by William D. Lipkind and Jonathan G. Blattmachr

A version of this paper was originally published in the February 2015 Journal of Taxation.

Introduction

This article will discuss some of the income tax aspects of what are called “variable” life insurance contracts. Some provisions are straight forward. However, others are not just complicated but finding the correct result is like walking through a maze.

Fortunately, all but one of them can be negotiated with a relatively certain end result. Nonetheless, one rule the Internal Revenue Service (“IRS” or “Service”) has attempted to create, called the “investor control” doctrine, is uncertain in scope and effect.

Life Insurance: Why It Seems Mysterious but Isn’t
Many people have strong views about life insurance¹ but a reasonable observation seems to be that it is probably the least understood financial product that is widely held. The peculiar structures of so-called “cash value” policies (more fully described below) that combine both a risk of death payment component and an investment component are especially confusing to many.

All investments involve some type of gambling—that a purchased stock or parcel of land will go up in value or that a bond will make the regular interest payments and will be paid in full upon maturity. In some senses, pure life insurance (sometimes, called “term insurance” but known in the insurance industry as the “net amount at risk”²) is a gamble as to when the insured will die and the death benefit paid. Obviously, the longer the insured lives, the lower the return on the premiums paid will be.³ In any event, all forms of insurance, including life insurance, typically involve risk shifting and risk distribution.

---

“Not only is life insurance a unique form of financial product, it is also treated uniquely or at least in a different manner than other such products are for certain legal or regulatory purposes.”

---

However, unlike virtually all other types of insurance, life products, as indicated above, commonly have an additional feature or component: an investment component, commonly called the “cash value” account.⁴ This additional feature is critical, for many life products, to maintain the payment of coverage at death at advanced ages. The reason is that the cost of the pure life insurance component (the net amount at risk) increases every year with the insured’s increasing age, becoming extremely great at advanced ages. By coupling the pure risk component (which typically declines at least at certain ages by design of the product or by choice of the owner if the owner is looking to maximize the cash value) with the cash value account (anticipated to grow in value), the death benefit may be maintained at a fixed or at least at a minimum level. Many products are designed so the net amount at risk declines, dollar for dollar, for increases in the investment component (commonly call the “cash value” account) and the death benefit, which will consist of the remaining “net amount at risk” and the investment (cash value) component, will remain constant.⁵ With a variable (universal) policy, “the cash value can be invested in a wide variety of separate accounts, similar to mutual funds, and the choice of which of the available separate accounts to use is entirely up to the contract owner. The ‘variable’ component in the name refers to this ability to invest in separate accounts whose values vary—they vary because they are invested in stock and/or bond markets. The ‘universal’ component in the name refers to the flexibility the owner has in making premium payments.”⁶

Unique Treatment under the Law
Not only is life insurance a unique form of financial product, it is also treated uniquely or at least in a different manner than other such products are for certain legal or regulatory purposes. For example, the regulation of pure term policies is governed almost exclusively by state rather than Federal law.⁷ If the cash value component of the life policy varies with investment experience, then that component is regulated under Federal law by the Securities & Exchange Commission.

---

“Under the law of most states, an owner’s interest in a policy of life insurance (including the cash value component) may be exempted from claims of the owner’s creditors.”

---

Under the law of most states, an owner’s interest in a policy of life insurance (including the cash value component) may be exempted from claims of the owner’s creditors.⁸ Also, usually, the death benefit paid is not subject to the claims of creditors of the insured or his or her estate (unless paid to the insured’s estate).⁹

Life insurance products and insurance companies are uniquely treated, to a significant degree, under the Internal Revenue Code. The taxation of insurers is under Subchapter L of the Code (entitled “Insurance Companies” with Part I dealing specifically with “Life Insurance Companies”).

The inclusion of life insurance proceeds in the gross estate of the insured for Federal estate tax purposes is dealt with under Section 2042 (which applies to no other asset).¹⁰ Even the allowance of an annual exclusion for the payment of premiums on a life policy owned by a trust has been specially developed.¹¹

Special Treatment for Income Tax Purposes

Except to the extent the Code has a specific rule to the contrary (as it does for interests in certain retirement plans and accounts, grantor trusts and zero coupon bonds¹²) and except where the income has been actually received, the determination of when a taxpayer must report an item in gross income turns on the doctrine of “constructive receipt.”

Treas. Reg. 1.451-2(a) sets forth the doctrine as follows:

“Income although not actually reduced to a taxpayer’s possession is constructively received by him in the taxable year during which it is credited to his account, set apart for him, or otherwise made available so that he may draw upon it at any time, or so that he could have drawn upon it during the taxable year if notice of intention to withdraw had been given. However, income is not constructively received if the taxpayer’s control of its receipt is subject to substantial limitations or restrictions.”

In fact, the timing of taxation of the growth in cash value in or receipt of income by a policy of life insurance apparently is based upon the doctrine. In what may be viewed as a seminal case, Cohen v. Commissioner, 39 TC 1055 (1963), to which the Commissioner has acquiesced¹³, the United States Tax Court stated, in part and in conclusion, “[W]e hold that the petitioner’s right to receive the cash surrender value including periodic increments thereof was subject to such ‘substantial restrictions’ as to make inapplicable the doctrine of constructive receipt. Petitioner would have been required to surrender his entire investment in the policies in order to realize that income.”

