “investor control” doctrine, should nevertheless be treated as their owner
for Federal income tax purposes. We agree.
As drafted, the Policies allowed the policyholder to submit only “general
investment objectives and guidelines” to the Investment Manager, who was supposed
to build a portfolio within those parameters by selecting individual
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securities for purchase or sale. We need not decide whether Lighthouse would be
considered the owner of the separate account assets if the parties to the arrangement
had meticulously complied with these strictures. They did not.
In determining whether petitioner owned the assets underlying the Policies,
we consider whether he retained significant incidents of ownership. In making
this assessment, “[t]echnical considerations, niceties of the law * * *, or the legal
paraphernalia which inventive genius may construct as a refuge from surtaxes
should not obscure the basic issue.” Clifford, 309 U.S. at 334. We focus instead
on the actual level of “control over investment” that petitioner exercised. Id. at
335.
The determination whether a taxpayer has retained significant incidents of
ownership over assets is made on a case-by-case basis, taking into account all the
relevant facts and circumstances. See Clifford, 309 U.S. at 336. The core “incident
of ownership” is the power to select investment assets by directing the
purchase, sale, and exchange of particular securities. Other “incidents of
ownership” include the power to vote securities and exercise other rights relative
to those investments; the power to extract money from the account by withdrawal
or other means; and the power to derive, in other ways, what the Supreme Court
-62-
has termed “effective benefit” from the underlying assets. Griffiths, 308 U.S. at
358. Petitioner enjoyed all of these powers.
1. Power To Direct Investments. Petitioner enjoyed the unfettered
ability to select investments for the separate accounts by directing the Investment
Manager to buy, sell, and exchange securities and other assets in which petitioner
wished to invest. Although the Policies purported to give the Investment Manager
complete discretion to select investments, this restriction meant nothing in
practice. We assess the true nature of the agreement by looking to its substance,
as evidenced by the parties’ actual conduct. See Gregory v. Helvering, 293 U.S.
465, 469 (1935); Sandvall v. Commissioner, 898 F.2d 455, 458 (5th Cir. 1990),
aff’g T.C. Memo. 1989-189 and T.C. Memo. 1989-56. In reality, the Investment
Manager selected no investments but acted merely as a rubber stamp for
petitioner’s “recommendations,” which we find to have been equivalent to
directives.
It is no coincidence that virtually every security Boiler Riffle held (apart
from certain brokerage funds) was issued by a startup company in which petitioner
had a personal financial interest. Petitioner sat on the boards of most of these
companies, and he invested in each of them through his personal accounts,
through IRAs, and through private-equity funds that he managed. He admitted
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that Boiler Riffle could not have obtained access to any of these investment
opportunities except through him.
It is likewise no coincidence that every investment Boiler Riffle made was
an investment that petitioner had “recommended.” The Investment Manager took
no independent initiative and considered no investments other than those
petitioner proposed. The record overwhelmingly demonstrates that petitioner
directed what investments Boiler Riffle should make, when Boiler Riffle should
make them, and how much Boiler Riffle should invest.
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 petitioner’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 petitioner’s “recommendations”
from an investment standpoint.
It was not uncommon for petitioner 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, petitioner in-
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vested 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.
Two deals that petitioner negotiated himself exemplify the parties’ modus
operandi. Without informing the Investment Manager, petitioner began negotiations
to acquire an interest in Longboard Vineyards, a financially-troubled winery,
with a $500,000 loan. On Mr. Lipkind’s advice, petitioner organized Signature, a
domestic C corporation, as the vehicle for making this loan. Mr. Lipkind reviewed
the operating agreement for Longboard and worked with it to draft the promissory
note and accompanying security agreement. Only after the paperwork was completed
did Mr. Lipkind notify the Investment Manager, with instructions to “get
this thing done.” Within days Boiler Riffle lent Signature $450,000, which enabled
Signature to lend Longboard $500,000 as petitioner wished.
There is no evidence that the Investment Manager performed any due diligence
for this transaction. Petitioner was thus able to negotiate a complex deal
with a financially-troubled winery, extract money from Boiler Riffle for the
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benefit of an entity he owned, and have the security for the resulting promissory
note be subordinated to a bank loan that Longboard was having trouble paying, all
without the Investment Manager’s raising a whisper. As if that were not enough,
petitioner proceeded to extract another $180,000 from Boiler Riffle via loans to
Signature. The first $100,000 covered a second cash infusion for the winery. An
email from Ms. Chang explains the other loan: “Jeff needs to borrow from Boiler
Riffle $80,000 as soon as possible for a deposit on the Canada Maximas lodge, to
be purchased through Wild Goose Investments.”
Petitioner also wanted to acquire an interest in Post Ranch, which was
developing a luxury property in Big Sur. He initially planned to make a $250,000
investment through his IRA, but decided it was “not a wise use of onshore dollars
at this time given existing capital commitments and the bank’s liquidity requirements.”
