Private placement life insurance (PPLI) policies that push the boundaries of what is acceptable under IRS rules elude the agency’s auditors due in part to gaps in training and silos within the agency, a Tax Notes investigation has found.
The Senate Finance Committee’s Democratic staff has been investigating PPLI, a special type of life insurance that is available only to wealthy investors. The committee believes that at least $40 billion is being sheltered in 3,061 domestic PPLI policies.
Leaked documents obtained by the International Consortium of Investigative Journalists and reviewed by Tax Notes show PPLI structures with millions of dollars set up in offshore tax havens like Belize and the Cayman Islands. Meanwhile, states have been cutting taxes to lure those policies from offshore jurisdictions.
Senate Finance Committee Chair Ron Wyden, D-Ore., says PPLI is one way to leverage the strategy known as “buy, borrow, die” in which investors can limit their tax liability, grow their wealth, and pass it on tax-free. Critics say the strategy contributes to wealth inequality.
“PPLI has been around for a long time, and it’s been abused for a long time,” said Jay D. Adkisson of Adkisson Pitet LLP. “Why it took [the Senate Finance Committee] so long to jump on PPLI is a mystery.”
Some of the challenge may relate to the nature of the transactions. PPLI issues might end up in different divisions of the IRS without directly encountering anyone with the expertise needed to challenge them.
The Justice Department has prosecuted cases involving life insurance wrappers in partnership with the IRS Criminal Investigation division in which PPLI is used for tax evasion. However, the issue with PPLI “boils down to investor control,” which isn’t an issue that CI would address, said Kevin F. Sweeney of Chamberlain, Hrdlicka, White, Williams & Aughtry.
Investor control — a term that means a taxpayer exercises too much control over the assets in the policy’s segregated account — can be a problem for PPLI policies, making them ineligible for tax benefits that are attractive to high-net-worth individuals and families.
The Tax Court defined the investor control doctrine in 2015 in Webber v. Commissioner, 144 T.C. No.17, which concerned a taxpayer that arranged and funded PPLI policies from an insurer based in the Cayman Islands. In that case, the court ruled that the taxpayer — who exchanged more than 70,000 emails directing specific investments (including start-ups in which he had a personal interest) for the policies — had exercised too much control over the policy assets, so he owed taxes on the
accumulated gains.
“There just hasn’t been a lot of PPLI-type audits, so I haven’t run into a revenue agent that I felt was acutely aware of it,” Sweeney said.
‘Audit Lottery Deal’
A February 21 report from Wyden on PPLI notes that the “investor control rules designed to curb abuse of PPLI policies are extremely difficult for the Internal Revenue Service (IRS) to enforce due to a lack of existing reporting requirements.” The report says the agency has an audit campaign related to abuse of PPLI policies, although no official campaign for PPLI has been announced by the IRS.
Individuals who take out domestic PPLI policies aren’t required to disclose them on their tax returns, making them difficult for the IRS to see. A senior Finance Committee staffer told Tax Notes that the committee learned that the IRS has no visibility into who owns a domestic PPLI policy unless it comes up in an audit.
Adkisson called IRS enforcement of PPLI policies “an audit lottery deal,” noting that “the audit rates are almost zilch.”
In one case, it wasn’t until international law firm Baker McKenzie disclosed the names of Ronald Schlapfer and his wife to criminal investigators in July 2012 that the IRS began scrutinizing their tax returns.
In September 2006 Schlapfer transferred his shares in European Marketing Group Inc., a hedge fund company formed in Panama, into a bespoke variable life insurance arrangement with Swisspartners Insurance Co. SPC Ltd. But for years before that transfer, the couple’s original tax returns didn’t disclose Schlapfer’s interest in the hedge fund or its related income.
The couple retroactively disclosed Schlapfer’s ownership of the hedge fund to CI to apply for the offshore voluntary disclosure program, which allowed U.S. taxpayers with income from undisclosed offshore assets to resolve their income tax liabilities and reporting obligations.
Schlapfer’s business was transferred into a PPLI policy, a move that allowed him to avoid paying taxes on gains from his business. Some tax attorneys believe that transferring a closely held business into a PPLI policy may violate IRS rules governing PPLI and investor control. Doing so can cause an investor to forgo the tax benefits related to PPLI and trigger taxes, fees, and interest on investment growth within the policy.
The principal item driving the changes reported in the packet of documents was the PPLI arrangement Schlapfer had funded in 2006. But the packet of disclosures also included a 2006 gift tax return, amended federal and state income tax returns for 2004 through 2009, Forms 5471 (“Information Return of U.S. Persons With Respect to Certain Foreign Corporations”) for 2004 through 2006, an offshore entity statement, and foreign bank account reports.
In 2014 an IRS revenue agent sent an information document request, asking for more documentation about the transfer of ownership of the company and of related accounts. In response, the Schlapfers’ counsel provided a copy of the European Marketing Group share certificate showing the September 22, 2006, transfer of all 100 shares to a segregated account for Schlapfer’s PPLI arrangement.