Hence, the investment (or cash value) component in the life policy would grow tax free and the receipt of that component at death as a death benefit was (and is) excludible as a general rule from gross income.¹⁴

Moreover, until the adoption in 1988 of Section 7702A (and amendments to Section 72) relating to modified endowment contracts (“MECs”), discussed below, the owner of the policy could make a partial surrender of a life policy or borrow from the policy’s cash value without being treated as having received any gross income, even if the cash value exceeded the sum of premiums paid (investment in the contract).

Meaning of Life Insurance for Tax Purposes
Until the enactment of the Deficit Reduction Act of 1984 (“1984 Act”), the Code did not have a definition of life insurance although it had many specific rules dealing with tax matters relating to life insurance, such as the exclusion from gross income of the receipt of proceeds payable by reason of the death of the insured.¹⁵ In order to obtain the benefits of income tax-free growth in the cash (or investment) value of a policy and to receive that growth income tax-free at death, all the contract had to be was life insurance under applicable law. As a consequence, many policies were sold to provide those tax benefits with minimal shifting of risk attributable to the death of the insured.

However, the 1984 Act added Section 7702(a) to the Code to provide a definition which a life policy had to meet so that the growth on or income earned on the investment or cash value component of the policy (such growth or income commonly called the “inside buildup”) would not be subject to income tax when earned “inside” the policy. Under that definition, a contract is a life insurance policy so the growth or income on its cash value is not subject to income tax when earned only if it is a life insurance contract under applicable law¹⁶ and it meets either (1) a certain cash (investment) value accumulation test or (2) a guideline premium test and falls within a certain cash value corridor, all as set forth in Section 7702(a).

Consequence If the Contract Does Meet the Definition
Section 7702(g) specifies the tax consequences if the contract is a life insurance policy under applicable law but does not meet either the cash value accumulation or the guideline premium test under Section 7702(a).¹⁷ Section 7702(g) provides that, in such a case, the income on the contract for any taxable year of the policyholder is treated as ordinary income received or accrued by the policyholder during such year. However, essentially, the amount of income is limited to the increase in the net (cash) surrender value¹⁸ of the contract during the taxable year¹⁹ plus the cost of pure life insurance protection (the net amount at risk) provided under the contract during the taxable year over the premiums paid under the contract during the taxable year. This seems to mean that the owner of the contract must include in gross income the increase in net surrender value and the cost of any term component essentially paid by the cash value component of the policy. Income taxation under Section 7702(g) does not turn on any borrowing or withdrawal—it is based solely on the annual increase in net surrender value (and the annual cost of the premiums paid by the policy’s cash value), over premiums paid for the year, and does not seem to be based upon any notion of constructive receipt.²⁰

---

“Not only is life insurance a unique form of financial product, it is also treated uniquely or at least in a different manner than other such products are for certain legal or regulatory purposes.”

---

Section 7702(g) goes on to provide that, with respect to any contract, which is a life insurance contract under the applicable law but does not meet the definition of life insurance contract under subsection (a), the excess of the amount paid by reason of the death of the insured over the net surrender value of the contract is deemed to be paid under a life insurance contract for purposes of Section 101²¹ (meaning, as a general rule, that the proceeds are not includible in gross income) and, essentially, will be treated as insurance for estate and gift tax purposes.²²

Therefore, if a contract is a policy of life insurance under applicable law but does not meet the definition of a life insurance policy under Section 7702(a) but never had an increase in net surrender value²³, any growth in cash value (even if gross cash surrender value has increased) will be subject to income tax during the lifetime of the insured or at his or her death (although, to the extent, the cash value is used annually to pay term premiums inside the policy it will be included in gross income for such year²⁴).

Modified Endowment Contract Rules
Despite the enactment of a statutory definition of life insurance, life insurance policies that met the definition could produce significant income tax benefits by avoiding taxation of growth in the cash value component of a policy and permitting that income to be accessed, in certain ways, such as by a partial surrender or by borrowing, income tax free.

Those benefits are discussed in the legislative history (“TAMRA Conference Report”²⁵) to the Technical and Miscellaneous Revenue Act of 1988 (“TAMRA”) that states, in part, that “the undistributed investment income (sometimes called the ‘inside buildup’) earned on premiums credited under a contract that satisfied a statutory definition of life insurance is not subject to current taxation to the owner of the contract. *** Amounts received under a life insurance contract prior to the death of the insured generally are not includible in gross income to the extent that the amount received does not exceed the taxpayer’s investment in the contract. Amounts borrowed under a life insurance contract generally are not treated as received and, consequently, are not includible in gross income.”²⁶ (Emphasis added.)