As Ms. Chang explained, petitioner was therefore “looking towards
Boiler Riffle” for the funds with which to invest. Mr. Lipkind advised petitioner
that a prudent investor would not make this investment, but petitioner insisted on
going ahead anyway. The Investment Manager raised no question about this risky
business. And Lighthouse agreed to create Philtap, a new special-purpose entity,
for the sole purpose of implementing petitioner’s wishes. The Post Ranch and
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Longboard deals vividly display petitioner’s unfettered control over the investments
in the separate accounts.
Petitioner testified as to his belief that the Investment Manager performed
“an appropriate level of due diligence.” He cites no record evidence to support
this proposition, and we did not find his testimony credible. Employees of the
Investment Manager would be in the best position to explain what due diligence
and investment research they performed in exchange for their $1,000 annual fee.
Petitioner’s failure to call them as witnesses creates an inference that their
testimony would not have assisted his position. See Am. Police & Fire Found.,
Inc. v. Commissioner, 81 T.C. 699, 705 (1983) (citing Wichita Terminal Elevator
Co. v. Commissioner, 6 T.C. 1158 (1946), aff’d, 162 F.2d 513 (10th Cir. 1947)).15
Among the hundreds of investments that the separate accounts made, petitioner
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. Walker, outside 15 general counsel for Lighthouse, testified that Lighthouse
did not conduct due diligence regarding investments, but that the “Investment
Managers would.” Mr. Walker had no personal knowledge of the Investment
Manager’s daily activities, and we found his testimony vague and unhelpful.
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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 petitioner six Milphworld promissory notes with an aggregate face value of
$186,600. And while Lighthouse initially discerned a “reputational risk”
regarding Safeview, it was petitioner, 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 petitioner’s “recommendations.”
In sum, petitioner actively managed the assets in the separate accounts by
directing the Investment Manager (through his agents) to buy, sell, and exchange
securities and other property as he wished. These facts strongly support a finding
that he retained significant incidents of ownership over those assets. See Clifford,
309 U.S. at 335 (finding lack of absolute control immaterial “since control over
investment remained”); Rev. Rul. 77-85, 1977-1 C.B. at 14 (policyholder
possesses investment control when he “retains the power to direct the custodian to
sell, purchase or exchange securities, or other assets held in the custodial
account”).
2. Power to Vote Shares and Exercise Other Options. Besides directing
what securities the separate accounts would buy and sell, petitioner
through his agents dictated what actions Boiler Riffle would take with respect to
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its ongoing investments. The Investment Managers took no action without a signoff
from Mr. Lipkind or Ms. Chang. With respect to routine shareholder matters,
these sign-offs may often have occurred by phone. As Mr. Lipkind noted to
petitioner: “We have relied primarily on telephone communications, not written
paper trails (you recall our ‘owner control’ conversations).” But examples from
the email traffic display a revealing tip of the iceberg.
Petitioner repeatedly directed what actions Boiler Riffle should take in its
capacity as a shareholder of the startup companies in which he was interested. He
directed how Boiler Riffle should vote concerning an amendment to Lignup’s
certificate of incorporation and participation in a second financing round. With
respect to Quintana Energy and Lehman Brothers, he directed how Boiler Riffle
should respond to capital calls. With respect to Accept Software, he directed
whether Boiler Riffle should participate in a bridge financing. With respect to
PTRx, he directed whether Boiler Riffle should take its pro-rata share of a series D
financing. With respect to Techtribenetworks, he directed whether Boiler Riffle
should convert its promissory notes to equity. And with respect to Lignup, he
directed whether Boiler Riffle would exercise pro-rata rights that he had assigned
to it. These facts support a finding that petitioner retained significant incidents of
ownership over the separate account assets. See Clifford, 309 U.S. at 332, 335
-69-
(power to vote shares was a significant incident of ownership); Rev. Rul. 77-85,
1977-1 C.B. at 13-14 (significant incidents of ownership included powers to vote
shares and exercise “any other right or option relating to [the] assets”).
3. Power To Extract Cash. Petitioner had numerous ways to extract
cash from the separate accounts, beginning with the traditional mechanisms of life
insurance policies. Each Policy permitted the policyholder to assign it; to use it as
collateral for a loan; to borrow against it; and to surrender it. Given how the Policies
were constructed, however, the amount petitioner could extract by surrender
or policy loan was limited to “premiums paid.” Because the investments petitioner
selected performed very well, no “premiums” had to be paid after 2000; thereafter,
ongoing mortality/administrative charges were defrayed by debiting the separate
accounts. Thus, even though the assets in the separate accounts were worth $12.3
million by 2007, the amount of cash petitioner could extract by surrender or policy
loan was capped at $735,046, the initial premiums paid during 1999 and 2000.
Petitioner urges that this restriction distinguishes the instant case from
Christoffersen, where the policyholder, prior to the annuity starting date, could
withdraw the full value of the account on seven days notice. We need not decide
whether the type of restriction to which petitioner and Lighthouse agreed, if it
meaningfully limited the policyholder’s ability to extract cash, would be sufficient
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to render an insurance company the owner of assets in a segregated account. On
the facts here, this restriction was trivial. Petitioner was able to extract, and did
extract, cash from the separate accounts without any need to resort to policy loans.
