Two recent proposals are designed to constrain the use of private placement life insurance (PPLI) and private placement annuity (PPA) contracts. One came from Senate Finance Committee Chair Ron Wyden, D-Ore., in a report issued by the Finance Committee Democratic staff, and the other was in Treasury’s green book for fiscal 2025.
Treasury included more details about how a statutory provision addressing PPLI and certain variable life insurance contracts would function, while Wyden’s report laid out principles. The mechanics of the rules outlined in the green book mostly track the Wyden principles, but there might be a snag in changing the treatment of PPLI and PPA contracts. And the green book proposal’s effective date might effectively give current PPLI arrangements a pass, while the Wyden principles would also apply the rules to existing policies.
Wyden’s Proposal
“Congress should close the PPLI loophole,” concluded Wyden’s report, which stressed that the Finance Committee is working on legislation to “significantly curb” the use of PPLI. It specified principles for the legislation, which included ensuring that both PPLI and PPA contracts will be taxed on current income. The report also identified a need for strong information reporting obligations supplemented by penalties “with teeth.” The exact information that would have to be reported wasn’t outlined, but the report called for enough “to make sure these transactions are transparent to the IRS, enabling them to more easily identify abuses.” It noted that otherwise, it’s difficult for the IRS to enforce compliance with investor control rules and detect abusive transactions and fraud.
The plan to subject earnings from PPLI and PPA contracts to immediate taxation would result in a positive revenue score. Wyden’s report estimates the domestic market for these types of insurance products at roughly $40 billion.
Wyden contrasted PPLI with “the rules that are intended to protect typical American families,” meaning the principal tax benefits accorded to life insurance policyholders. Those include no taxation on growth in the value of life insurance policies, the availability of tax-free loans against the policy in certain situations, and general nontaxation of the insurance proceeds the beneficiary receives after the insured’s death.
Unlike prior legislative proposals from Wyden, such as last year’s Billionaires Income Tax Act, which would require billionaires to mark to market tradable covered assets, the February report didn’t propose an income or asset test. Under the Billionaires Income Tax Act, only applicable taxpayers were subject to the mark-to-market regime, so most taxpayers — possibly including a large contingent of PPLI holders — were excluded.
Budget Proposal
Last year, the Biden administration proposed modifying the rules for insurance products that don’t meet the statutory definition of a life insurance contract. That proposal was motivated by concern that “frozen cash value” contracts designed as life insurance contracts under foreign law and failed insurance contracts under the U.S. tax code result in a relatively small amount of tax due — potentially even zero. “Increases in a contract’s asset value are not included in taxable income because they are either offset by a payment of premiums during the taxable year or are not part of a contract’s surrender value,” the fiscal 2024 green book explained. Taxing the excess of a contract’s net surrender value over the premiums paid was intended to fully tax the policyholder on the earnings that accrued on a failed contract’s underlying investments.
The Biden proposal’s three-part solution first redefined income on the contract for a failed contract by changing net surrender value to “net investment value,” defined as the amount representing the contract’s death benefit for a given date, less the contract’s amount at risk and any specific charges that might be imposed upon a contract’s surrender for the same date. The result would be current taxation of the earnings credited to the failed contract. The second part of the proposal was to deem amounts distributed and policy loans from a failed contract to be amounts distributed or loaned under a modified endowment contract. Thirdly, the proposal sought to deem the excess of the amount paid because of the death of the insured over the contract’s net investment value as paid under a life insurance contract when determining the exclusion amount of death benefit proceeds and estate and gift taxes.
This year’s green book targeted PPLI and PPA. Treasury argued that there is “relatively minimal life insurance justification for PPLI contracts and the predominant investment orientation of PPLI, PPA, and similar contracts.” Accordingly, it concluded that those contracts “should not give rise to the same tax benefits traditionally provided to life insurance and annuities under the Code.” Treasury further justified the proposal by saying that most individual PPLI policyholders reportedly have a net worth of $20 million or more, with at least $10 million in liquid assets. That’s a bit lower than the Wyden report’s finding regarding one PPLI carrier, where the average annual income of a PPLI client was over $7 million and the average net worth was over $100 million.