To curb some of these benefits for policies that met the definition of life insurance under Section 7702(a), TAMRA added a new rule for life insurance policies that the Act defined as “modified endowment contracts,” under new Section 7702A, which is any contract that “satisfies the present-law definition of a life insurance contract but fails to satisfy a 7-pay test.”²⁷ (Emphasis added.) Under that new law enacted as part of the Act, “amounts received under modified endowment contracts are treated first as income and then as recovered basis. In addition, loans under modified endowment contracts and loans secured by modified endowment contracts are treated as amounts received under the contract.”²⁸

Therefore, the increase in the investment component (the inside buildup) of a policy that meets the definition of a life insurance policy under Section 7702(a) (that is, one that is a life policy under applicable law and meets either (1) a certain cash value accumulation test or (2) a guideline premium test and falls within a certain cash value corridor) is not currently taxed but, if the premiums are withdrawn (such as by a partial surrender) or borrowing against the cash value occurs, the inside build up is taxed, to the extent of the surrender or borrowing, under Section 72 if the policy is a modified endowment contract (a “MEC”).

Technically, this occurred by changes made to the Code by TAMRA Section 5012(c), which added Section 7702A which provides a definition of a modified endowment contract and made amendments to Section 72(e) to cause partial surrenders of a MEC or borrowing against the cash value of a MEC to be included in gross income. (Partial surrenders or borrowing against cash value of a policy that is not a MEC continue to be income tax free.)

More on the Definition and Treatment of a Modified Endowment Contract

Section 7702A, as indicated, contains the definition of a modified endowment contract as “any contract meeting the requirements of section 7702…which…fails to meet the 7-pay test of subsection (b).” (Emphasis added.) Quite apparently, this means a contract meeting the definition of a life insurance contract under Section 7702(a) that fails to meet the 7-pay test as suggested by the emphasized portions of the Conference Report quoted above. Although no regulation has been issued discussing the definition of modified endowment contracts, it seems quite certain, for the reasons set forth immediately below, that it includes only contracts that meet the definition of a life policy under Section 7702(a) and not one dealt with under Section 7702(g), which would be one that does not meet that definition.

First, as noted, the TAMRA Conference Report certainly must be referring only to insurance policies defined in Section 7702(a) by referring to “the present-law definition of a life insurance contract.” Indeed, there is no other definition of a life insurance contract in the Code other than in Section 7702(a).

Second, Section 7702A refers only to a contract that meets the “requirements” of Section 7702 and only Section 7702(a) has requirements. Section 7702(g) does not contain requirements. It deals with the “Treatment of [a contract] which…[is a] life insurance contract under the applicable law [but] does not meet the definition of life insurance contract under subsection (a).” Hence, all that Section 7702(g) does is provide the income tax treatment of a contract that does not meet the tax definition of life insurance under Section 7702(a); Section 7702(g) provides no “requirements” at all.

Third, as described above, Section 7702(g) eliminates the income tax free buildup in investment value and provides that such buildup is taxed to the policy owner each year but it limits the amount of gross income to the annual increase in the net surrender value (and the cost of term insurance essentially paid by the cash value). Because the owner of a policy that does not meet the Section 7702(a) definition is taxed currently on increases to the net surrender value and cannot withdraw or borrow the account value to the extent it exceeds the net surrender value, there would seem to be no need to have a contract that does not meet the definition of life insurance under Section 7702(a) fall under the tax treatment of modified endowment contracts under Section 7702A and Section 72. Section 72 essentially provides that any withdrawal of premium or borrowing of cash value from a MEC is first treated as income earned on the cash value before being treated as a tax free return of premium (investment).

The definition of a modified endowment contract, as stated, is under Section 7702A and its taxation is governed by Section 72(e). TAMRA added the definition of a MEC and provided for partial surrenders and borrowings against the cash value of a MEC to be included in gross income. Prior to the TAMRA changes, Section 72(e) essentially provided that partial surrenders and borrowings against the cash value of a life policy were not included in gross income. Prior to the TAMRA changes, Section 72(e) essentially provided that partial surrenders and borrowings against the cash value of a life policy were not included in gross income. However, under TAMRA, beginning in 1988, such surrenders and borrowing are included in gross income if the policy is a MEC. The reason is that Section 72 provides rules with respect to amounts received as an annuity under an annuity or life insurance contract and to amounts not received as an annuity.²⁹ Section 72(e)(2)(B) essentially provides that any amount received before the annuity starting date of the contract is included in gross income to the extent it is deemed to consist of income earned in the contract but not to the extent it exceeds the investment in the contract—and the amount received before the annuity starting date is deemed to consist of the income earned through that time. Section 72(e)(3) essentially provides that this profit is the amount by which the cash value (determined without regard to any surrender charge) exceeds the investment in the contract (essentially premiums paid). Section 72(e)(4)(A) basically provides that amounts received as a loan under a policy fall under the income inclusion rule of Section 72(e)(2)(B). So, up to this point, there is an indication that any amount received under any policy to the extent of gross cash value over premiums paid is included in gross income.

