Tax Terrorism: Nasty Truths About Investor Control Theory and the Accommodation of Social Security Privatization - Bobby Lewis Dexter

• Jurisdiction: United States,Federal
• Publication year: 2006
• Citation: Vol. 57 No. 2

Tax Terrorism: Nasty Truths about Investor Control Theory and the Accommodation of Social

Security Privatizationby Bobby Lewis Dexter^*

I. Introduction

While American taxpayers spend the vast majority of their tax lives shouldering the monetary burden of the prevailing progressive tax scheme, Congress will, periodically, lighten the load and extend the warm hand of legislative grace.¹ New deductions,² creative tax credits,³ and outright reductions in income tax rates⁴ are not uncommon, and in fact, political motivations have long fueled an aggressive interest in the modification of federal tax rules to curry favor with large segments of the population.⁵ The protection of retirement savings from the burden of immediate taxation is a special congressional favorite.⁶ In addition to easing the tax burden on those disciplined enough to make financial provision for their retirement years, shielding money earmarked for use in old age makes eminently good sense and is profoundly appealing from a political perspective. One unfortunate side effect of Congress's occasional, tax-sheltering largesse, however, is the enhanced potential for taxpayer abuse. And for creative tax planners, retirement vehicles-like life insurance contracts and annuities-have been ripe with potential for quite some time.

Historically, life insurance contracts and annuities have served useful societal purposes. In the event of the untimely death of the principal breadwinner, the receipt of tax-free death benefits allows a surviving spouse to cover final expenses, care for minor children, and maintain the lifestyle to which they have become accustomed.⁷ Similarly, by providing a steady stream of income, deferred annuities allow seniors to enjoy active retirement years without the irritant of financial distress.⁸

Several years ago, despite contrary, state-level regulatory directives, insurance companies began to introduce various investor-friendly features to traditional life insurance and annuity products in an effort to attract investment dollars.⁹ To some limited extent, the introduction of variable life insurance contracts¹⁰ and variable annuities¹¹ gave investors the freedom to direct the investment of premium dollars¹² that under ordinary circumstances, are paid in over time and allocated internally to special accounts.¹³ By law, such accounts are segregated (for accounting and other purposes) from the insurance company's general business accounts and are thus referred to as "segregated asset accounts" or "separate accounts."¹⁴ While variable contract holders could participate in the investment of their premiums, these policyhold-ers also enjoyed the same tax benefits historically associated with traditional life insurance and annuity contracts. These products continue to enjoy a tax-favored status. Thus, to the extent premium dollars paid in earn interest (or to the extent assets purchased with premium dollars appreciate in value), the investors suffer no immediate tax consequences, despite the enhanced overall "cash value" of their contracts.¹⁵ However, prior taxpayer attempts to abuse the "tax-free build-up" features, characteristic of life insurance contracts and annuities (especially via their "variable" incarnations), prompted Congress to respond. In particular, Congress enacted the Tax Equity and Fiscal Responsibility Act of 1982 ("TEFRA"),¹⁶ which contained a number of temporary and permanent provisions. Two years later, Congress enacted the Deficit Reduction Act of 1984 ("DEFRA"),¹⁷ which brought about a number of changes in the taxation of insurance companies and their financial products.

Congress, of course, was not the only entity to respond to perceived taxpayer abuses. Before the enactment of TEFRA and DEFRA, through a series of Revenue Rulings¹⁸ issued in the early 1980s, the Internal Revenue Service (the "IRS" or the "Service"), introduced the so-called "investor control" doctrine. Ostensibly relying on overarching tax principles set forth in the common law, the Service asserted that taxpayers who, in substance, directed the investment of separate account assets underlying a contract (even if such assets were held by insurance companies on behalf of policyholders) would be treated as the owners of those assets for tax purposes.¹⁹ As a result, taxpayers would be forced to pay taxes currently on any investment earnings with respect to those assets and thereby lose the ability to enjoy the tax-free build-up in the cash value of the associated life insurance or annuity contract.²⁰

