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Abstract:
The first wraparound insurance tax shelter was marketed in the mid-1960s as a means for contract owners to exploit the inconsistency arising from the difference in the tax treatment of investment returns earned inside variable insurance contracts and the economically similar returns available outside such contracts. Federal income tax is deferred (and in some cases eliminated) on the income accruing inside variable insurance products - called inside buildup. In the most recent iteration of the wraparound insurance gambit, insurance companies wrapped private-placement, hedge-fund interests inside variable insurance products in order to allow contract owners to defer tax on the ordinary income thrown off by such interests. The tax agencies have developed a legal framework that has been fairly effective at cutting back particular iterations of the shelter. This framework, generally referred to as the investor control doctrine, has, however, been unable to stop altogether the periodic flourishing of new forms of wraparound insurance. In addition, the framework's success in curbing particular iterations of the shelter may allay immediate fairness concerns and thereby mask the need for broader reform of the underlying systemic flaw.

investor control, variable insurance, variable annuity, inside buildup, wraparound insurance

Abstract:
The economic substance doctrine is a judicial method used to assess transactions suspected of being nothing more than elaborate (and illicit) tax avoidance. Courts vary in their formulation of the doctrine. Generally, the test consists of (1) a subjective inquiry into the taxpayer's motivations for entering the suspect transaction and (2) an objective inquiry into whether the transaction accomplished anything beyond tax effects. Both inquiries frequently revolve around the profit potential of the suspect transaction. In making an objective inquiry into profit, courts focus on the profit potential exclusive of taxes - the pre-tax landscape. This Article suggests that although a pre-tax inquiry has intuitive appeal, use of the pre-tax viewpoint is flawed first because it may foster overly imaginative speculation about alternate endings for the transaction. Second, the pre-tax viewpoint does not sufficiently account for the difficulty in separating the economics of a transaction from its tax consequences. In particular, the pre-tax viewpoint fails to account for implicit taxes and tax clienteles.

This Article argues for a shift to a post-tax emphasis for the objective inquiry into profit, and it proposes a two-step method for making such a shift. First, the suspect transaction would be determined to be an illegitimate tax shelter if the taxpayer's after-tax result were substantially outside the after-tax result range available on economically comparable market transactions. The after-tax result on the comparable would be computed using the taxpayer's highest rate bracket. On the other hand, if the after-tax return on the suspect transaction were substantially similar to that the comparables range, the taxpayer would satisfy the objective inquiry. Second, if it is not possible to determine with confidence the after-tax returns for economically equivalent market comparables, the court would undertake a factor-based analysis of whether the after-tax result more likely than not resulted from economic opportunity rather than tax arbitrage.

Abstract:
The economic substance doctrine is a judicial method used to assess transactions suspected of being nothing more than elaborate (and illicit) tax avoidance. Courts vary in their formulation of the doctrine. Generally, the test consists of (1) a subjective inquiry into the taxpayer's motivations for entering the suspect transaction and (2) an objective inquiry into whether the transaction accomplished anything beyond tax effects. Both inquiries frequently revolve around the profit potential of the suspect transaction. In making an objective inquiry into profit, courts focus on the profit potential exclusive of taxes - the pre-tax landscape. This Article suggests that although a pre-tax inquiry has intuitive appeal, use of the pre-tax viewpoint is flawed first because it may foster overly imaginative speculation about alternate endings for the transaction. Second, the pre-tax viewpoint does not sufficiently account for the difficulty in separating the economics of a transaction from its tax consequences. In particular, the pre-tax viewpoint fails to account for implicit taxes and tax clienteles.

This Article argues for a shift to a post-tax emphasis for the objective inquiry into profit, and it proposes a two-step method for making such a shift. First, the suspect transaction would be determined to be an illegitimate tax shelter if the taxpayer's after-tax result were substantially outside the after-tax result range available on economically comparable market transactions. The after-tax result on the comparable would be computed using the taxpayer's highest rate bracket. On the other hand, if the after-tax return on the suspect transaction were substantially similar to that the comparables range, the taxpayer would satisfy the objective inquiry. Second, if it is not possible to determine with confidence the after-tax returns for economically equivalent market comparables, the court would undertake a factor-based analysis of whether the after-tax result more likely than not resulted from economic opportunity rather than tax arbitrage.

Abstract:
Variable life insurance and annuity contracts are susceptible to being marketed and sold to taxpayers for whom such contracts are unsuitable and to being used in wraparound insurance shelters. As a method of addressing these problems, I propose current taxation for the risky returns on these contracts but continued deferral for a deemed, risk-free return amount. The increased transparency resulting from the forced separate tax accounting of contract components should improve consumers' ability to receive adequate suitability evaluations and may also lead to lower fees. Current taxation of risk-related returns removes an apparently key shelter incentive and should make it possible to eliminate costs imposed as a result of the government's response to the wraparound shelter.

This last point requires further elaboration in light of the literature on the taxation of risk (Domar-Musgrave). This literature posits that, given certain preconditions, taxpayers effectively do not pay tax on risky returns under a normative, flat-rate income tax. Because of the problems associated with pinning down the real-world implications of Domar-Musgrave, using it to inform incremental reform proposals remains unusual. Yet, tax shelter reform seems particularly ripe for examination in light of Domar-Musgrave since shelters are generally marketed to the group of taxpayers most likely to be able to satisfy the preconditions necessary for the non-taxation of risk.

The details of my proposal are guided by the view that, to the extent possible, incremental reform should adhere to a normative income tax, which (in theory) would have the further effect of facilitating Domar-Musgrave results. The details of my proposal accommodate, however, a range of views as to the real-world implications of Domar-Musgrave. Thus, if one assumes that risky returns are meaningfully taxed under our current system, my proposal removes a shelter incentive - the promise of a lower tax on risky returns than that which is available outside variable insurance contracts. If, on the other hand, one assumes that risky returns are largely untaxed, my proposal provides a politically feasible way of removing unnecessary anti-shelter provisions while not substantially affecting taxpayers' ability to reach Domar-Musgrave results.