Carajo – There’s Gold in Them Thar Hills!

The New Gold Rush- The Use of Private Placement Insurance Products for Managing Bitcoin and Other Crypto-Currency Trading

Overview

Someday when CNN creates a documentary of the early 21^st century, the story of Bitcoin and cryptocurrencies will have it place as the Internet Gold Rush. Under the doctrine of “don’t know about history and don’t know much about biology,” the business purpose of the cryptocurrency as eluded me to this point. However, all is not lost because every other math and science class at the United States Military Academy eluded me as well. Nevertheless, as the Forty Niners declared, “there is gold in them thar hills”.

In my short travels in Cryptolandia, I have seen average folks with average wealth amass small fortunes in a short period of time in bitcoin. The question is with the volatility of trading and the price of bitcoin, can they retain this wealth. Private placement insurance products will help bitcoin owners to trade their cryptocurrency portfolios with no taxation.

This article focuses on the use of private placement life insurance (PPLI) for bitcoin and cryptocurrency trading as a vehicle for deferring gain in cryptocurrency trading.

Taxation of Bitcoin

Before its amendment by the 2017 tax act,IRC §1031provided that personal property could be transferred in a non-taxable exchange. The 2017 tax act amendedIRC §1031to exclude personal property from qualifying for non-recognition in an exchange. Virtual or cryptocurrency as defined in IRS Notice 2014-21 is treated as “property” under IRC §1221 for income tax purposes and not currency.

As a result, trades of virtual currency will qualify as short -term capital gain or long- term capital gain income. Depending on the level of income, the long-term capital gains rate may be 0%, 15% or 20 percent. In addition, the 3.8 percent net investment income tax may apply. Short term gains continue to be taxed as ordinary income.

Overview of Private Placement Life Insurance

PPLI is a variable universal life insurance policy that is treated as non-registered security for federal and state securities law purposes. The product is available to accredited investors and qualified purchasers as defined in federal securities law. PPLI offerings are exempt from the Investment Company Act of 1940 under Section 3(c)(1) and 3(c)(7) offerings.

Life insurance has enjoyed significant tax advantages for decades. In general, life insurance offers five distinct tax benefits:

1. Tax-deferred “inside build-up” of policy cash values. This is the “sacred cow” of the life insurance industry. The industry has preserved the tax preferred treatment of life insurance for decades. As a twenty-five-year veteran of the industry, the author has seen numerous tax proposals to change the tax treatment life insurance disappear in a matter of hours after a new tax proposal was issued. The collective clout of the life insurance industry and agents result in a powerful combined political force.

2. Non-recognition of capital gains. The policyholder has the ability to switch investment options within the product without triggering taxation. Life insurance separate accounts are legally the owners of the investments within variable insurance products. The life insurer receives a reserves deduction equal to its investment income.

3. The option of tax-free access to policy cash values through a partial surrender of the cash value and low-cost policy loans. Life insurance policies receive “LIFO” treatment. A policyholder may take a partial surrender of the cash value and recover his tax basis in the contract first. Policy loans with a net cost of approximately 25-50 basis points per annum also receive income tax-free treatment.

The policy’s basis is its cumulative premiums. Once the policyholder has recovered his basis in the contract, the policyholder has a contractual right to a policy loan which allows the policyholder to borrow up to ninety percent of the policy cash value.

4. Income tax-free death benefit. The policy cash value grows on a tax-free basis. The policyholder can access investment gains within the policy on a tax-free basis during lifetime, and beneficiaries receive the death benefit income-tax free.
5. Estate tax-free death benefits through the use of third party ownership of the policy such as an irrevocable life insurance trust (“ILIT”). IRC Sec 2042 provides that as long as the insured does not retain any incidents of ownership within the policy, the death proceeds will not be included in the taxable estate of the decedent.

The tax law definition of life insurance can be found in IRC Section 7702. The Code provides for two different definitions of life insurance. The policyholder must select and maintain the definition used throughout the life of the policy at the time of the policy’s issuance.