One method was by selling assets to the separate accounts. Shortly after
the Policies were initiated, petitioner sold shares of three startup companies to the
1999 Fund for $2,240,000. Through these transactions, petitioner was able to
derive liquidity from assets that might otherwise have been difficult to sell.
Petitioner extracted cash from the separate accounts in numerous other
ways. In November 2006 he extracted $450,000 from Boiler Riffle by causing it
to lend that amount to Signature, his C corporation, for an investment he wished to
make in Longboard Vineyards. In 2006 petitioner extracted $50,000 from Boiler
Riffle by causing it to purchase from him a Techtribenetworks promissory note. In
February 2007 he extracted an additional $186,600 from Boiler Riffle by causing
it purchase from him six Milphworld promissory notes. In early 2007 he extracted
$200,000 from Boiler Riffle by causing it to lend that sum to Techtribenetworks,
which enabled that company to repay its $200,000 promissory note to him. In
September 2007 he extracted $100,000 from Boiler Riffle for a second cash
infusion through Signature to Longboard. And in fall 2007 he extracted $80,000
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from Boiler Riffle to cover a deposit he wished to make on a Canadian hunting
lodge.
Within the space of 12 months petitioner thus extracted from Boiler Riffle
more than $1 million in cash for personal use. There is nothing in the record to
suggest that he could not have extracted more if he had wished. Given his ability
to withdraw cash at will, he had no need to surrender the Policies or use policy
loans to extract cash. The fact that these latter mechanisms were capped at
$735,046 is thus immaterial.
As the Supreme Court emphasized in Clifford, 309 U.S. at 335, a taxpayer
need not have absolute control over investment assets to be deemed their owner.
The taxpayer there could not “make a gift of the corpus to others” or “make loans
to himself” for five years. But the Court found this “dilution in his control [to be]
insignificant and immaterial, since control over investment remained.”
Petitioner’s ability to withdraw cash at will from the separate accounts supports a
finding that he retained significant incidents of ownership.
4. Power To Derive Other Benefits. Petitioner used Boiler Riffle to
finance investments that may have been a source of personal pleasure, including a
winery, a Big Sur resort, and a Canadian hunting lodge. More tangible benefits
flowed from the fact that the investments in the separate accounts mirrored or
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complemented the investments in his own personal portfolio and the portfolios of
the private-equity funds he managed. Petitioner regularly used the separate
accounts synergistically to bolster his other positions.
After making an early stage investment, petitioner sought to find new investors
for his startup ventures, aiming to enhance their prospects and move them
closer to a “liquidity event.” Boiler Riffle provided a readily available source of
new investment funds. Petitioner often made personal financial commitments to
these fledgling ventures, then had Boiler Riffle discharge those commitments on
his behalf. When petitioner lacked the desire (or liquidity) to exercise pro-rata
offering rights on his own shares, he assigned those rights to Boiler Riffle for
exercise, thus avoiding dilution in his overall position. Boiler Riffle sometimes
provided the critical missing piece of the puzzle, as when petitioner structured a
$1.2 million financing for JackNyfe and needed Boiler Riffle “to be on point for
the first $400,000.” In all these ways, petitioner derived “effective benefit” from
the separate accounts. See Griffiths, 308 U.S. at 358.
“[W]here the head of the household has income in excess of normal needs,
it may well make but little difference to him (except income-tax-wise) where
portions of that income are routed--so long as it stays in the family group.”
Clifford, 309 U.S. at 336. Petitioner used Boiler Riffle as a private investment
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account through which he actively managed a portion of his family’s securities
portfolio. Formalities aside, he maintained essentially the same rights of
ownership over those assets, apart from current receipt of income, that he would
have possessed had he chosen to title the assets in his own name.16 Since
petitioner owned the separate account assets for Federal income tax purposes, all
dividends, interest, capital gains, and other income received by Boiler Riffle
during the tax years in issue were includible in petitioner’s gross income under
section 61.17
16Petitioner contends that his position differed in one respect from that of an
actual owner: Because the death benefit could be paid in cash rather than in kind,
Lighthouse conceivably could keep, rather than distribute to him, the stock of the
startup companies he caused it to buy. But the Policies provided that Lighthouse
would pay the death benefit “in cash to the extent of liquid assets and in kind to
the extent of illiquid assets.” Since the shares held by the separate accounts were
not publicly traded, they were presumably illiquid; the Policies thus explicitly
anticipated that the death benefit would to this extent be paid in kind. Although
Lighthouse nominally had discretion to reject in-kind payment, it rubber-stamped
all of petitioner’s other “recommendations.” There is no reason to believe it
would countermand his preference as to the form of the death benefit. In any
event, the Eighth Circuit in Christoffersen, 749 F.2d at 516, held that the
“limitation of withdrawals to cash, rather than shares, d[id] not reflect a lack of
ownership or control” by the policyholders over the mutual fund shares in the
segregated account.
