TAXATION AT A DISTANCE. (Webber v. Commissioner) (Wyly, In re)

• Date: 22 September 2022
• Author: Gordon, Jeff

INTRODUCTION 32
                I. THE TANGLED DOCTRINE OF LIFE INSURANCE TAXATION 36
                A. An Introduction to Private Placement Life Insurance 37
                B. The Shaky Policy Case for Inside Buildup 40
                C. Investor Control: The Exception to Inside Buildup 43
                D. Exploiting "Investor Control" 47
                E. Estate Taxation of Life Insurance Also Relies
                on Control Tests 49
                II. WEBBER AND WYLY -- A MORE FORCEFUL CONTROL TEST? 53
                A. Webber v. Commissioner 53
                B. Securities Exchange Commission v. Wyly 57
                III. TAXATION AT A DISTANCE 61
                A. Criticizing Investor Control 62
                1. Control in Comparative Perspective 62
                2. Is Life Insurance Different? 64
                B. The Obsolescence of Investor Control 67
                C. Taxing Based on Benefits 70
                D. Including Life Insurance in the Estate
                Based on Benefits 73
                IV. CONCLUSION: PIERCING THE VEIL OF LEGAL DISTANCE 75
                

INTRODUCTION

How should the government tax income and wealth held at a distance, i.e. at a deliberate legal remove from the original owner? I explore this question through the case of private placement life insurance, one of the largest and fastest growing modes in which the wealthiest Americans hold their money. I also examine offshore trusts. What these legal vehicles have in common is that they offer lower (or nonexistent) tax rates compared to traditional onshore wealth management, while still providing access to the same asset classes (e.g., stocks, bonds, even private equity and hedge funds) that investors may wish to hold in their portfolios. Close study of these vehicles illuminates a tension between how tax law understands ownership and how ownership actually functions in the world. Specifically, tax law is at risk of overemphasizing the significance of control as a trigger for imposing the burdens of ownership, even when control is not necessary to enjoy its benefits.

The Code has come to afford special treatment to life insurance due to some combination of reasoned policy, industry lobbying, and illogical application of existing tax rules and judicial anti-abuse doctrines. Congress has good reason to close these loopholes for revenue purposes alone: the tax expenditure associated with the non-taxation of life insurance income is estimated at $370 billion over ten years. (1) But in addition to pragmatic revenue considerations, it is important to clarify legal theory and doctrine on when it is appropriate to tax wealth held at a distance like any other wealth, and when preferential tax treatment is justified.

In the case of life insurance and offshore trusts, what I call "control doctrines" have emerged at the IRS and in the courts, advancing the theory that trust creators should be taxed only if they exercise substantial control over the management of the distant wealth. Control belies the appearance of legal distance. But I question whether control is an appropriate consideration for assigning tax liability. I argue that the ecosystem of professional wealth managers, trust administrators, and tax lawyers has matured to such a degree that wealthy taxpayers do not need to exercise control in the traditional sense in order to ensure their will is done. Professional service providers can be entrusted with all the control that is necessary. In making this argument, I seek to extend to tax law a form of legal analysis in which changes in social conditions justify changes in the interpretation of the law. Control over an investment account does not have the same social significance it may have once had, and doctrine should follow.

To the extent that scholars have acknowledged the control doctrines, it is with approval. Practitioners, for their part, have taken keen notice and analyzed this development with some concern, as well as enduring confidence that they will be able to plan around the new doctrine. Other practitioners have protested that the investor control doctrine is groundless. My position is distinct from all of these. I argue that investment income should be taxed to its owners more frequently and systematically than it now is, but unlike other proponents of this position, I reject the control doctrine as the best means of doing so. Instead, I offer a more fundamental critique of existing law--one that reaches beyond "control" as the defining characteristic of ownership. If tax policy coheres around control tests, it will fail to make a dent in those tax planning strategies that involve holding wealth at a distance. And yet, as I argue, there is a better, more direct justification for taxing such wealth. That is to tax based on economic benefit, including the benefit an insured person receives when their life insurance account accumulates income to pass on to their heirs, regardless of what kind of legal box the account is sitting in.