Private Placement Investment Diversification Rules

The taxation of variable insurance products is covered in IRC Sec 817(h). Treasury regulations 1.817-5 provide a detailed overview of the investment diversification requirements of variable insurance products. The regulations address a wide range of investment alternatives that are not found in retail variable life and annuity products such as direct investment in real estate, and commodities.

IRC Sec 817(h) provides that investment diversification is tested separately in each fund within the policy. No single investment may represent more than fifty five percent of the fund; two investments seventy percent; three investments eighty percent; and four investments 90 percent. Therefore, a fund must have at least five investments in order to meet the diversification requirements. The cliché “the devil is in the details” is a fitting statement to describe the application of the rules.

Treasury regulations 1.817-5 provide very detailed guidance on the investment diversification rules. The regulations interpret these rules for investment asset classes that are rarely seen in retail variable insurance products and only recently in private placement insurance products for the high net worth marketplace. Part of this reason has to do with the limitations of the life insurance non-forfeiture rules in each jurisdiction dealing with death benefit liquidity as well as the liquidity necessary for policy loans and policy surrender. As a result, most retail variable insurance products have registered funds that provide for daily liquidity and daily mark-to-market for investment fund net asset valuation purposes.

The regulations provide that diversification is tested on the last day of each calendar quarter with a 30-day correction period in the event a fund does not meet the diversification requirements on the last day of each quarter. The regulations provide a one-year startup period that begins the day a fund receives its initial funding. Real property accounts have a five-year period to meet the diversification requirements.

A fund that was previously diversified but for the appreciation or depreciation of securities within the portfolio continues to remain diversified. The regulations provide that all of the securities of the same issuer are treated as a single security for diversification purposes. All of the commodities of the same commodity are treated as a single security for diversification purposes. A portfolio of Treasury bills and treasury securities are considered to be automatically diversified. Each cryptocurrency is treated as a different security for investment diversification purposes.

Investor Control Doctrine

In a life insurance or annuity contract, it is the policyholder (owner) that has the ability to control and manage the incidents of ownership associated with the policy. One of the incidents of ownership is the ability to control the investment decisions or fund selection within the policy. Two notions of investor control exist. The first notion is the subject of several rulings and cases dealing with “wrapping” publicly available investments.

The Service has ruled a number of times regarding the ability of a taxpayer to “wrap” investments that are “publicly available”, i.e. not limited exclusively to life insurance company separate accounts, and ultimately decided in Christoffersen v. U.S., that the taxpayer and not the insurance company should be taxed on the policy’s underlying income.

The second notion of the investor control doctrine is the more sinister problem. It deals with the idea that a policyholder retains so much direct or indirect control over investments that the policyholder is deemed to be in constructive receipt of the underlying investments within the policy. The consequence of this problem is that the policyholder forfeits the substantial tax advantages of life insurance and annuities. The determination of what constitutes investor control for tax purposes is a fact specific determination.

The Tax Court’s decision in Webber v. Commissioner (T.C., No. 14336- 11, 144 T.C. No. 17, 6/30/15 provides guidance to the application of the second theory of investor control outlined above. The facts of the case were egregious from the standpoint of policyholder control, but the tax results of the case offer guidelines as to how to operate a PPLI policy for virtual currency traders.

The best suggestions post-Webber include the creation of an insurance dedicated fund (IDF) managed by an independent party not under the legal control of the virtual currency trader. Secondly, investor control refers to policyholder (policyowner) control. While the Webber Court failed to discuss in detail the grantor trust aspects of the taxpayer’s trust in the Webber case, most tax practitioners believe that a grantor trust in which the grantor (taxpayer in most cases) is the owner for income tax purposes, is a negative factor for tax purposes. As a result, a non-grantor trust which is treated as a separate entity for income tax purposes, is better suited to serve as the policyholder in order to avoid the adverse tax consequences of the grantor trust.

Conclusion

PPLI offers the virtual currency trader unparalleled tax advantage. The gains from trades are non-taxable. The policyholder has the ability to access the gains on a tax-free basis. The death benefit is also tax-free. Some complexity exists as to how to navigate the troubled-waters of investor control, but it is worth the effort to learn to swim upstream in the rapids.