Old Supreme Court Case Blows Offshore Life Insurance Tax Plan

Tax planning, with the Supreme Court common tax laws

Tax planning with Supreme Court common tax laws

The lesson for your tax planning.   Be sure that your tax planner knows the tax code and “common law.”  Common law is called a  “doctrine.”   Common law is created by court cases.  

   Mr. John Thomas and Lee Kidd tax planners ignored this.   The  result?  Disaster!  

The blog is about the oldest doctrine, the “assignment of income.”  Doctrines are a two-edged sword. Great tax planners use court doctrines to save you taxes.  For example, the IRS was wiped out (on this link) by an 18th Century Supreme Court case. 

Want to take your tax planning to the next level, then contact me, Brian Dooley, CPA, MBT  at [email protected]

Here is the story-  High-end offshore tax planning uses a combination of an offshore asset protection and an offshore whole life insurance policy.

A foreign life insurance policy is not like your typical domestic life insurance.  You pay lots of money for the insurance premiums at the beginning of the policy. Then the owner of the policy (the person who purchased the life insurance) directs the investments.  

The income is tax-free. If you want the money in the policy, you merely take a loan.  You never pay off these loans.  When you die, the debt is canceled. 

Now, some domestic policies are similar.  They are called variable whole life insurance policies.  In these policies, you can decide to be in an investment fund managed by the insurance company. However, foreign life insurance policy investments can be decided by the owner.  

“Sophisticated” tax advisers get ridiculous fees for setting up these structures and issuing the tax opinion.  They tell their client that the tax opinion prevents the IRS from charging a penalty if the tax plan is defeated.  

By the way, this is no longer true.  The courts rarely accept the tax opinion. The courts believe that the CPA or attorney is not independent because they are paid for the opinion. If you want protection, then like our clients, your apply for an IRS ruling. 

Back to the point of this blog.. this sophisticated offshore tax plan was undone by a 100-year-old Supreme Court doctrine.  The doctrine is below. 

But first the lesson for your tax planning.   Be sure that your tax planner knows the tax code and “common law.”  Common law is the court doctrines. 

Here is what happen to these  Wealthy taxpayers: John Thomas and Lee Kidd, own and operate a group of oil and gas related businesses based in West Texas.

Thomas and Kidd set up an offshore “asset protection trust” then purchase cash-value life insurance policies, whose cash values would be invested with the principal and interest allocated to “separate asset” accounts (or “segregated accounts”).

The goal was to set aside the property of these accounts and account for them separately from other insurance policies, shielding them from the owners of other insurance policies and the creditors of the insurance companies. One of the district court’s key findings is that the accounts were invested by the client’s instructions.  

Thomas and Kidd hired a “top notch” law firm and CPA firm.  Fantastic trust agreements, LLC operating agreements, and life insurance contracts were drafted.  And why not… all the Wealthy were using this tax plan.

The IRS and the court easily chopped up the plan noting that Thomas Kidd still owned the income produced by the assets held in the by life insurance company in their policy.    The Assignment of Income Doctrine overrode all of the tax code relied upon by their attorneys and CPAs.

This is what you need to know for every tax plan:   “This case turns on the application of the assignment of income doctrine and the economic substance doctrine. An excellent explanation of the assignment of income doctrine is found in Caruth Corp. v. United States, 865 F.2d 644 (5th Cir. 1989):

The assignment of income doctrine holds that one who earns income cannot escape tax upon the income by assigning it to another. “[I]f one, entitled to receive at a future date interest on a bond or compensation for services, makes a grant of it by anticipatory assignment, he realizes taxable income as if he had collected the interest or received the salary and then paid it over.”

 Justice Holmes announced the doctrine by a now-famous metaphor: income tax may not be avoided through an “arrangement by which the fruits are attributed to a different tree from that on which they grew.” Lucas v. Earl, 281 U.S. at 115, 50 S. Ct. at 241.

When a taxpayer gives away earnings derived from an income-producing asset, the crucial question is whether the asset itself or merely the income from it, has been transferred. If the taxpayer gives away the entire asset, with accrued earnings, the assignment of income doctrine does not apply. Blair v. Commissioner, 300 U.S. 5, 14, 57 S. Ct. 330, 334, 81 L. Ed. 465 (1937) (taxpayer’s gift conveyed entire interest in income stream, and so did not fall under the assignment of income doctrine); United States v. Georgia R.R. & Banking Co., 348 F.2d 278, 285 (5th Cir.1965), cert. Denied, 382U.S. 973, 86 S. Ct. 538, 15 L. Ed. 465 (1966).

If the taxpayer carves income or a partial interest out of the asset, and retains something for himself, the doctrine applies. P & G Lake, 356 U.S. at 265 & n. 5, 78 S. Ct. at 694 & n. 5 (assignment of income doctrine applied because the taxpayer transferred a “short-lived . . . payment right carved out of” a larger interest; “[o]nly a fraction of the oil and sulphur rights were transferred, the balance being retained”).

Ultimately, the question is whether the taxpayer himself ever earned income, or whether it was earned instead by the assignee. In terms of Justice Holmes’ metaphor, the question is whether the fruit has been attributed to a different tree, or whether instead the entire tree has been transplanted.8

A major question is whether TKOP (or its ultimate owners, Thomas and Kidd) retained beneficial ownership of the overriding royalty interests.

For tax purposes, “[t]he true owner of income-producing property . . . is the one with beneficial ownership, rather than mere legal title. It is the ability to command the property, or enjoy its economic benefits, which marks a true owner.” 9 “Even assuming their validity under State law, contractual arrangements designed to circumvent this rule, by attempting to deflect income away from the one who earns it, will not be recognized for Federal income tax purposes. Determining who earns the income depends upon which person or entity, in fact, controls the earning of the income, not who ultimately receives the income.”

As the Supreme Court noted in Commissioner v. Sunnen, 333 U.S. 591, 604 (1948), the “crucial question [is] whether the assignor retains sufficient power and control over the assigned property or over receipt of the income to make it reasonable to treat him as the recipient of the income for tax purposes.” In C.M. Thibodaux Co., Ltd. v. United States, 915 F.2d 992, 995-96 (5th Cir. 1990), we applied Sunnen in holding that a corporate taxpayer had made an anticipatory assignment of income when it transferred the right to receive bonuses, delay rentals, and royalties under mineral leases but retained the right to manage the leases. We reasoned that although the transfer qualified as a property transfer under Louisiana law, in substance it was an anticipatory assignment of income under federal income tax law which must be taxed to the corporation.”

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