Despite the disclosure of the share certificate in 2014, the IRS didn’t appear to have a good understanding of how PPLI arrangements worked long after that. As late as March 2017 — only a few months before the clock would run out on the IRS’s pursuit of gift taxes from the Schlapfers in November 2017 — an IRS revenue agent assigned to the case reported in the activity log that the agency was “research[ing] foreign life insurance policies.”
The IRS reevaluated Schlapfer’s 2006 gift tax return and determined that there was no taxable gift that year because the gift was completed in 2007 when the substitution of his elderly insured relatives as policyholders became effective. Schlapfer disagreed and withdrew from the program.
In 2019 the IRS issued a notice of deficiency, determining that Schlapfer owed approximately $4.4 million in gift tax and about $4.3 million in additions to tax under section 6651(a)(2) and (f).
Schlapfer challenged the assessment, arguing that the period for the IRS to assess gift tax had expired because he had given the agency enough information in his 2013 disclosures to put the government on notice of the gift. The Tax Court sided with Schlapfer, determining that his disclosure was adequate and that the three-year period for assessing the gift tax had run out before the IRS issued a notice of deficiency.
The court said it didn’t matter, for notice purposes, whether the gift involved was a gift of stock, as Schlapfer had told the IRS in his offshore disclosure package, or of an insurance policy.
That distinction is important for income tax purposes, however: The Schlapfers’ amended returns for 2004 through 2006 collectively reported additional income totaling more than $8.2 million from the hedge fund company before he transferred it into the PPLI policy in September 2006, resulting in nearly $3 million of additional tax liability. Income from that company disappeared from their income tax filings once the company was transferred into the PPLI policy account — initially because of the lack of insurance policy reporting in the United States and later because the relatives to whom Schlapfer transferred the policy live abroad.
Schlapfer’s lawyer, Scott Michel of Caplin & Drysdale Chtd., declined to answer questions from Tax Notes, saying in an email that neither Schlapfer “nor his representatives will have any comment on this matter.”
Researching with Interest
Potential issues with investor control weren’t addressed in the court filings.
Documents obtained by Tax Notes through a FOIA request indicate that IRS employees in the Small Business/Self-Employed Division weren’t trained to identify the arrangements and that, left to research on their own, they didn’t find many.
In Schlapfer’s case, court records indicate that the IRS received documents from which it could — but did not — correctly identify the PPLI policy. Those disclosures occurred as part of the Schlapfers’ participation in a voluntary disclosure program, not because the IRS identified their PPLI arrangement.
In lightly redacted logs the IRS produced in the Schlapfers’ case, notes made by revenue agents and an IRS estate tax attorney collectively mentioned “insurance” only a handful of times. The estate tax attorney assigned to the case interviewed Schlapfer in May 2016 and collected and reviewed “two data disks of information concerning Swisspartners’ arrangements with” Schlapfer.
Yet when that attorney closed the estate tax file in September 2016, he didn’t accurately characterize either the policy or the gift under review, which he described as a “gift of [European Marketing Group] stock to a life insurance company as the underlying asset of a variable life insurance policy.”
In his disclosures to the IRS, Schlapfer had variously described the creation and subsequent transfer of the PPLI policy as “a gift of controlled foreign company stock” to his mother and “a transaction to gift to mother for the benefit of his nephews.”
Even insurance specialists at the IRS may not have been informed about how PPLI arrangements work and how to look for them.
Documents in the International Consortium of Investigative Journalists’s offshore leaks archive show that in March 2015 an IRS life insurance actuary wrote to a trust company in the Cook Islands asking about PPLI, how the policies were designed and marketed, and by whom, and whether compliance with U.S. tax laws was an issue.
Despite “many years doing product development and administration with life insurance companies,” the actuary wrote, the PPLI market was new to him, and he was “researching it with interest.”
The actuary’s questions were part of an investigation into Threshold Alliance Ltd., a Cook Islands insurance company that was in business for only three years. Threshold was the initial PPLI insurer for a married couple whose PPLI arrangement ultimately failed to pass muster with the Tax Court in 2019 in Wegbreit v. Commissioner, T.C. Memo. 2019-82, resulting in a significant tax and penalty liability.
The actuary, who worked in the Large Business and International Division until 2018, told Tax Notes that training on abuses of life insurance for actuaries at the agency “was not very deep.”
The actuary said his job was to audit life insurance companies to ensure that reserves were being calculated correctly, and that there wasn’t much collaboration between actuaries and revenue agents on life insurance issues.
“The insurance companies are not the problem — it’s the people using [life insurance] for tax avoidance that the actuaries don’t touch,” he said.
The actuary said regular review by IRS audit team members of tax cases by industry, in addition to opportunities to discuss litigation and audit findings within a peer group but with advice from more experienced professionals, could help with enforcement efforts in this area.
The training materials for IRS employees in SB/SE obtained by Tax Notes included no specific mention of PPLI, insurance wrappers, or the investor control rules.