The implications of this analysis stretch beyond life insurance and offshore trusts, and to issues ever-present in legal battles against the law of "high-wealth exceptionalism" more broadly. (2) First, the same questions apply to taxing interests in other intermediated investment and wealth-holding vehicles: various forms of trust, structured legal settlements, deferred compensation agreements and assets held by private foundations. (3) All these are ways of holding money at a distance, with some legal intermediary placed in between the beneficial owner and the assets. In each case, the question is to what extent the liabilities of ownership (here, taxation) should go along with the benefits of ownership, even when that ownership is incomplete.

Second, this issue will not be limited to the forms of taxation that it currently bedevils, the income tax and estate tax, both of which I discuss here. Dealing with this issue will also be essential to making a wealth tax operational. Just as life insurance and offshore trusts are attractive means of escaping the existing tax systems, they would likely grow all the more appealing as means to avoid a wealth tax, if enacted. Taxpayers would have an incentive to move as much money as possible into life insurance, assuming the wealth tax exempted life insurance under the same conditions (e.g., when held outside the policyholder's control) that the estate tax currently does. And the same incentives will apply to other legal techniques for holding wealth at a distance, such as in private foundations. Therefore, it will be critical for a realistic wealth tax bill to address wealth held in these forms.

Third, examining the existing doctrines for taxing at a distance leads to some important observations about the relationship between extreme wealth and legal formalism. Allison Anna Tait observes that ultra-wealthy families constitute themselves as quasi-sovereigns, answerable to their own "family constitutions" rather than to the laws of nations. (4) This "law of high wealth exceptionalism" is made possible by certain legal forms, above all the family trust. (5) As Katharina Pistor has observed, private lawyers turn assets into capital by "encoding" them through certain legal modules found in contract law, collateral law, corporate law and trust law. (6) The insurance and trust vehicles discussed here are prime examples of this process in action: lawyers make existing investments more valuable (on an after-tax basis) simply by wrapping them in new legal forms. I build on Pistor's work by demonstrating how an awareness of this "coding of capital" should affect our interpretation of certain legal categories that imagine the individual taxpayer as an independent actor--in particular, the concept of control.

Part I examines the current landscape of private placement life insurance and its taxation. Subpart I.A explains why life insurance has grown so popular with wealthy investors; tax benefits are a big part of the story. Subpart LB examines the few plausible policy justifications for affording life insurance such plum tax status and finds them unconvincing. Subpart I.C recounts the legal history of the investor control doctrine, one of the IRS's only tools against tax-free life insurance arrangements. Subpart I.D explains how easy it is for taxpayers to get around the investor control doctrine. Subpart I.E pivots to describe the way life insurance is treated under the estate tax, where a control test plays a similar role. Part II introduces what some observers consider to be a promising turn in life insurance and trust taxation: two recent cases where judges blew up seemingly foolproof investment arrangements because the taxpayers were exercising too much control and dominating their supposedly independent trustees. I argue that these cases do not actually represent a promising path for tax enforcement. In Part III, I argue that, beyond its deficiencies in practice, investor control is not a philosophically coherent basis for taxing insurance or trusts. Subpart III.A compares life insurance to other investments and concludes that there is no good reason for control to matter more here than there. Subpart III.B warns about the risks of embracing investor control and building it into a wealth tax, where the same issues of taxing at a distance would present themselves. Subpart III.C presents a better approach: taxing based on economic benefit, regardless of the formal legal container where income is recorded. Subpart III.D applies the economic benefit principle to the estate and gift taxation of life insurance. The Conclusion considers an analogy between the economic benefit approach to taxing wealth at a distance and veil-piercing doctrines and determines that this approach is less a substance-over-form rule than a rule that denies the relevance of form from the outset.

I. THE TANGLED DOCTRINE OF LIFE INSURANCE TAXATION

"PPLI [private placement life insurance] is like a tax-free parallel
                universe."
                --FieldPoint Private wealth management memo (7)
                

In this Part, I explain how wealthy individuals use private placement life insurance and life insurance trusts to minimize or altogether eliminate income and estate taxes on certain investments...