Investment Management Commentary
November 2002
IRS Limits Use of Private Partnerships as Funding
Vehicles for Variable Insurance Products
In recent years, the financial services industry has
merged two of the fastest growing investment
products — hedge funds (i.e., unregistered
partnerships that are not publicly traded) and
variable insurance products. Typically, an insurance
company permits the purchaser of a variable annuity
or variable life insurance contract to designate one or
more hedge funds as the funding vehicle for the
contract; in industry parlance, the insurance company
has “wrapped” a variable insurance product around a
hedge fund. When such a variable contract is
properly structured, the income and investment gains
from the underlying hedge funds are not subject to
current federal and state income taxes.
On November 4, the Internal Revenue Service
(“IRS”) made available private letter ruling
200244001 (“Letter Ruling”).1 The Letter Ruling
concludes that, where a segregated asset account on
which variable life insurance contracts are based
(“separate account”) holds an interest in a hedge fund
that is available to investors without an insurance
“wrapper,” the contract holders, and not the
insurance company that issued the contracts, are the
owners of the interest and thus are taxed currently on
the income and gains it generates. This conclusion
raises questions, which are discussed below, about
the viability of certain structures involving insurance
products that invest in hedge funds.
VARIABLE INSURANCE CONTRACTS & THE IRS
If a separate account satisfies rules required by the
Code, then the insurance company, not the contract
holders, is considered the owner of the assets in the
separate account, thereby providing the contract
holders tax deferral of the income building up in the
account.
Section 817(h) of the Code requires that the
investments made by a separate account be
“adequately diversified.” Code section 817(h)(4)
and section 1.817-5(f) of the Regulations set forth a
“look through” rule for meeting the diversification
requirement. This rule allows a separate account to
“look through” an entity in which it invests, such as a
mutual fund or partnership, and count the separate
account’s proportionate share of the entity’s assets
when determining its own diversification. To qualify
for this “look-through,” (1) the interests in the entity
must be held by a limited group of investors
(including separate accounts) (“Permitted Investors”)
and (2) public access to the entity must be available
exclusively through the purchase of a variable
contract. (Such an entity is referred to below as an
“insurance-dedicated entity.”) Essentially, this means
that separate accounts must invest in funds specially
created for them by fund managers and cannot invest
in publicly available mutual funds or partnerships.
One exception to the foregoing is contained in
section 1.817-5(f)(2)(ii) of the Regulations, which
Although private letter rulings may not be cited as precedent, tax practitioners look to such rulings as generally
indicative of the IRS’s views on the proper interpretation of the Internal Revenue Code (“Code”) and the Treasury
regulations thereunder (“Regulations”).
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provides that a separate account can “look through” a
hedge fund without regard to whether it is insurancededicated (“Hedge Fund Look-Through
Regulation”).
THE LETTER RULING
The insurance company account in the Letter Ruling
will be divided into sub-accounts with different
investment objectives (each of which will be treated
for federal income tax purposes as a separate
account).2 With an exception not relevant here, these
separate accounts will invest in hedge fund interests
sold in private placement offerings to investors that
need not be Permitted Investors; that is, the hedge
funds are not insurance-dedicated entities.
The IRS ruled that, because the interests in the hedge
funds are available for purchase not only by a
prospective contract holder but also by other
members of the general public, a contract holder’s
position will be substantially identical to what his or
her position would have been had the hedge fund
interests been purchased directly. Therefore, the
earnings and gains from a hedge fund interest held in
any separate account underlying a variable contract
are includible in the contract holder’s gross income.
In reaching this conclusion, the IRS did not even
mention the Hedge Fund Look-Through Regulation.
This suggests that, regardless of whether a separate
account satisfies the section 817 diversification
requirement, public access to the separate account’s
investment other than through the purchase of a
variable contract makes the contract holder the
owner of the investment for federal income tax
purposes.