The proposal would render all earnings on PPLI, PPA, and similar contracts taxable and limit deferral through a penalty tax by defining covered contracts as any PPLI or PPA contract that is —
Defined as a variable contract subject to SEC regulation as a security that is not a registered product with the SEC, with respect to which the purchaser, as a condition of purchase, must have sufficient income and wealth to qualify (or can otherwise qualify) as an accredited investor or qualified purchaser under SEC regulations at the time of purchase.
The definition also covers four situations in which a variable life insurance contract would be a covered contract. A variable contract here would be defined as “any life insurance or annuity contract for which the amount of the covered insurance company’s obligations to the contract holder depends in whole or in part (by law, regulation, or the terms of the contract) on the value of assets that are designated to support the contract.” If any of the premiums are paid in kind rather than in cash, a variable life insurance contract would be a covered contract, as would a variable life insurance contract if the underlying assets include assets purchased from the policyholder, persons related to the policyholder, or a business or other entity in which the policyholder or a related person has more than de minimis ownership. These provisions evidently aim to minimize the number of investor control cases that the IRS will have to handle by restricting in-kind premiums and investments in a business controlled by the policyholder.
Covered contracts would also include a variable life insurance contract that —
In combination with contracts owned by persons related (directly or indirectly) to the contract’s policyholder, owns an interest in a separate account of an insurance company, and the cash value of the related contracts, in the aggregate, represents at least 5 percent of the value of any distinct investment option whose assets are accounted for in that separate account.
This provision appears to target customized investment funds — perhaps especially “clone funds,” in which investment advisers establish insurance-dedicated funds to mimic or replicate the underlying investment strategy of other investment vehicles, according to the Finance Committee report.
Finally, variable life insurance contracts issued abroad would be covered if any of the investment assets supporting the contract would cause the contract to be salable only to an accredited investor or qualified purchaser under Regulation D of the Securities Act of 1933 if sold or marketed in the United States. Regulation D is in 17 C.F.R. section 230.501 and defines an accredited investor as an individual or married couple with a net worth of more than $1 million, excluding their primary residence, or annual income of over $200,000 for individuals and $300,000 for couples. Qualified purchasers under the Investment Company Act of 1940 are individuals or couples who own, directly or through a company or trust, at least $5 million in investments.
Covered contracts would be denied most of the tax benefits accorded to life insurance and annuity contracts. Additional reporting requirements would also apply. The green book said the exemption for pure life insurance benefits — amounts paid in excess of a contract’s cash value — received under PPLI contracts would be preserved.
“This is a good step forward in stemming the abuse of PPLI. The definition of covered contracts seems to get at the cases where we’re really worried there is some abuse going on,” said Luís Carlos Calderón Gómez of Yeshiva University’s Benjamin N. Cardozo School of Law. He added that it would be important for future statutory language to ensure that the IRS has sufficient flexibility to challenge transactions it deems abusive. “Giving a bit of flexibility to the IRS in the statute is important here, because we’ve seen that these are highly sophisticated taxpayers who have been able to deftly structure and adapt these transactions,” he said.
Two categories of covered contracts include rules that would examine the policyholder’s relationships. There could be some resistance to those rules because other relationship rules in the tax code typically hinge on specific family relationships but exclude other types of personal relationships, Calderón Gómez noted.
Statutory language might elaborate on what constitutes a de minimis ownership interest under the definition of covered contracts, and the indirect and constructive ownership rules could come into play. “Depending on how the rules are written, there may be an opportunity to say a policyholder or related person doesn’t own underlying assets under this provision, which could be a potential issue,” Calderón Gómez said.
Uncovering Abuses
Both proposals say that PPLI’s treatment needs to be changed because of abusive transactions that are at best opaque to the IRS. PPLI’s recent history features cases such as Webber v. Commissioner, 144 T.C. 17 (2015), and Wegbreit v. Commissioner, T.C. Memo. 2019-82. Webber involved an application of the investor control rule, which the court determined the taxpayer violated rather egregiously.