However, under TAMRA, beginning in 1988, such surrenders and borrowing are included in gross income if the policy is a MEC. The reason is that Section 72 provides rules with respect to amounts received as an annuity under an annuity or life insurance contract and to amounts not received as an annuity.29 Section 72(e)(2)(B) essentially provides that any amount received before the annuity starting date of the contract is included in gross income to the extent it is deemed to consist of income earned in the contract but not to the extent it exceeds the investment in the contract—and the amount received before the annuity starting date is deemed to consist of the income earned through that time. Section 72(e)(3) essentially provides that this profit is the amount by which the cash value (determined without regard to any surrender charge) exceeds the investment in the contract (essentially premiums paid). Section 72(e)(4)(A) basically provides that amounts received as a loan under a policy fall under the income inclusion rule of Section 72(e)(2)(B). So, up to this point, there is an indication that any amount received under any policy to the extent of gross cash value over premiums paid is included in gross income. However, Section 72(e)(5)(A) and (C) basically together provide that Section 72(e)(2)(B) and Section 72(e)(4)(A), which in essence cause partial surrenders and borrowings (up to gross cash value above premiums paid) to be included in gross income, do not apply to non-annuity payments under a life policy with the exception, added by TAMRA, for modified endowment contracts. In other words, these rather complexly weaved provisions of Section 72 provide that partial surrenders or borrowings from a life insurance policy are included in gross income only if the policy is a MEC.

Comparison of Taxation under Section 7702(g) and Taxation of MECs

It will be noted that the treatment of a modified endowment contract generally is more beneficial under Sections 7702A and 72 than the treatment prescribed for policies the taxation of which is governed by Section 7702(g): the owner can avoid any taxation of the inside buildup for a modified endowment contract merely by not surrendering or borrowing; but the taxation of the inside buildup of a policy that is not described in Section 7702(a) and, therefore, whose treatment is prescribed by Section 7702(g), cannot be avoided, except that it is limited to “the increase in the net surrender value of the contract during the taxable year, and the cost of life insurance protection provided under the contract during the taxable year” over premiums paid that year. (Emphasis added.) Hence, it seems there would be no reason for the definition of a modified endowment contract to include one that is not described in Section 7702(a).³⁰ This is borne out by the words of Section 7702A and the legislative history of the TAMRA by which that section was added to the Code.

However, there may be one circumstance in which a policy not meeting the definition of life insurance under Section 7702(a) may fare better than a modified endowment contract. That is the case where the amount borrowed from a MEC is included in gross income is greater than the total increases in net surrender value of a policy the income taxation of which is determined under Section 7702(g) whether borrowing from the latter policy occurs or not (which borrowing, of course, could never exceed net surrender value). As mentioned above, a modified endowment contract is taxed under Section 72.³¹ Section 72(e)(2)(B) provides, in effect, that distributions under the contract shall be included in gross income to the extent allocable to income on the contract, and shall not be included in gross income to the extent allocable to the investment in the contract. Section 72(e) (2)(C) provides that the amount allocable to income is limited to the “cash value of the contract (determined without regard to any surrender charge) immediately before the amount is received, over … the investment in the contract at such time.” (Emphasis added.) Hence, an increase in cash value of a modified endowment contract will be included in gross income (to the extent of a withdrawal or borrowing) even to the extent there is a cash surrender charge (by which cash surrender value is reduced to net surrender value).³² For a policy not described in Section 7702(a), the inside buildup is taxed (annually without regard to any surrender or withdrawal) only to the extent there is no surrender charge. See, in particular, Section 72(e)(5) which retains prior law treatment of distributions (presumably, including borrowings) that are not annuity payments from a policy except for modified endowment contracts.

It seems relatively certain that borrowing against a policy that is not described in Section 7702(a) (that is, one that is not a modified endowment contract) does not result in income tax inclusion although any increase in net surrender value each year would.

A Little More on Surrender Value
As noted above, Section 7702(g) expressly provides that, if the policy does not fall under the definition under Section 7702(a), the annual increase in the net surrender value is included in the owner’s gross income. It seems reasonably certain that net surrender value is the gross cash surrender value reduced by what would be the actual surrender charges imposed upon the surrender of the policy. However, as noted, Section 72(e)(2)(C) provides that the amount allocable to income is limited to the “cash value of the contract (determined without regard to any surrender charge) immediately before the amount is received, over … the investment in the contract at such time.” (Emphasis added.)

These two provisions are not inconsistent. They simply fall under different rules. The latter (Section 72(e)(2)(C)) deals only with a modified endowment contract, which as explained is one that meets the definition of a life insurance policy under Section 7702(a) and does not comply with the so-called seven pay test set forth in Section 7702A. Hence, any owner of a modified endowment contract who borrows cash from the policy or does a partial surrender of the policy for cash must include the cash in gross income to the extent of gross cash value (but only to the extent it exceeds premiums paid). In contrast, Section 7702(g), dealing with policies that do not meet the definition of a life insurance policy under Section 7702(a), limits the amount the owner must include in gross income to annual increases in value—and this increase must be included in gross income even if not withdrawn or borrowed. As recited in the TAMRA Conference Report, borrowing against the cash value of a policy does not result in gross income (except for a modified endowment contract which by its definition cannot include a policy the income taxation of which is governed by Section 7702(g)).

