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"Is Private Placement Life Insurance the Next IRS Tax Enforcement Target?," The Legal Intelligencer

June 24, 2024

Kevin Sweeney Article Published in The Legal Intelligencer

Taxpayers with PPLI policies and their advisers should consider proactively seeking legal advice about whether they are likely to survive IRS scrutiny and, if not, the best and most appropriate way to get back into tax compliance.

On Aug. 16, 2022, President Joe Biden signed the Inflation Reduction Act (IRA) into law, which allocated more than $40billion to the Internal Revenue Service (IRS) for tax enforcement activities over a span of 10 years. Although this funding did and continues to fill important IRS needs for tax enforcement resources, it comes with the expectation that the allocated money will be used in a manner likely to result in significant future tax collections.

Since the IRS began receiving this funding, the IRS commissioner has announced several new initiatives and existing areas of increased scrutiny focused on extracting additional taxes and penalties from wealthy Americans. This includes audits of corporate jet usage, high-income nonfiler initiatives and civil examinations/criminal investigations into alleged tax avoidance transactions involving micro-captives, syndicated conservation easements, Puerto Rico Act 20/22/60incentives, and Malta pension plans.

The IRS is not alone in its recent scrutiny of wealthy taxpayers. Certain members of Congress, including Senate Finance Committee Chair Ron Wyden, have also taken a particular interest in the tax-related activities of wealthy Americans as of late. One such activity that has drawn congressional scrutiny over the past several years is the use of private placement life insurance (PPLI), of which Wyden formally launched a congressional investigation on Aug. 15,2022.

What Is PPLI?
PPLI is a form of permanent variable universal life insurance. In addition to their insurance components, PPLI policies build cash value based on the performance of investment accounts they hold. In contrast to traditional variable universal life insurance, the investment options within these policies are customizable and allow investments in alternative assets, such as hedge funds, real estate and derivatives. Because of the legal requirements necessary to purchase some forms of PPLI, such as meeting “accredited investor” and “qualified purchaser” requirements, and the fees involved, promoters typically market these policies to very wealthy taxpayers.

Tax Treatment of PPLI
PPLI is generally treated as life insurance for federal income tax purposes so long as it satisfies certain IRS requirements. As an insurance product, investments made within a PPLI policy typically receive more favorable tax treatment than traditional investments.

Unlike traditional investments, income generated by an investment within a PPLI policy during the insured’s life is generally not subject to income tax. This treatment enables insurance-wrapped investments to grow faster than outside investments. Additionally, withdrawals up to the policy owner’s cost basis are also generally not subject to income tax. Furthermore, the owner can borrow from the PPLI policy up to its cash surrender value without reducing the death benefit as long as the loan is repaid before death. In addition to the tax benefits to the policy owner, the death benefit is generally not subject to income or estate tax either.

To achieve these favorable tax benefits, the PPLI policy must meet certain technical requirements, which may include qualifying as a life insurance contract for federal income tax purposes, complying with restrictions on the amounts and timing of premiums paid, keeping policy investments adequately diversified and ensuring that the taxpayer lacks sufficient incidents of ownership over the policy investments. The latter is more commonly known as the investor control doctrine and generally turns on whether the taxpayer had the power to decide the specific investments of the policy. The investor control doctrine has been a source of particular scrutiny by the IRS in the few cases where the tax treatment of PPLI was at issue.

To date, there have been very few litigated PPLI tax matters. This is likely due (at least in part) to the tax reporting requirements for PPLI or lack thereof. With the exception of international information reporting for foreign PPLI, it is typically not reportable by a taxpayer.

Wyden’s PPLI Report
On Feb. 21, Sen. Wyden issued a report on PPLI based on the investigation he launched back in 2022. In that report, he called it a “tax shelter for the wealthiest 0.1 percent of Americans.” The report included these findings:

⦁ The PPLI industry is now at least a $40 billion tax shelter used exclusively by a few thousand millionaires and billionaires. ⦁ Unlike traditional insurance policies, PPLI policies are an ultra-niche financial product that is not available to middle-class families. ⦁ PPLI policies are actively promoted to ultra-wealthy Americans as tax-free hedge and private equity fund investments. ⦁ PPLI policies are actively promoted to millionaires and billionaires as a way to transfer significant wealth to their heirs while bypassing income, gift and estate taxes. ⦁ Guardrails against abuse of PPLI policies are nearly impossible for the IRS to enforce due to a lack of disclosure requirements. ⦁ The IRS should increase scrutiny of the PPLI industry’s compliance with investor control rules. ⦁ Legislation is needed to increase oversight of PPLI and curb abuse of these products as tax avoidance by the wealthiest 1% of Americas.

Future Tax Enforcement of PPLI Matters
In light of the IRS’s need to justify its tax enforcement funding, its recent focus on wealthy taxpayers, Senator Wyden’s call for more IRS scrutiny of PPLI, the small population of U.S. persons with PPLI policies and the large amounts of potentially tax-free income held in these policies, it is likely that the IRS will attempt to identify and aggressively audit PPLI policyholders in the coming months and years.

Although there is nothing inherently wrong with PPLI, there is a complex set of rules that must be followed to achieve the desired tax benefits. Taxpayers with PPLI policies and their advisers should consider proactively seeking legal advice about whether they are likely to survive IRS scrutiny and, if not, the best and most appropriate way to get back into tax compliance. Even if they choose not to be proactive, taxpayers who come under IRS audit should immediately seek out tax controversy attorneys with an understanding of PPLI. Given the typical size of these policies and the IRS’s stated intention to extract taxes and penalties from wealthy taxpayers, a wait-and-see approach could prove to be very costly.

Kevin F. Sweeney is a former federal tax prosecutor. Now a shareholder in the Philadelphia office of Chamberlain, Hrdlicka, White, Williams & Aughtry, he focuses on IRS audits, civil and criminal tax litigation, white-collar criminal defense and IRS whistleblower matters. Sweeney can be reached at 610-772-2327 or by email at ksweeney@chamberlainlaw.com.

Reprinted with permission from the June 4, 2024, edition of The Legal Intelligencer © 2024 ALM Media Properties, LLC. All rights reserved. Further duplication without permission is prohibited, contact 877-257-3382 or reprints@alm.com.