The Letter Ruling also failed to discuss two previous
private letter rulings in which separate accounts
invested in insurance-dedicated entities (in each case,
a mutual fund) that, in turn, invested in entities that
were not insurance-dedicated (“Prior Rulings”). In
neither of the Prior Rulings did the IRS conclude that
those entities’ earnings and gains were includible in
the contract holders’ income. The only factual
difference between the Prior Rulings and the Letter
Ruling is that the separate accounts in the Prior
Rulings held their interests in the non-insurancededicated entities indirectly through an intermediary
insurance-dedicated entity (interests in which
investors could not purchase other than through a
variable contract), while in the Letter Ruling the
separate accounts proposed to own interests directly
in the non-insurance-dedicated entities.
The Letter Ruling has several important implications
for sponsors and distributors of variable insurance
products and the underlying hedge funds. Among
these are the following:
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In the future, insurance companies that offer
variable insurance products that will wrap
around a hedge fund managed by an
unaffiliated adviser will need assurance that the
hedge fund will be offered solely to Permitted
Investors.
In the future, managers that distribute their
hedge funds through an insurance company
must determine whether the insurance company
will provide sufficient distribution
opportunities to offset the manager’s inability
to offer the hedge funds through other
channels.
Insurance companies and hedge fund managers
of existing variable insurance contracts
wrapped around hedge funds that are not
insurance-dedicated must determine whether
and how to restructure their products to comply
with the Letter Ruling. For example, an
insurance company might remove any noncompliant hedge funds from the investment
options available to its variable insurance
contract holders, or a hedge fund manager
might decide to redeem the interests of all nonPermitted Investors. Of course, each of these
(and other) options may pose significant tax,
corporate law, and investor-relations issues.
The Letter Ruling also leaves unanswered a number
of important questions that may have a significant
bearing on how insurance companies and hedge fund
Although the Letter Ruling dealt with separate accounts underlying variable life insurance contracts, its reasoning
would apply equally to separate accounts underlying variable annuity contracts.
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Kirkpatrick & Lockhart LLP
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managers ultimately structure future products and
restructure existing products, including:
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Can a manager offer to non-Permitted Investors
a hedge fund that is identical or substantially
identical to a hedge fund that serves as a
funding vehicle for variable insurance
contracts? In this regard, it is notable that
mutual fund managers often, without any
challenge from the IRS, create two identical (or
virtually identical) mutual funds, one that funds
variable insurance products and one that is
offered to the public.
May an insurance-dedicated fund of hedge
funds invest in underlying hedge funds that are
not insurance-dedicated, or must both the fund
of hedge funds and all the underlying hedge
funds be insurance-dedicated funds? There is
currently no reason to believe that the IRS
would extend its conclusion in the Letter
Ruling to apply to indirect ownership of
interests in non-insurance-dedicated entities
(the case considered in the Prior Rulings). The
fact, however, that the IRS reached the
conclusion in the Letter Ruling despite the
contrary indication provided by the Hedge
Fund Look-Through Regulation makes this an
issue to be watched closely.
The Letter Ruling will require those hedge fund
managers and insurance companies that offer hedge
fund interests “wrapped” in insurance products to
reconsider structures in which the separate accounts
invest directly in non-insurance-dedicated entities
and look at alternative structures.
THEODORE L. PRESS
202.778.9025
tpress@kl.com
SCOTT D. NEWMAN
212.536.4054
snewman@kl.com
JOEL D. ALMQUIST
617.261.3104
jalmquist@kl.com
DIANE E. AMBLER
202.778.9886
dambler@kl.com
TARA C. SIRMANS
202.778.9272
tsirmans@kl.com
Kirkpatrick & Lockhart LLP
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Kirkpatrick & Lockhart LLP maintains one of the largest investment management practices in the United
States, with over 60 lawyers devoting all or a substantial portion of their practice to this area. According to
the April 2002 American Lawyer, K&L is a mutual funds “powerhouse” that represents more of the largest
25 investment company complexes and their affiliates than any other law firm.