Section 817 and Section 7702(a)
As mentioned above, there are specific Code provisions that provide for the taxation of life insurance companies.³³ Section 817 provides a special rule in determining that tax relating to variable contracts. Section 817(h) provides that, in order to be considered a variable contract for purposes of Subchapter L, which, as stated above, governs the taxation of insurance companies, as well as for purposes of Section 7702(a), so the contract is a life insurance policy, the investment component of the contract, among other things, must at least be adequately diversified as provided in Section 817(h) and the regulations promulgated thereunder.³⁴ Hence, if the contract is not adequately diversified, then it seems that it is not treated as a life insurance policy for purposes of Section 7702(a) apparently even if it otherwise meets the definition of life insurance (because it is insurance under applicable (local) law and meets either the cash value accumulation or the guideline premium test). And the regulations indicate the tax treatment of a variable contract the investments in which are not adequately diversified is the same as a contract that does not meet at least one of the two tests under Section 7702(a) or, in other words, the annual increase in the net surrender value must be currently included in the gross income of the owner of the contract. Indeed, the regulations provide, in part:

“[F]or purposes of…section 7702(a), a variable contract…shall not be treated as…[a] life insurance contract…for which the investments of any such account are not adequately diversified.***If a variable contract which is a life insurance or endowment contract under other applicable (e.g., State or foreign) law is not treated as a life insurance… contract under section 7702(a), the income on the contract for any taxable year of the policyholder is treated as ordinary income received or accrued by the policyholder during such year in accordance with section 7702 (g) and (h).”³⁵

Hence, just as current income taxation of the investment (cash value) component of a life insurance contract that fails to meet AT LEAST one of the two actuarial tests under Section 7702(a) occurs to the extent of the annual increase in the net surrender value so too is the income taxation of the investment component of a variable contract that fails to meet the diversification requirements of Section 817(h)—that is, only to the extent of the annual increase in the net surrender value (plus cost of insurance for the year).

No Income from Borrowing from Non-Section 7702(a) Policies

As discussed above, until 1988, borrowing from the cash value (investment) account of any life policy did not result in the owner having any gross income even if the cash value account exceeded premiums paid at the time of the borrowing. TAMRA made changes causing the owner of a MEC to include any borrowing from the cash value account in gross income to the extent the value (without regard to any surrender value) of the account exceeds premiums paid. And, as explained, an owner who borrows against the investment (cash) value of a contract that fails to meet AT LEAST one of the two actuarial tests of Section 7702(a) does not have to include any portion of the borrowing in gross income because any increase in net (cash) surrender value is annually taxed to the owner even if not borrowed or otherwise withdrawn. The same seems true for a policy that fails to meet the diversification requirements of Section 817(h) and, in that sense, is preferable to a Section 7702(a)  “compliant” contract that is a MEC.

Nonetheless, to avoid having to include increases in cash value in a contract that is not Section 7702(a) compliant and a contract that fails to meet the Section 817(h) diversification requirements, the net surrender value cannot exceed premiums paid. That means the owner of such contracts can borrow or make a partial surrender of the policy only up to the amount of premiums paid but no more—the owner (or the owner’s beneficiary) can receive more only upon the death of the insured. Hence, the owner is “locked” into the contract until it matures (by the death of the insured or the insureds). Therefore, a taxpayer should acquire such a frozen cash value only if the owner is certain that there will be no need to access from the policy more than the premiums paid.

Investor Control Doctrine
As mentioned earlier in this article, despite the fact the a taxpayer must report, as a general rule, only income actually or constructively received unless there is a statutory provision requiring inclusion without constructive receipt, the IRS has attempted to engraft an additional doctrine that could cause the owner of a variable life policy to include in gross income earnings “inside” the policy and without any statutory provision such as for MECs and for contracts that do not meet the definition of life insurance under Section 7702(a). And it seems to have tried to develop this “theory” despite the fact that the Commissioner has acquiesced, as noted above, in Cohen in which the Tax Court ruled there was no such constructive receipt with respect to earnings in the life insurance policy saying, as quoted above, “the petitioner’s right to receive the cash surrender value including periodic increments thereof was subject to such ‘substantial restrictions’ as to make inapplicable the doctrine of constructive receipt. Petitioner would have been required to surrender his entire investment in the policies in order to realize that income.” (Emphasis added.) The IRS calls this new theory of income taxation of life insurance policies (AND annuity contracts) the “investor control” doctrine.

---

“Even indirect communication with the insurance company or its advisor with respect to investments inside the policy by its owner alone could trigger the doctrine, causing the owner to be taxed on income earned inside the policy.”

---

The Service began its quest to establish that doctrine in Rev. Rul. 77-85.³⁶ It has continued to issue several additional revenue and private letter rulings dealing with the doctrine.³⁷ It was not until 2003, by the issuance of Rev. Rul. 2003-91³⁸ and Rev. Rul. 2003-93³⁹, that the Service, without explanation or proffered rationale, attempted to extend this alleged doctrine from variable annuity contracts to variable life insurance policies.⁴⁰ In any event, the IRS has not established the parameters of the doctrine⁴¹, although it has indicated that having a variable contract offer investments through a so-called “insurance dedicated fund” or (“IDF”)⁴²will not implicate the investor control issues provided, among other things, “no Private Placement Variable Annuity (PPVA) or Private Placement Variable Universal Life (PPVUL) Investment Account owner can directly or indirectly influence the IDF manager with respect to the selection of funds or securities to fulfill the IDF’s investment mandate.”⁴³ Nonetheless, it may have suggested that even indirect communication with the insurance company or its advisor with respect to investments inside the policy by its owner alone could trigger the doctrine, causing the owner to be taxed on income earned inside the policy.⁴⁴