17Petitioner is the tax owner of the underlying assets even though the Policies
are nominally owned by the Trusts. If the Trusts were deemed to be the
owners of the underlying assets, it appears that their income would be attributable
to petitioner under the grantor trust rules. See secs. 671, 677, 679.
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E. Petitioner’s Counterarguments
1. “Constructive Receipt.” Petitioner contends that he may not be
taxed on the income realized by Boiler Riffle during 2006-2007 because he was
not in “constructive receipt” of this income. The “constructive receipt” doctrine
prevents cash basis taxpayers from manipulating the annual accounting principle
by artificially deferring receipt of income to a later tax year. See generally Boris I.
Bittker & Lawrence Lokken, Federal Taxation of Income, Estates and Gifts, para.
105.3.3, at 105-61 (3d ed. 2012). Under this doctrine, “[i]ncome although not
actually reduced to a taxpayer’s possession is constructively received by him in
the taxable year during which it is credited to his account, set apart for him, or
otherwise made available so that he may draw upon it at any time.” Sec. 1.451-
2(a), Income Tax Regs. “[I]ncome is not constructively received,” however, “if
the taxpayer’s control over its receipt is subject to substantial limitations or restrictions.”
Ibid. Petitioner contends that he could enjoy actual receipt of Boiler
Riffle’s income only by surrendering the Policies for their (relatively puny) cash
surrender value of $735,046. In his view this constituted a “substantial limitation
or restriction” that precludes constructive receipt.
Although the Eighth Circuit in Christoffersen, 749 F.2d at 516, briefly
mentioned the “doctrine of constructive receipt,” that principle has no necessary
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application here. “As summarized by a much-quoted metaphor, constructive
receipt means that ‘a taxpayer may not deliberately turn his back upon income and
thus select the year for which he will report it.’” Bittker & Lokken, supra, at 105-
62 (quoting Hamilton Nat’l Bank v. Commissioner, 29 B.T.A. 63, 67 (1933)). The
“investor control” doctrine addresses a different problem, and a finding of “constructive
receipt” is not a prerequisite to its application.
It is undisputed that the owner of the separate account assets during 2006-
2007 actually received the income at issue. The question we must decide is whether
petitioner or Lighthouse was that “owner.” If petitioner was the true owner,
he is treated as having actually received what the separate accounts actually received;
resort to “constructive receipt” is not necessary. The taxpayer in Clifford,
309 U.S. at 355, could not access the trust income for five years, yet the Supreme
Court held that he nevertheless owned the assets titled to the trust. We reach the
same conclusion here.18
2. Application to Life Insurance. Petitioner contends that the “investor
control” doctrine, if it applies to anything, should not be applied to life
In any event, we reject petitioner’s pr 18 emise that the $735,046 limitation on
cash surrender value constituted a “substantial limitation[] or restriction[],” sec.
1.451-2(a), Income Tax Regs., that would preclude constructive receipt. As noted
previously, petitioner was able to withdraw unlimited amounts of cash from the
separate accounts in other ways. See supra pp. 69-71.
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insurance contracts. As he points out, Revenue Ruling 77-85, and its immediate
successors addressed segregated asset accounts supporting variable annuity
contracts. In 2003 the Commissioner applied the same principles to segregated
asset accounts supporting variable life insurance contracts. See Rev. Rul. 2003-
91; Rev. Rul. 2003-92. Citing Skidmore, 323 U.S. at 140, petitioner contends that
the latter two rulings “are not entitled to deference as they are not ‘thoroughly considered’
* * * as to the application of investor control to life insurance.”
We disagree. The statutory text fully supports the Commissioner’s position
that variable life insurance and variable annuities should be treated similarly in
this (and in other) respects. As pertinent here, section 817(d)(2) defines a
“variable contract” as a contract that is supported by a segregated asset account
and that “(A) provides for the payment of annuities [or] (B) is a life insurance
contract.” If “investor control” principles apply to the former, they would seem to
apply to the latter by a parity of reasoning.
Petitioner contends that fundamental differences exist between annuity and
insurance contracts because, under the latter, “the insurance company has assumed
a significant obligation to pay a substantial death benefit.” In petitioner’s view,
the “investor control” doctrine should apply only where the policyholder occupies
essentially the same position that he would have occupied if he had purchased the
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assets in the separate account directly. Here, petitioner says that his position differs
because Lighthouse’s obligation to pay the minimum death benefit “substantially
shifts the risks between the parties.”
The existence of an insurance risk, standing alone, does not make Lighthouse
the owner of the separate account assets for Federal income tax purposes.
Lighthouse agreed to assume the mortality risk in exchange for premiums that it
(or its reinsurer, Hannover Re) actuarially determined to be commensurate with
this risk. After 2000 these premiums were replaced by mortality and administrative
charges debited to the separate accounts. Unless the Trusts continued to pay
the actuarially determined mortality charges, directly via premiums or indirectly
via debits to the separate accounts, the Policies would have lapsed and Lighthouse
would have had no more insurance risk.