In Wegbreit, the taxpayers’ PPLI was determined not to be insurance, and the court found clear and convincing evidence of fraudulent intent. The Tax Court opinion is smattered with practice pointers that even non-litigators know, like not throwing every possible argument against the wall to see what sticks and ensuring your account of the facts is consistent. The Tax Court held that the Wegbreits underreported their income by nearly $15 million from 2005 to 2009. Both the government’s and the taxpayers’ approach to the case irritated the court, which pointed out that “respondent continues to use the shotgun approach to theories of the case rather than selecting the strongest arguments and focusing on them,” and that the Wegbreits’ briefs “misstate the record and are unreliable.”
The Government Accountability Office issued a report in 2020 saying that the individualization of offshore insurance products poses a special challenge for enforcement. In its prefatory letter to Senate Budget Committee ranking member Chuck Grassley, R-Iowa, the GAO noted that “taxpayers can hold offshore insurance for a number of legitimate reasons.” But the IRS has also identified instances of abuse.
Effective Date
The green book’s proposal would be effective after December 31, 2024, and would apply to covered contracts issued on or after the day following the date of the green book’s publication, which was March 11. Substantial modifications of existing life insurance or annuity contracts or exchanges of contracts would be treated as new contracts under the proposal, whereas the Finance Committee’s report concluded that legislation should apply to existing policies as well as new policies. Unlike the report, the green book’s plan appears to exempt existing PPLI policies that don’t otherwise violate applicable rules, such as the investor control doctrine.
A Constitutional Hitch
The proposals might suffer from the same fatal defect: They could violate equal protection under the Fifth Amendment. There appears to be no rational basis for treating PPLI differently than variable universal life insurance (VULI) of the type owned by millions of taxpayers, said David S. Neufeld of Flaster Greenberg PC. “PPLI owned by the ultrawealthy is the same product as VULI,” he said, adding that “in all material tax consequences, PPLI is indistinguishable from other variable insurance.”
The only difference between PPLI and VULI is that the investments held in the former are subject to Securities Act Regulation D, Neufeld said. Regulation D allows exemptions from the securities registration requirements for companies offering private placements by limiting them to investors who are presumed to be both sophisticated enough to assess the risks of those investments and able to withstand the financial hit if the investment goes south.
The premise for distinguishing between taxpayers who purchase PPLI and those who buy VULI is irrational, Neufeld said. Instead of taxing the targeted group of taxpayers on the basis of their activities, the proposal would tax them based on the fact that they are not the group that is restricted in their investments under securities law, he said. “The Senate Finance Committee’s report and the administration’s green book would use a federal securities provision intended to protect one class of investor under the securities law as a bludgeon to punish another class of investor under the tax law,” he said.
Neufeld noted that the attributes of PPLI that the proposals deem problematic are also part of variable insurance: The premiums are invested in securities, gains within the policy are realized tax free, cash can be borrowed tax free at favorable rates against the policy, and the death benefit can be received free from income tax and be excluded from the estate tax. “Every middle-class person in America can, to use the Senate’s phrase, buy/borrow/die just like the ultrawealthy, and many do,” he said.
Even if a statutory scheme modeled on the green book proposal is determined to be unconstitutional, it could be modified to give it a rational basis that is similar to one used for other tax laws. The tax code already makes distinctions between taxpayers engaged in the same activities based on income. The ability-to-pay theory that underlies that differentiation could ensure that a statute based on the green book’s plan would pass rational basis review.
Reporting
Adding reporting requirements is a common thread in both proposals, but the details on what might be included are scarce. The green book proposal would place the decision-making responsibility on the IRS and Treasury and would require reporting from both policyholders and their insurance companies. The green book adds that the reports should include “information on policy distributions and premiums,” and that if a taxable amount is attributable to a distribution from a covered contract and the recipient fails to include it in gross income, the tax and penalties owed could be assessed within six years of filing the return, instead of the typical three years under section 6501.