The IRS produced just over 1,100 pages of presentation slides, training scripts, handouts, and a textbook provided to trainees. Another 447 pages were completely redacted. Most of the documents were used to train employees about foreign trusts and offshore compliance, international information returns, and how to gather evidence in foreign jurisdictions. Most of the dated materials are from 2021, years after the agency was unable to parse the Schlapfers’ PPLI arrangement.
The only reference that might touch on these arrangements was a list of foreign financial assets reportable on Form 8938, “Statement of Specified Foreign Financial Assets,” under the Foreign Account Tax Compliance Act.
Luís Carlos Calderón Gómez of Yeshiva University’s Benjamin N. Cardozo School of Law said that while training is important, training alone won’t solve much without the IRS getting more information about PPLI policies.
“Training is not a critical failure right now — the critical issue is that we have no practical ways of seeing whether people have a PPLI policy,” Calderón Gómez said. “Not letting the perfect be the enemy of the good, training on the law plus some more emphasis on detecting PPLI in the audits of high-net-worth individuals would be a welcome improvement.”
Not Advisable
The structure at issue in Schlapfer is “definitely not something we would recommend to our clients,” said Peter T. Dziedzic Jr. of Life Insurance Strategies Group LLC.
Dziedzic said he is surprised the IRS didn’t go after Schlapfer’s PPLI policy, observing that it appears to run afoul of the investor control rules.
Calderón Gómez agreed.
“This is the rare case where the IRS could have acted, but refused to act, presumably because of a lack of knowledge,” Calderón Gómez said. “To be fair to the IRS, there was some disagreement about the vitality, applicability, and solidity of the investor control doctrine prior to Webber.”
Michael Sardar of Kostelanetz LLP said it’s likely that the client was advised to make a voluntary disclosure because the structures likely did not pass muster.
“That’s why the case is not at all about the life insurance,” Sardar said. “It seems that an ancillary issue arose of the transfer of the underlying policy and the assets within it being a gift.”
Because of how the OVDP worked, Sardar said it would make sense for the IRS to disregard the financial structure and look at the underlying asset. Under the program, taxpayers could inform the IRS of their tax violations, and if their income was from legal sources and they cooperated, they could pay the amount due and limit their criminal exposure.
“I don’t think there was an opportunity for the IRS in this instance to question or analyze the validity of the policy and the structure,” he said.
In an August 7 reissued opinion in Shands v. Commissioner, Judge Florence Y. Pan, writing for a three-judge panel of the D.C. Circuit, said the IRS normally wouldn’t conduct a formal audit of disclosures provided through the IRS’s OVDP, which launched in 2011.
One area that could have identified issues is LB&I.
A training presentation from LB&I, dated May 26, 2015, shows that employees were trained to examine offshore life insurance and annuities. The training materials, obtained byTax Notes through a Freedom of Information Act request, show that offshore life insurance policies must satisfy the investor control tests established under IRS Rev. Rul. 77-85, 1977-1 C.B. 12, and Rev. Rul. 81-225, 1981-2 C.B. 12. The training materials are dated about a month before the 2015 Tax Court ruling
in Webber, the first time the court applied the investor control doctrine.
Observing that the LB&I training presentation mentions offshore insurers allowing payment of premiums using assets rather than money, Andrew Granato of Yale Law School and Yale School of Management, who coauthored a recent draft paper on cash-value life insurance, told Tax Notes that “the issue is on the IRS’s radar, but in Schlapfer, that doesn’t seem to have translated to a challenge.”
The IRS said in a statement to Tax Notes that its training material covers basic concepts informing examiners of what to look for in abusive offshore arrangements that are similar to PPLI, in which money is moved offshore, still controlled by the taxpayer, and is later repatriated.
Escaping Oversight
Offshore PPLI policies are subject to reporting requirements under FATCA, and policyholders are required to file FBARs with Treasury.
Although individuals must disclose their ownership of an offshore PPLI policy by filing an FBAR, the requirements are less clear for financial institutions.
“Without any information reporting required under FATCA, offshore PPLI transactions are even harder to identify than domestic PPLI transactions,” the Finance Committee report says.
Although offshore PPLI policies should be disclosed on FBARs, some taxpayers don’t report them.
In 2021 the Justice Department charged Swiss Life Holding AG and three of its subsidiaries with orchestrating a tax evasion scheme that included more than 1,600 PPLI offshore policies and concealed over $1.4 billion from the IRS. The scheme was in response to a crackdown by U.S. authorities on individuals and entities using foreign bank accounts to evade U.S. taxes and reporting requirements. Instead of hiding assets in foreign bank accounts, taxpayers put money in PPLI policies
and then failed to report them.
A former Justice Department official said that because insurance wrapper schemes are hard for authorities to identify, they are likely escaping IRS and Treasury oversight.
“Now that you don’t really have the voluntary disclosure program anymore . . . I’m not sure there’s the same focus on it that there used to be,” the former official said.
In 2023 Wyden released a mark-to-market proposal for billionaires with a provision targeting PPLI that would require insurers and reinsurers to report the policies.