During the tax years in issue the insurance risk borne by Lighthouse was
almost fully reinsured with Hannover Re and was actually quite small. As of year
end 2006 and 2007, the values of the assets in the separate accounts exceeded the
Policies’ minimum death benefit by at least $1.7 million and $6.8 million, respectively.
In any event, whatever mortality risk existed was fully compensated by
mortality risk charges ($12,327 for the years in issue) paid directly or indirectly by
the policyholder. Under these circumstances, the insurer’s obligation to pay a
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minimum death benefit does not tell us who owns the separate account assets, any
more than the insurer’s obligation to pay an annuity benefit determined who
owned the separate account assets in Revenue Ruling 77-85. To the extent the
“investor control” doctrine seeks to limit misuse of tax-favored investment assets,
there is no good reason to limit its application to annuities. In the case of both
annuities and insurance contracts, ownership is determined by which party has
“significant incidents of ownership” over the underlying assets. Here that party
was petitioner.
3. Section 7702. In 1984 Congress created a statutory definition of
the term “life insurance contract” for Federal income tax purposes. Under section
7702(a), a policy will be treated as a “life insurance contract” only if it satisfies
either the “cash value accumulation” test or both the “guideline premium” test and
the “cash value corridor” test. These tests require complex calculations involving
the relationships among premium levels, mortality charges, interest rates, death
benefits, and other factors. Respondent does not contend that the Policies fail
these tests or that they otherwise fail to qualify as “life insurance contracts” within
the meaning of section 7702(a).
After enacting section 7702 Congress continued to examine the use of
insurance contracts as investment vehicles. This led to the 1988 enactment of
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section 7702A, which defines a “modified endowment contract.” Congress
concurrently directed the Secretary of the Treasury to study “the effectiveness of
the revised tax treatment of life insurance and annuity products in preventing the
sale of life insurance primarily for investment purposes.” Technical and
Miscellaneous Revenue Act of 1988, Pub. L. No. 100-647, sec. 5014(a), 102 Stat.
at 3666; see H.R. Conf. Rept. No. 100-1104, 1988 U.S.C.C.A.N. 5048, 5159 (Oct.
21, 1988).
Sections 7702 and 7702A impose quantitative restrictions on life insurance
and endowment contracts that have significant investment aspects. From this premise,
petitioner concludes that the “investor control” doctrine cannot be applied to
an insurance policy that satisfies the statutory definition. This is a variation on
petitioner’s preceding argument--that the “investor control” doctrine should not be
applied to life insurance.
As we explained previously, petitioner’s conclusion does not follow from
his premise. The fact that the Policies constitute “life insurance contracts” within
the meaning of section 7702(a) does not determine, for Federal income tax purposes,
who owns the separate account assets that support the Policies. The latter
inquiry depends on who has substantial “incidents of ownership” over those
assets. Section 7702, with its focus on quantitative relationships among
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premiums, interest rates, and mortality charges, does not purport to address this
question.
Petitioner alternatively contends that, if the “investor control” doctrine is
applied to treat him as the owner of the separate account assets, the tax results
should be dictated by section 7702(g). That subsection provides that, in specified
circumstances, the policyholder shall be treated as receiving “the income on the
contract” accrued during a particular year. The “income on the contract” is
defined as “the increase in the net surrender value,” plus “the cost of life insurance
protection provided,” minus “the premiums paid.” Sec. 7702(g)(1)(B). Here,
there was no increase in the Policies’ cash surrender value during 2006-2007, and
there were no “premiums paid.” Petitioner accordingly contends that section
7702(g) limits his income inclusion to the “the cost of life insurance protection
provided” during the years in issue. According to petitioner, that cost would be
$12,327, the mortality charges paid by the separate accounts during 2006-2007.
Petitioner’s argument fails at the threshold. Section 7702(g) dictates the
annual income inclusion for a policyholder “[i]f at any time any contract which is
a life insurance contract under the applicable law does not meet the definition of
life insurance contract under subsection (a).” Both parties agree that the Policies
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meet the definition of “life insurance contract” in section 7702(a). Given the statute’s
express terms, section 7702(g) is thus inapplicable.
Under the “investor control” doctrine, the separate account assets are
treated for tax purposes as being owned by the policyholder, not by the insurance
company. Consistently with this premise, Revenue Ruling 77-85 and its
successors uniformly treat the policyholder as taxable on the “inside buildup,” that
is, on the dividends, interest, capital gains, and other income realized on those
assets annually. It would be illogical to find that petitioner owns the underlying
assets, then tax the income earned on those assets as if they were owned by the
insurance company. Petitioner’s reliance on section 7702(g) is accordingly
misplaced.
4. Section 817(h). In 1984 Congress amended the Code to
include section 817(h), captioned “Treatment of Certain Nondiversfied Contracts.”