The only authority upon which the IRS has relied in its revenue rulings is Christoffersen v. United States.⁴⁵ However, reliance on Christoffersen, as approving the doctrine or establishing it, may be misplaced. First, that case involves an “annuity” contract, not life insurance. These are, of course, substantially different financial products⁴⁶ and by and large are treated in quite different ways for tax purposes. As explained earlier, Sections 7702(a) and 7702A apply only to life policies, not annuities.⁴⁷ As indicated above, the legislative history to those sections is filled with references exclusively to life insurance contracts, not both life insurance and annuity products.⁴⁸

Second, as the United States Court of Appeals in Christoffersen points out, the taxpayers did not even claim the product had been “annuitized”—that is, had actually become an annuity contract.⁴⁹ The court does go on to discuss that, under the arrangement in place during the tax years in question, the taxpayers “surrendered few of the rights of ownership or control over the assets of the sub-account” and that “the possibility that the assets [would] be converted into an annuity in 2021 [did] not significantly impair the Christoffersens’ ownership since all, or any portion, of the assets [could] be withdrawn before that time.”⁵⁰ Perhaps, most important, in contrast to adopting any new doctrine of “investor control,” the court found, citing to Treas. Reg. § 1.451-2(a), quoted above and that sets forth the constructive receipt doctrine, that “[u]nder the long recognized doctrine of constructive receipt, the income generated by the account assets should be taxed to the plaintiffs in the year earned, not at some later time when the Christoffersens choose to receive it. This is the essence of Rev. Rul. 81-225, which we find persuasive.”⁵¹

The arrangement in Christoffersen seems entirely different than the life policy dealt with in Cohen: a policy of life insurance involves substantial shifting of risk at death that an annuity contract may not or at least does not in the same way a life policy does. And, as the Tax Court indicated in Cohen, this risk shifting would be forfeited by surrendering the policy and obtaining the underlying assets in the cash value account. This would seem to fall clearly under that part of Treas. Reg. 1.451-2(a), the constructive receipt of income regulation, which provides, in part, that “income is not constructively received if the taxpayer’s control of its receipt is subject to substantial limitations or restrictions.” And the restriction appears to be there regardless of the underlying investments in the policy or the identity of the person who controls the investments.

Perhaps, therefore, in light of the Service’s acquiescence in Cohen, the only viable hope for the IRS of some sort of judicial acceptance of an investor control doctrine with respect to variable life policies, other than constructive receipt, would be on the principles of income taxation enunciated in Helvering v. Clifford⁵², regarded by some as the seminal case of charging the grantor with a trust’s income prior to the adoption of the so-called Clifford regulations. Indeed, the IRS in Christoffersen rolled out such an argument, in addition to constructive receipt, to the Court of Appeals.⁵³ The court, in comparing the Christoffersens’ interests in the “annuity” contract to those of the grantor in the trust in Clifford, stated, “Upon examination of the Contract as a whole, we must conclude that the Christoffersens, and not [the annuity company], own the assets of the sub-account.” But later in its opinion, the court stated, “Under the long recognized doctrine of constructive receipt, the income generated by the account assets should be taxed to the plaintiffs in the year earned, not at some later time when the Christoffersens choose to receive it. This is the essence of Rev. Rul. 81-225, which we find persuasive.” (footnote omitted; emphasis added.)

Consequently, it seems that it is uncertain how the court in Christoffersen reached its conclusion. It does not seem that Clifford is based upon the constructive receipt doctrine.⁵⁴ The Supreme Court does not mention it in its opinion. It was observed long ago, in discussing Clifford and Douglas v. Willcuts,⁵⁵ the latter case holding the grantor of a trust he created in connection with his divorce was to substitute for his alimony obligations and therefore the trust’s income was taxable to him:

The cases stemming from the [Douglas v.] Willcuts case emphasize the settlor’s support obligation, whereas one of the greatest avenues of expansion of the Clifford doctrine has developed on the settlor’s control. Nonetheless, these two approaches are so intertwined in the constructive receipt concept as to be almost inextricable. Often it is hard to tell just what the basis of the commissioner’s argument is….⁵⁶ (emphasis added.)

So, although it is not certain, it may be that there are two doctrines that could possibly be applied: constructive receipt under Treas. Reg. 1.451-2(a) and deemed ownership of the assets under the Clifford principles. And, if either applies, the taxpayer will have to include the earnings in gross income. Cohen seemed to foreclose taxation under the constructive receipt doctrine with respect to a life insurance policy.⁵⁷ If Clifford represents a doctrine separate from and in addition to constructive receipt, deciding whether the owner of a life policy is taxed on its earnings seems more complicated and, in many situations, uncertain.

As pointed out by many commentators, as well as the Treasury, Clifford turned on whether the taxpayer held a sufficient number of the “bundle of rights”⁵⁸ of property ownership (and benefit) meaning its application had to be determined on a case by case basis. “Recognizing that the application of this principle ‘to varying and diversified factual situations’ has led to considerable uncertainty, the Treasury has now set down specific norms by which in its judgment the doctrine is to be applied,”⁵⁹ by the promulgation of the Clifford regulations under Section 22 of the Internal Revenue Code of 1939 (which were adopted with virtually no change as the “grantor trust” rules under Subpart E of Part 1 of Subchapter J of Chapter 1 of the Internal Revenue Code of 1954).