We represent private funds, offshore funds, mutual funds, insurance companies, broker-dealers, investment
advisers, retirement plans, banks and trust companies, and other financial institutions. We also regularly
represent fund managers and distributors, independent directors of investment companies, retirement plans
and service providers to the investment management industry. In addition, we frequently serve as outside
counsel to industry associations on a variety of projects, including legislative and policy matters.
We work with clients in connection with the full range of investment management products and activities,
including all types of private and offshore investment funds, variable insurance products, funds of hedge
funds, open-end and closed-end investment companies, and unit investment trusts. Our investment
management practice also includes extensive tax experience and expertise, dealing with the tax aspects of all
types of investment products, including the complex tax rules that apply to partnerships (and entities
classified as such, like limited liability companies), insurance company separate accounts, regulated
investment companies, and investments in financial products.
We invite you to contact one of the members of our investment management practice, listed below, for
additional assistance. You may also visit our website at www.kl.com for more information, or send general
inquiries via email to investmentmanagement@kl.com.
WASHINGTON
BOSTON
Joel D. Almquist
Michael S. Caccese
Philip J. Fina
Mark P. Goshko
617.261.3104
617.261.3133
617.261.3156
617.261.3163
jalmquist@kl.com
mcaccese@kl.com
pfina@kl.com
mgoshko@kl.com
310.552.5071
wwade@kl.com
212.536.4024
212.536.4054
212.536.3941
212.536.3924
212.536.4008
bkramer@kl.com
snewman@kl.com
rmarshall@kl.com
rmclaughlin@kl.com
lschechter@kl.com
415.249.1047
415.249.1015
415.249.1010
eclavere@kl.com
dmishel@kl.com
rphillips@kl.com
LOS ANGELES
William P. Wade
NEW YORK
Beth R. Kramer
Scott D. Newman
Richard D. Marshall
Robert M. McLaughlin
Loren Schechter
SAN FRANCISCO
Eilleen M. Clavere
David Mishel
Richard M. Phillips
Clifford J. Alexander
Diane E. Ambler
Catherine S. Bardsley
Arthur J. Brown
Arthur C. Delibert
Robert C. Hacker
Benjamin J. Haskin
Kathy Kresch Ingber
Rebecca H. Laird
Thomas M. Leahey
Cary J. Meer
R. Charles Miller
Dean E. Miller
R. Darrell Mounts
C. Dirk Peterson
Alan C. Porter
Theodore L. Press
Robert H. Rosenblum
William A. Schmidt
Lynn A. Schweinfurth
Donald W. Smith
Robert A. Wittie
Robert J. Zutz
202.778.9068
202.778.9886
202.778.9289
202.778.9046
202.778.9042
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202.778.9369
202.778.9015
202.778.9038
202.778.9082
202.778.9107
202.778.9372
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202.778.9298
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202.778.9186
202.778.9025
202.778.9464
202.778.9373
202.778.9876
202.778.9079
202.778.9066
202.778.9059
calexander@kl.com
dambler@kl.com
cbardsley@kl.com
abrown@kl.com
adelibert@kl.com
rhacker@kl.com
bhaskin@kl.com
kingber@kl.com
rlaird@kl.com
tleahey@kl.com
cmeer@kl.com
rmiller@kl.com
dmiller@kl.com
rmounts@kl.com
cpeterson@kl.com
aporter@kl.com
tpress@kl.com
rrosenblum@kl.com
wschmidt@kl.com
lschweinfurth@kl.com
dsmith@kl.com
rwittie@kl.com
rzutz@kl.com
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This publication/newsletter is for informational purposes and does not contain or convey legal advice. The information herein
should not be used or relied upon in regard to any particular facts or circumstances without first consulting a lawyer.
© 2002 KIRKPATRICK & LOCKHART LLP.
ALL RIGHTS RESERVED.