It provides that a variable contract based on a separate account “shall not be
treated as an annuity, endowment, or life insurance contract for any period * * *
for which the investments made by such account are not, in accordance with
regulations prescribed by the Secretary, adequately diversified.” Id. In
authorizing the Department of the Treasury to prescribe diversification standards,
Congress stated its intention that:
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the standards [should] be designed to deny annuity or life insurance
treatment for investments that are publicly available to investors and
investments which are made, in effect, at the direction of the investor.
Thus, annuity or life insurance treatment would be denied to variable
contracts (1) that are equivalent to investments in one or a relatively
small number of particular assets (e.g., stocks, bonds, or certificates
of deposits of a single issuer); (2) that invest in one or a relatively
small number of publicly available mutual funds; (3) that invest in
one or a relatively small number of specific properties (whether real
or personal); or (4) that invest in a nondiversified pool of mortgage
type investments. * * *
H.R. Conf. Rept. No. 98-861, at 1055 (1984), 1984-3 C.B. (Vol. 2) 1, 309.
Citing this language, petitioner contends that Congress intended section
817(h) to eliminate the “investor control” doctrine altogether. Petitioner’s reliance
is again misplaced. Congress directed that the new diversification standards
should govern situations where the investments in the separate account “are made,
in effect, at the direction of the investor.” H.R. Conf. Rept. No. 98-861, at 1055.
This would be true, Congress noted, where the investments, though actually
selected by the insurance company, are so narrowly focused and undiversified as
to be a proxy for mutual funds or other “investments that are publicly available to
investors.” Ibid.
In adopting a regulatory regime to identify situations in which investments
“are made, in effect, at the direction of the investor,” Congress expressed no intention
to displace the “investor control” doctrine. That doctrine identifies situations
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in which investments are made at the actual direction of the investor, such that he
exercises actual control over the investment account. See Rev. Rul. 77-85, 1977-1
C.B. at 14 (policyholder possesses investment control when he “retains the power
to direct the custodian to sell, purchase or exchange securities, or other assets held
in the custodial account”).19
Apart from one safe harbor in section 817(h)(2), Congress left the diversification
requirements to be implemented through “regulations prescribed by the
Secretary.” Sec. 817(h)(1). The Secretary issued temporary and proposed
regulations outlining diversification standards in 1986. 51 Fed. Reg. 32633
(temporary), 32664 (proposed) (Sept. 15, 1986). The preamble stated, 51 Fed.
Reg. at 32633:
The temporary regulations * * * do not address any issues other than
the diversification standards[.] * * * In particular, they do not
provide guidance concerning the circumstances in which investor
control of the investments of a segregated asset account may cause
the investor, rather than the insurance company, to be treated as the
As commentators have noted, t 19 he section 817(h) diversification standards
may supersede some aspects of the pre-1984 revenue rulings that discuss publicly
available investments held by segregated asset accounts. See, e.g., David S.
Neufeld, “The ‘Keyport Ruling’ and the Investor Control Rule: Might Makes
Right?,” 98 Tax Notes 403, 405 (2003). But Congress did not, expressly or by
implication, indicate any intention that section 817(h) should displace the bedrock
“investor control” principles enunciated in Revenue Ruling 77-85, which address
situations where the policyholder exercises actual control over the investments in
the separate accounts.
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owner of the assets in the account. For example, the temporary
regulations provide that in appropriate cases a segregated asset
account may include multiple sub-accounts, but do not specify the
extent to which policyholders may direct their investments to
particular sub-accounts without being treated as owners of the
underlying assets. Guidance on this and other issues will be provided
in regulations or revenue rulings under section 817(d), relating to the
definition of variable contract.
Final regulations concerning diversification standards were issued in
1989. T.D. 8242, 1989-1 C.B. 215; see sec. 1.817-5, Income Tax Regs.
Since issuing those final regulations, the IRS has continued to issue both
public and private rulings invoking the “investor control” doctrine to
determine ownership of assets in segregated asset accounts. See, e.g., Rev.
Rul. 2003-91, 2003-2 C.B. 349-350; Rev. Rul. 2003-92, 2003-2 C.B. 351-
352; Priv. Ltr. Rul. 201105012 (Feb. 4, 2011); Priv. Ltr. Rul. 200420017
(May 14, 2004); Priv. Ltr. Rul. 9433030 (Aug. 19, 1994); see also C.C.A.
200840043 (October 3, 2008). As the Commissioner has explained: “[T]he
final regulations do not provide guidance concerning the extent to which
policyholders may direct the investments of a segregated asset account
without being treated as the owners of the underlying assets.” Priv. Ltr.
Rul. 9433030.20
In private letter ruling 20 9433030, for example, the taxpayer sought a ruling
(continued...)
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In sum, by enacting section 817(h), Congress directed the
Commissioner to promulgate standards for determining when investments in
a segregated asset account, though actually selected by an insurance
company, “are made, in effect, at the direction of the investor.” H.R. Conf.