In Clifford, the taxpayer held many rights⁶⁰ and the court certainly did not indicate that investment control alone would be sufficient.⁶¹ “Our point here is that no one fact is normally decisive but that all considerations and circumstances of the kind we have mentioned are relevant to the question of ownership and are appropriate foundations for findings on that issue.”⁶²

It is at least arguable that Congress was sufficiently concerned about the vagaries of the alleged investor control doctrine that it adopted Section 817(h) to provide a definite set of rules about it. “Because [Section] 817(h) and the associated regulations were enacted after the investor control authorities, and because they address some of the same issues as those authorities, many in the insurance industry concluded that [Section] 817(h) superseded the investor control doctrine.”⁶³

At least part of the legislative history to the enactment of Section 817(h) supports that conclusion. “The [Deficit Reduction Act of 1984] adopts a provision that grants the Secretary of the Treasury regulatory authority to prescribe diversification standards***In authorizing the Treasury to prescribe diversification standards, the Congress intended that the standards be designed to deny annuity or life insurance treatment for investments that are publicly available to investors and investments which are made, in effect, at the direction of the investor. Thus, annuity or life insurance treatment will be denied to variable contracts (1) that are equivalent to investments in one or a relatively small number of particular assets (e.g., stocks, bonds, or certificates of deposit of a single issuer); (2) that invest in one or a relatively small number of publicly available mutual funds; (3) that invest in one or a relatively small number of specific properties (whether real or personal); or (4) that invest in a nondiversified pool of mortgage-type investments.***If the segregated account does not meet the prescribed diversification standards, then a variable contract based on the account will not be treated as an annuity, endowment, or life insurance contract for purposes of subchapter L (relating to taxation of insurance companies), section 72 and section 7702(a) (relating to the definition of a life insurance contract).”⁶⁴

Although certain regulations, as noted above, have been promulgated by the Treasury under Section 817(h), none appears to deal with the four areas quoted above specifically or “investments which are made, in effect, at the direction of the investor.”⁶⁵ This seems to have been acknowledged by the IRS. For example, in Rev. Rul. 2003-91, the Service stated:

Approximately two years after enactment of § 817(h), the Treasury Department issued proposed and temporary regulations prescribing the minimum level of diversification that must be met for an annuity or life insurance contract to be treated as a variable contract within the meaning of § 817(d). The preamble to the regulations stated as follows:

The temporary regulations . . . do not provide guidance concerning the circumstances in which investor control of the investments of a segregated asset account may cause the investor, rather than the insurance company, to be treated as the owner of the assets in the account. For example, the temporary regulations provide that in appropriate cases a segregated asset account may include multiple sub-accounts, but do not specify the extent to which policyholders may direct their investments to particular sub-accounts without being treated as owners of the underlying assets. Guidance on this and other issues will be provided in regulations or revenue rulings under section 817(d), relating to the definition of variable contracts.

T.D. 8101, 1986-2 C.B. 97 [51 FR 32633] (Sept. 15, 1986). The text of the temporary regulations served as the text of proposed regulations in the notice of proposed rulemaking. See LR-295-84, 1986-2 C.B. 801 [51 FR 32664] (Sept. 15, 1986). The final regulations adopted, with certain revisions not relevant here, the text of the proposed regulations.

As foreshadowed in T.D. 8101 (quoted immediately above), the IRS has issued revenue rulings⁶⁶, but no regulations (proposed, temporary or final), dealing with investor control. However, unlike regulations, revenue rulings are not entitled to a high level of deference by the Federal courts.⁶⁷ Essentially, revenue rulings seem to merely state the official position of the Service and are not binding upon taxpayers or courts as regulations may be.

In any event, it seems appropriate to mention that Section 817(h) and the definition of life insurance under Section 7702(a) were both enacted as part of the Deficit Reduction Act of 1984. And the legislative history seems to make clear that the failure of a contract that is life insurance under applicable state law but fails to meet at least one of the two tests of Section 7702(a) or any diversification standard promulgated by regulation under Section 817(h) would mean the treatment of the contract would be as prescribed under Section 7702(g) which limits the current taxation of gain or income experienced inside the policy to annual increases in net surrender value only.⁶⁸ This would seem to mean that the policy’s owner who has investor control would be taxed pursuant to Section 7702(g), which is the result of “flunking” the diversification requirements of Section 817(h), if the investor control doctrine is embodied somehow within the latter section.

