Beating the "wrap": the agency effort to control wraparound insurance tax shelters

Virginia Tax Review, Summer, 2005 by Charlene Davis Luke

I. INTRODUCTION

The owners of cash value life insurance and annuity contracts have long been able to defer paying tax on the income accruing inside these products--that is, on the "inside buildup." (1) Early insurance products provided their contract owners with only a low, guaranteed return close to the risk-free rate of return. (2) Concerns about the effect of inflation on these products, however, triggered the creation in 1952 of a new insurance product: an annuity tied to investments yielding a variable, risk-related return. (3) It took some time for the variable annuity to gain acceptance, perhaps because of uncertainty surrounding its classification for securities and tax law purposes. (4) In 1959, the Supreme Court provided some resolution of the securities law questions, and shortly thereafter Congress signaled its decision to allow the inside buildup of variable annuities to accumulate on a tax-deferred basis. (5)

Beginning around 1965, taxpayers began to exploit the inconsistency arising from the difference between the treatment of variable insurance returns and the economically similar returns available outside variable insurance. (6) In the tax avoidance game (7) that has developed, variable contract purveyors wrap a variety of income-producing investments inside variable annuities or life insurance in order to defer paying tax on the inside buildup. The contract marketers also try to minimize insurance features of the contracts (e.g., the mortality bet) to maximize the contract holder's control over the income-producing assets underlying the contract, and to provide contract holders with access to the inside buildup without triggering tax liabilities. In the most recent iteration of this "wraparound" insurance gambit, insurance companies--with the likely complicity of sophisticated, wealthy taxpayers--wrapped private placement hedge fund interests inside variable insurance products in order to defer tax on the ordinary income thrown off by such interests. (8) Thus, hedge fund wrappers were being used primarily to convert ordinary income into tax-sheltered income. (9)

Although Congress has at times intervened in the history of this game, to good effect, (10) it has left intact the tax subsidy for variable insurance inside buildup and thereby the incentive for taxpayers to exploit this preference. (11) Congress has provided the Treasury and the Internal Revenue Service (Service) with some authority to keep variable insurance products from becoming ready, tax-preferred substitutes for commonplace, taxable investments. (12) Exercising this authority, however, has required the tax agencies to distinguish proper risk-based returns from improper risk-based returns. (13) The fundamental economic similarity of all risk-based returns makes this line-drawing exercise ultimately impossible. (14)

The tax agencies are frequently hampered by flaws in the statutory base from which they must operate. One tax agency strategy--the one used in the case of variable insurance products--is to raise the cost of a particular avoidance technique so that it becomes less attractive to most (if not all) taxpayers. Using this method, the agencies have been able to arrive at a legal framework that has been fairly effective at cutting back a particular iteration of the shelter, but it is a framework that has also permitted the periodic flourishing of new forms of wraparound insurance. As a result of its ability to resolve immediate fairness concerns raised by a particular version of the shelter, the agencies' framework may diminish the prospect of broader legislative reform of the underlying systemic flaw. (15)

Part II of this article provides a brief introduction to the insurance terminology and tax treatment necessary to an understanding of wraparound insurance contracts. (16) Part III provides a detailed history of the wraparound insurance technique and the government's responses to it. (17) Readers familiar with variable insurance products and the history of the wraparound insurance tax shelter may wish to begin with Part IV, which assesses the effectiveness of the agencies' responses and discusses alternative approaches that may better further the goal of fundamental reform. Part V is the conclusion.

II. INSURANCE PRODUCT AND TAX BACKGROUND

A. Annuity Contracts

Annuity contracts are structured in two phases. (18) First, during the accumulation phase, the contract holder pays premiums and investment income builds up in the contract. In a fixed annuity, this income builds up at a low rate guaranteed by the insurance company. Following the accumulation phase, if the contract holder does not elect to receive a lump sum payment, (19) the annuity contract enters the annuitization phase during which the investment buildup (including income that continues to accrue during annuitization) is turned into a stream of periodic payments. (20) Annuitization has long been described as "the reverse of life insurance" (21) because the mortality bet made in the case of an annuity tied to a life contingency is that the contract holder will have a long life rather than die prematurely. (22)