Rept. No. 98-861, supra at 1055, 1984-3 C.B. at 309. It would be wholly
contrary to Congress’ purpose to conclude that the enactment of section
817(h) disabled the Commissioner from determining, under the “investor
control” doctrine, that investments in a segregated asset account are made,
in actual reality, at the direction of the investor. The Secretary clearly
stated, when promulgating the new diversification standards, that the
“investor control” doctrine would continue to apply, and the Commissioner’s
public and private rulings during the ensuing 30 years confirm
his view that this doctrine remains vital. Congress has certainly evidenced
20(...continued)
that assets held in a separate account would be treated as owned by the insurance
company and not the policyholder. The taxpayer represented that the separate
accounts would be adequately diversified under section 817(h). The Commissioner
then proceeded to consider whether the policyholder or the insurance company
should be treated as the owner of the separate account assets under Christoffersen,
749 F.2d 513, Revenue Ruling 77-85, and other authorities. The
Commissioner followed the same path in Revenue Rulings 2003-91 and 2003-92.
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no disagreement with that position.21 For all these reasons, we conclude that
the enactment of section 817(h) did not displace the bedrock “investor
control” principles enunciated in Revenue Ruling 77-85.
IV. Subsidiary Issues
A. Webify Stock Basis
The bulk of the income realized by Boiler Riffle during the tax years
in issue consisted of capital gain on the sale of Webify stock. IBM
purchased these shares in 2006 for more than $3 million, of which
$2,731,087 was paid in 2006 and $212,641 in 2007. The parties disagree as
to the basis of these shares.
21Congress in one respect has expressed its disagreement with the Commissioner’s
implementation of section 817(h), countermanding a provision of the
1986 proposed regulations that would have deemed all Government securities to
be issued by a single entity. See 134 Cong. Rec. 29723 (1988). Congress then
revised the statute by adding section 817(h)(6), which provides that, “[i]n
determining whether a segregated asset account is adequately diversified * * *,
each United States Government agency or instrumentality shall be treated as a
separate issuer.” See Technical and Miscellaneous Revenue Act of 1988, Pub. L.
No. 100-647, sec. 6080, 102 Stat. at 3710 (Nov. 10, 1988). Since Congress has
revisited section 817(h) to revise one aspect of the Commissioner’s implementation
of the diversification standards, the fact that it has left undisturbed the
Commissioner’s continuing invocation of “investor control” principles is not
without significance. Courts ordinarily are slow to attribute significance to
Congress’ failure to act on particular legislation, Aaron v. SEC, 446 U.S. 680, 694
n.11 (1980), but in some situations Congress’ inaction may provide a “useful
guide,” see Bob Jones Univ. v. United States, 461 U.S. 574, 600-602 (1983). The
latter would seem to be true here.
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We have found as a fact that the basis of the Webify shares when
sold was $838,575. Petitioner was unable to locate copies of wire transfers
or similar documents covering the numerous transactions in which these
shares were acquired. However, Butterfield Bank’s financial statements for
Boiler Riffle provide a consistent picture. Although Butterfield Bank did
not provide robust investment management services, no one has criticized
its bookkeeping or accounting. Indeed, both parties relied, in numerous
respects, on the integrity of the financial statements and other documents
that it prepared. In determining the long-term capital gain in 2006 and 2007
on the sale of Webify stock, therefore, the parties shall use a basis of
$838,575. See secs. 1001, 1221.22
B. Boiler Riffle Distributions
Respondent argues that the distributions Boiler Riffle made to
Lighthouse in 2006-2007 to cover the Policies’ annual mortality and
administrative charges should be included in petitioner’s income. These
payments were derived from income Boiler Riffle realized on the separate
account investments. We have held that petitioner, as the owner of these
Petitioner appears 22 to argue that all of the basis should be allocated to
payments received in 2006. If there is any disagreement on this point, the parties
can resolve it as part of the Rule 155 computations.
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investments, is taxable in full on the income they generated. If petitioner
were separately taxed as the deemed beneficiary of the payments made from
this income, as respondent asks us to hold, petitioner in effect would be
subject to double taxation. We decline that request.23
V. Accuracy-Related Penalty
Section 6662 imposes a 20% accuracy-related penalty upon the
portion of any underpayment of tax that is attributable (among other things)
to a substantial understatement of income tax. See sec. 6662(a) and (b)(2).
An understatement is “substantial” if it exceeds the greater of $5,000 or
10% of the tax required to be shown on the return for that year. Sec.
6662(d)(1)(A). The Commissioner bears the burden of production with
respect to a section 6662 penalty. Sec. 7491(c). If respondent satisfies his
burden, the taxpayer then bears the ultimate burden of persuasion. See
Higbee v. Commissioner, 116 T.C. 438, 446-447 (2001).
As an alternative to his “23 investor control” position, respondent contends
that the Chalk Hill Trust in effect owned Boiler Riffle, with the result that petitioner,
as the owner of that grantor trust, would be taxable on Boiler Riffle’s income
under subpart F. See sec. 1.958-1(b), Income Tax Regs. (providing that a
CFC owned by a foreign grantor trust is treated as owned by the grantor).
