I was never a Pink Floyd fan growing up. In later years I was even less of a fan after hearing that Roger Waters, the frontman, was very anti-semitic. Nevertheless, I thought that the title of an album, “Dark Side of the Moon”, was catchy.
I have previously written about the two sides of PPLI. One side sees the PPLI, sees the industry, as an extension of the retail variable life insurance and corporate owned life insurance industry with institutional pricing and customized investment funds managed by large institutional money managers. The other side sees the policy as tax advantaged, institutionally priced with investment options designed to migrate tax-sensitive investment and low basis capital assets. The latter is the other side of the moon.
The traditionalists say that the PPLI business was never meant to be the latter, i.e. the Wild West of the life insurance industry. Who has the correct view of the World? The answer to this question may not be as straight-forward when you look through the lens of the Treasury Regulations and the alternate investment diversification testing for life insurance. Viewed through this lens, a discussion of the investor control doctrine and congressional intent does not seem as straight-forward as it might otherwise seem.
The investor control doctrine is a tax rule that effectively says that if a “policyholder” retains too much control directly or indirectly of the policy’s investments, the policyholder forfeits the tax benefits of treatment as life insurance. The inside build up of the cash value is immediately taxable. In the Webber Case, the taxpayer was not assessed tax penalties for the determination that the policyholder had violated the investor control doctrine. Nevertheless, the alternate diversification testing method stands in direct contrast to the proposition that the only “good” and viable insurance policies are ones that feature large commingled funds managed by institutional quality money managers.
The basic rules dealing with investment diversification in variable life insurance and annuities can be found in IRC Sec 817(h) and Treas. Reg. 1-817-5. Generally, the rules provide that no single investment can represent 55% of a fund; two investments 70 percent; three investments 80 percent; four investments 90 percent; resulting in a portfolio of at least five investments. The general start up rule to meet these diversification rules is a year. Real estate has a five-year start up period. The treasury regulations contemplate an explanation of an odd assortment of asset classes that do not exist at all or ever, in retail variable insurance products. Why are these asset classes mentioned at all? The reason is that life insurers have used these products to prevent unrelated business taxable income (UBTI) tax treatment for fund offerings from investment advisory subsidiaries to tax-exempt investors. These offerings ranged from hotels to senior housing, and timber as well as agriculture.
The alternate investment diversification testing method found in the treasury regulations Treas. Reg. 1.817-(b)(3) is limited to life insurance contracts. Oddly enough, like the dark side of the moon, the provision contemplates a significant concentration in a single or limited number of concentrated investment holdings along with U.S. treasury securities. These rules seem to fly in the face of traditionalists who envision the PPLI product space as a replica or the retail and COLI and BOLI space. Traditionalists do not want the PPLI terrain to be littered with investment transactions that challenge the investor control doctrine through the purchase of a single or portfolio of concentrated investment positions.
My question is if the Service did not contemplate these transactions, why is the alternate method in the treasury regulations? A few examples show how the rules work.
Example 1
At the end of a calendar quarter, the account value of a PPLI contract has a total value of $100,000. The treasury securities represent 90 percent of the account. The value of shares in Company A are worth $10,000. The 55% limit is increased by 45% (.5 x 90% in T-Securities = 45%) to 100% and can be applied to assets of the account other than Treasury securities.
Example 2
On the last day of a calendar quarter, the account value of a PPLI contract has a total value of $100,000. Treasury securities represent $60,000. Shares of Company A have a value of $30,000. Shares of Company B represent $10,000. The 55% and 70% is increased by 30% - (.5 percent x 60 percent =30%). The single holding is increased to 85% and two holdings to 100% of the account value.
Summary
This is a complicated and little-known area, which stands for the proposition that the Service contemplated large concentrated holdings within variable life insurance contracts. Contrary to popular belief that PPLI only considers large institutional commingled funds as acceptable investment options, the treasury regulations point to a different story; not only has it not been told but has been forgotten.