But the IRS has indicated, at least in private letter rulings, that the investor control doctrine falls under the uncertain principles of Clifford, not Section 817(h).⁶⁹ Although the Supreme Court in Clifford did mention that the taxpayer, to whom the trust income was attributed, held investment control over the assets, this “right” was only one of the several he held. Hence, it seems unlikely that the court would find under an application of Clifford to variable life insurance policies that controlling, much less merely communications about, investments would be sufficient to cause the income earned inside the policy to be attributed to the policy owner.⁷⁰

In fact, it seems relatively certain that investor control over assets alone cannot under the Clifford principles cause the income from those assets to be taxed to the taxpayer holding that control even if the taxpayer paid the premiums on the life policy in which those assets are held. Less than two months after deciding Clifford, the Supreme Court decided Helvering v. Fuller.⁷¹ In that case, the taxpayer (Mr. Fuller of the famous Fuller Brush Company) created a trust, in connection with his divorce, for his wife. According to the dissent (by Justice Reed) “the settlement agreement shows that the husband retained voting power over the stock placed in trust. 60,380 shares of Class A Common Stock of the Fuller Brush Company, the only class of voting stock, was placed in the trust. An equal amount was retained by the taxpayer. The aggregate was a majority of the total of voting stock outstanding.”⁷² Yet it is certain that the Court, in holding the husband was not taxable on the dividends received by the trust, rejected both the application of the Clifford principles and the constructive receipt doctrine. In fact, although the Court was aware Mr. Fuller had the voting power, it stated, in part, “If the debtor retained no right or interest in and to the property, he would cease to be the owner for purposes of the federal revenue acts. See Helvering v. Clifford, 309 U.S. 331…”⁷³ Hence, this voting power alone was not sufficient to cause the taxpayer to be taxed on the trust’s income. It seems, therefore, that control over investments alone is not sufficient to cause taxation either under the Clifford principles or constructive receipt. In fact, the IRS seems to have acknowledged that at least unofficially.⁷⁴

---

“The consequence of the doctrine applying may be viewed as sufficiently adverse (no income tax avoidance) that most taxpayers likely will try to ensure that the structure of their life policies falls on the safe side of the doctrine.”

---

In any event, for the constructive receipt doctrine to be applied, the taxpayer must have had some entitlement to the income with which the taxpayer is charged. As mentioned above, if a contract of life insurance is a frozen cash value policy, no one can receive any income,⁷⁵ and certainly not in the year it was earned. Such a policy is designed to maximize the death benefit, not to provide any access to the increase in cash value. Section 7702(g), which provides the income taxation of policies that fail to meet AT LEAST ONE OF the actuarial tests of Section 7702(a) or the diversification tests of Section 817(h), causes no current taxation of income except to the extent of an increase in net surrender value for the year (something that cannot occur under a frozen cash value policy).⁷⁶ Hence, it would seem relatively certain that any investor control doctrine should not be applied, at least in the absence of further developments in the law (by legislation or, perhaps, regulation), to such a policy even if the doctrine has some viability in other contexts.⁷⁷ It seems even more certain that the investor control doctrine should not apply if the owner is the insured under the frozen cash value policy as the insured could never access or benefit from the increase in the account value as it could never be accessed by anyone during the insured’s lifetime—in other words, it is difficult to discern what other “incidents of ownership,” in addition to controlling investments, the insured owner could have when no one during the insured’s lifetime could benefit from the “inside buildup” within the policy.⁷⁸

Nonetheless, the consequence of the doctrine applying may be viewed as sufficiently adverse (no income tax avoidance) that most taxpayers likely will try to ensure that the structure of their life policies falls on the safe side of the doctrine, such as set forth, by example, in Rev. Rul. 2003-91.

Summary and Conclusions
Earnings inside a contract that constitutes life insurance under applicable (local) law that is not withdrawn is not subject to income taxation as earned except to the extent of the annual increase in net surrender value if the contract fails to meet AT LEAST one of the two tests set forth in Section 7702(a) or the diversification rules of Section 817(h) and its regulations. Moreover, neither the receipt of any amount by a partial surrender of the policy nor any amount received by a borrowing against cash value is included in gross income unless the policy is a MEC and then such an amount is included in income to the extent of the increase in cash value (determined without regard to any surrender charge). However, according to the Service’s investor control doctrine, a policy owner of a variable life policy will be taxed on the income earned inside the contract where the owner has an undefined level of control over the investments and, perhaps, has certain other undefined “incidents of ownership,” although, as mentioned, perhaps limited to annual increases in net surrender value if the doctrine falls under the purview of Section 817(h). Although, despite the contention of the IRS to the contrary, it does not seem that any court has adopted an independent investor control rule. Nonetheless, general tax principles developed by the Supreme Court, as reflected in the Clifford case might cause the owner of a variable contract to be taxed on the earnings in some cases. Hence, it seems prudent to attempt to ensure structuring the policy to avoid that result.

What is a Directed Trust?

In its simplest form, a directed trust is a trust arrangement that effectively relieves the trustee of specific duties, such as investments or distributions, and requires the trustee to act upon the direction of an advisor named in the trust agreement. Directed trusts are often directed as to investments and/or directed as to distributions. For example, with a directed trust that is directed for investments, the trust's terms specify an appointed investment advisor who holds the authority to direct the trustee in all matters related to investments within the trust. The trustee, in this scenario, takes direction for all investment-related actions guided by explicit guidance from the authorized party designated by the trust's terms. This division of responsibilities results in a partnership where the trust company or trustee manages the administrative aspects of the trust, while the client's chosen financial advisor or family advisor maintains control over investment decisions and asset management.