Job Well Done: Preventing the Use of Private Placement Life Insurance to Wrap Hedge Fund Investments

Abstract

As the economy continues to see a significant rise in hedge fund activity, investors continue to look for mechanisms that will mitigate the tax burden on their hedge fund investments. In an attempt to avoid the harsh ordinary tax income, taxpayers may wrap hedge fund interest within a private placement life insurance contract. An insurance wrapper is a life insurance contract in which a portion of the policyholder’s premium payment is invested in a hedge fund. Because the hedge fund interests are held within an insurance policy, gains on the investments are shielded from tax. Policyholders may also be able to access their money during their lifetimes by withdrawing or borrowing funds from the policy, tax-free. While the use of private placement life insurance contracts gives wealthy investors the prospect of huge tax savings on hedge fund investments, the transaction also gives rise to the question of whether the practice is a bona fide planning device or an improper shelter. There is a blurry line between an improper tax shelter and more legitimate strategies that take advantage of the intricacies of the tax code. Improper shelters arise because of the difficulty in perfectly specifying or defining the tax base. Through revenue rulings, private letter rulings, and treasure regulations, the Treasure Department and the Internal Revenue Service convey their position and offer guidance to practitioners and taxpayers regarding the relevant transaction. This Note analyzes the effectiveness of these rulings and regulations in the context of private placement life insurance wrappers. Ultimately, the rulings and regulations have succeeded in preventing the use of life insurance as a tax shelter for hedge fund investments, leaving no cause for Congressional concern today.