As an estate and tax planner, we work hard to create a plan to save clients tax dollars. But sometimes, the worst enemy is not the IRS, but the client themselves.

Mr. Webber is a highly successful investor and hedge-fund manager. In the late 1990s, he found another way to leverage that expertise by making, as the court considers it, a “synergistic” investment. As a part of his estate planning, Mr. Webber purchased two private placement variable life insurance plans through his grantor trust. While the trust moved around from Alaska to off-shore and then back to Delaware, the problem was not where the trust was located, but Mr. Weber’s micromanagement.

The two policies were on two of Mr. Webber’s elderly relatives, with Mr. Webber’s children, brother, and nieces and nephews as beneficiaries. Private placement insurance is not like the type you generally think of where you purchase a policy through an insurance company or broker. First, they are usually established through an off-shore insurance company these days, although the idea started in the U.S. These types of policies require a separate account be set up for the benefit of each policy. This does two things – the money in the account is protected from the creditor claims of the insurance company, and the funds are solely for the benefit of the policy. While a small portion of the amount deposited goes to actually pay for the insurance risk and administrative charges, the remaining funds are invested to produce growth and income. The goal is to have the growth outpace the premiums for the risk, and to allow that growth to continue without having to pay income tax. How? When the amount from the policy is finally paid out, there is no income tax on the proceeds from life insurance. In Mr. Webber’s case, the two policy accounts managed to make enough income through the two policies in two years to create a tax bill of over $650,000.

The other great thing is that these types of policies generally have very low premiums compared to the risk, meaning the policy holder can afford to put more into the account for investments. Mr. Webber took full advantage of that.

The trick is the investment, in particular, how much control the policy holder has on directing the investments, and keeping the investment diversified. Obviously, as with Mr. Webber, if you are successful at investing, you try to stick with what you know. Unfortunately, the IRS did not think this type of arrangement passed the ‘smell’ test. The IRS has created the ‘Investment Control Doctrine’ through a series of its revenue rulings to address this technique. As the name implies, the test is whether the policy holder keeps enough control that the income in the separate account is credited back to the policy holder and taxed as income.

Furthermore, Congress enacted §817(h) of the Internal Revenue Code to address these types of investment. This is the part that requires keeping a diverse portfolio of investments in the account. The Investment Control Doctrine and §817(h) approach these private placement variable insurance policies (and also private placement variable annuities) two different ways – the first looks at the control the policy holder has on the investments, and the second requires diversification of the investments. While the insurance industry vociferously insisted that the Investment Control Doctrine no longer applied, the IRS insisted, and since no one wanted to challenge the IRS, everyone has, for the past 30 years, quietly complied with the revenue rulings –until Mr. Webber.

So how did Mr. Webber manage to catch the IRS’s attention? His tax advisor’s instructions were interpreted very loosely. While Mr. Webber never directly communicated with the nominal investment advisor for the two policies, some 70,000 e-mails indicate that Mr. Webber relayed his instructions through his tax advisor and his employees. In addition, the investments were in companies that Mr. Webber invested in, either personally or through hedge funds he managed. Furthermore, some of the investments were in companies where Mr. Webber served on the board of directors. He also used the investments to fulfill obligations he took on to invest in the companies. The investment advisor also did not dot the i’s and cross the t’s, failing to properly perform their due diligence on the investments.

To Mr. Webber’s credit, he was up front with the IRS about his planning, properly reporting the movement of the policies from Alaska to the Bahamas and back to Delaware, which helped him to avoid the 20% penalty. He did, however, end up owing income taxes on the account earnings.

All is not lost for Mr. Webber. The policies were on his elderly relatives, one of whom passed away, paying the insurance distribution to trusts for Mr. Webber’s children, brother, and nieces and nephews free of estate tax, and the second, who was 97-years-old at the time the decision was written earlier this year, offering a second opportunity to get further money out of the estate.

So what is the lesson here? Follow instructions, but also check to see if the instructions have changed. Tax law is, unfortunately, a continually changing area of law, and what worked yesterday may come under the scrutiny of the IRS tomorrow. While many clients are very reluctant to check in with their attorney because of the cost, Mr. Webber is evidence that not getting a check-up for a few thousand dollars over the years cost him $650,000. Can this type of tax planning work? Absolutely, but you have to know the limits, and you have to dot the i’s and cross the t’s.

Webber v. Commissioner – Dotting the I’s and Crossing the T’s