While Congress, the Treasury Department, and the IRS have responded to taxpayer attempts to abuse the tax-favored status of life insurance and annuity contracts, the end result is only partially satisfactory from a tax theory perspective. Under the old, pre-TEFRA statutory regime, contract holders could effect a partial surrender of their contracts and thereby access contract earnings without paying the appropriate taxes, a result deemed untenable by both Congress and the IRS. This Article notes that although Congress fixed the basic problem and implemented clear deterrents by enacting TEFRA, the Service's investor control doctrine survives. Arguably, the doctrine now presents a host of administrability issues and may ultimately serve to exert a chilling effect on legitimate investment activity. Furthermore, the doctrine lacks firm theoretical footing. By requiring immediate taxation, the Service focuses more on the mere exercise of investor discretion rather than on that which traditionally heralds imminent and just taxation under well-established tax principles, namely "undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion."²¹ Congress's response to the basic problem (enacting specific Internal Revenue Code ("Code") provisions in TEFRA) has the added benefit of comporting with this long-standing tax principle.

The privatization of Social Security²² could have promised profound challenges to the investor control doctrine (given the level of investor discretion anticipated). A recent IRS pronouncement, Revenue Ruling 2003-91,²³ handily eliminates the apparently imminent conflict between longstanding, IRS-asserted doctrine and the demands of the political arena. One could argue that the pronouncement reflects little more than doctrinal evolution, but such evolution is a giant leap away from the twenty-two-year-old notion that investor discretion should be minimal and appears to be a doctrinal accommodation of potential Social Security privatization. This Article argues that the investor control doctrine should be dismissed. I further propose that investor discretion should be allowed with respect to the investment of contract assets, subject to (1) investment professional guidance or risk assessment, (2) age-sensitive adjustments with respect to the percentage of contract assets subject to investor discretion, and (3) limits with respect to the aggregate amount a taxpayer may invest in variable life insurance or variable annuity contracts.

Part II of this Article provides background information, chronicling the pre-TEFRA investor abuse environment, the Service's initial doctrinal response, Congress's legislative reaction (under TEFRA and DEFRA), and post-DEFRA developments. Part III of this Article presents a critique of the modern investor control doctrine in light of its theoretical footing and presents arguments related to the doctrinal accommodation of Social Security privatization. The focus shifts forward in Part IV where I present the variable contract model. In Part V, I present an argument summary and my general conclusions.

II. Background

Public policy has long supported the various benefits associated with life insurance contracts and similar financial instruments issued by insurance companies:

The Treasury Department has in the past recognized and continues to recognize the social benefits of encouraging insurance protection. In the event of the death of a working spouse, life insurance proceeds can be a source of support for the surviving spouse and minor children, and can enable the survivors to maintain their standard of living. In certain cases, life insurance may enable the surviving spouse and minor children to avoid becoming dependent on governmental assistance, thereby relieving the government of an obligation it otherwise would have to assume.²⁴

The same can be said with respect to the purchase of annuity contracts and the prevention of financial distress and governmental dependency in the retirement years.²⁵ With the innovative assistance of those in the life insurance industry, taxpayers have, over the years, attempted to abuse these products by (1) investing large sums of money in them; (2) enjoying the tax-free build up in policy cash values; and (3) attempting to access policy earnings prematurely (with no tax result) either by taking loans out against the policy, using the policy as collateral, or effecting a partial surrender of the policy.²⁶ This activity was particularly prevalent during the late 1970s, and the Service responded to these developments by issuing a series of Revenue Rulings.²⁷ In addition to setting forth the Service's view of the federal income tax ramifications of such transactions, the rulings also served to spark the evolution of the so-called "investor control" doctrine.²⁸ Under that doctrine, investors purchasing variable contracts, yet effectively maintaining a certain degree of control over the investment of their premium dollars, are deemed to own the purchased assets.²⁹ In the Service's parlance, such policyholders maintain "sufficient incidents of ownership" over the assets supporting their contracts.³⁰ Accordingly, any earnings attributable to such assets are taxed currently to the policyholder.³¹

A. "Wraparound Annuities" and the Early Revenue Rulings

Perhaps the earliest Revenue Ruling of note is Revenue Ruling 7785³² (for schematic, see...