Whereas we have found petitioner to be the owner of the assets in the separate
accounts, Lighthouse was the owner of Boiler Riffle and other special-purpose
entities it created. Because Boiler Riffle had no U.S. shareholders, the CFC rules
do not apply.
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The section 6662 penalty does not apply to any portion of an
underpayment “if it is shown that there was a reasonable cause for such
portion and that the taxpayer acted in good faith with respect to * * * [it].”
Sec. 6664(c)(1). The decision whether the taxpayer acted with reasonable
cause and in good faith is made on a case-by-case basis, taking into account
all pertinent facts and circumstances. Sec. 1.6664-4(b)(1), Income Tax
Regs. A taxpayer may be able to demonstrate reasonable cause and good
faith by showing reliance on professional tax advice. Sec. 1.6664-4(c)(1),
Income Tax Regs.; see Neonatology Assocs., P.A. v. Commissioner, 115
T.C. 43, 99 (2000), aff’d, 299 F.3d 221 (3d Cir. 2002).
“Advice” must take the form of a “communication” that sets forth the
adviser’s “analysis or conclusion.” Sec. 1.6664-4(c)(2), Income Tax Regs.
In assessing whether the taxpayer reasonably relied on advice, we consider
whether the adviser was competent; whether the adviser received accurate
and complete information from the taxpayer; and whether the taxpayer
actually relied in good faith on the advice he was given. Neonatology
Assocs., P.A. , 115 T.C. at 99.
Petitioner urges that he reasonably relied on Mr. Lipkind’s advice.
Mr. Lipkind was clearly a competent tax adviser. He is an expert in income
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and estate tax, and he diligently researched the relevant legal issues. He
also received accurate and complete information about the Lighthouse
arrangements because he set up petitioner’s estate plan.
Mr. Lipkind provided petitioner with “advice.” Mr. Lipkind did not
himself render a written legal opinion, but he reviewed and considered
written opinion letters from reputable law firms addressing the relevant
issues. Three of these opinion letters specifically addressed the “investor
control” doctrine; they concluded that the Lighthouse policies, as structured,
would comply with U.S. tax laws and avoid application of this doctrine. By
informing petitioner that he concurred in these opinions, Mr. Lipkind
provided petitioner with professional tax advice on which petitioner actually
relied in good faith.
We likewise conclude that petitioner’s reliance was “reasonable.”
Petitioner made multiple filings with the IRS setting forth details about the
Trusts and Lighthouse, including gift tax returns filed for 1999 and 2003
and Form 3520 filed when the Policies were transferred to an offshore trust.
Petitioner did not attempt to hide his estate plan from the IRS. This
supports his testimony that he believed this strategy would successfully
withstand IRS scrutiny, as Mr. Lipkind had advised.
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The revenue rulings discussing the “investor control” doctrine
adopted consistent positions and ultimately set forth a “safe harbor.” Rev.
Rul. 2003-91, 2003-2 C.B. at 347. However, the outer limits of the doctrine
were not definitively marked when Mr. Lipkind rendered his advice in
1998. Whether an investor exercises impermissible “control” presents a
factual issue, and Mr. Lipkind dictated the “Lipkind protocol” as a
mechanism for keeping petitioner on the supposed right side of the line.
Although the “Lipkind protocol” was formalistic and ultimately
unsuccessful, we do not fault petitioner, who had no expertise in tax law, for
following his lawyer’s advice on this point. Cf. Van Camp & Bennion v.
United States, 251 F.3d 862, 868 (9th Cir. 2001) (“Where a case is one ‘of
first impression with no clear authority to guide the decision makers as to
the major and complex issues,’ a negligence penalty is inappropriate.”
(quoting Foster v. Commissioner, 756 F.2d 1430, 1439 (9th Cir. 1985)));
Montgomery v. Commissioner, 127 T.C. 43, 67 (2006); Williams v.
Commissioner, 123 T.C. 144, 153-154 (2004) (reasonable cause may be
-92-
found where return position involves issues that were novel as of the time
that return was filed).24
For these reasons, we conclude that petitioner is not liable for the
accuracy-related penalty for any of the years in issue.
To reflect the foregoing,
Decision will be entered under Rule 155.
24We disagree with respondent’s submission that Mr. Lipkind was a
“promoter” upon whom petitioner could not reasonably rely. See 106 Ltd. v.
Commissioner, 136 T.C. 67, 79-80 (2011), aff’d, 684 F.3d 84 (D.C. Cir. 2012).
Mr. Lipkind has maintained a continuous attorney-client relationship with
petitioner for more than a dozen years. Mr. Lipkind had no stake in petitioner’s
estate plan apart from his normal hourly rate, and Mr. Lipkind received no remuneration
or other benefit from Lighthouse, Boiler Riffle, or the Investment
Manager. Mr. Lipkind did not plan the private placement life insurance structure,
but only advised petitioner to purchase such a policy after thoroughly vetting
Lighthouse, an unrelated insurance company. The evidence established that Mr.
Lipkind recommended the Lighthouse estate plan only to his wife, to petitioner,
and to a small number of other clients.
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