The tax court concluded that the Taxpayer was owner of accounts under "investment control" doctrine in Webber, (2015) 144 TC No. 17144 TC No. 17 (See Below).
Under the "investment control" doctrine, the taxpayer who established a grantor trust that purchased "private placement" variable life insurance policies insuring the lives of two elderly relatives was the actual owner of the assets in the separate accounts underlying the policies.
The premiums paid for the policies, less various expenses, were placed in separate accounts whose assets inured exclusively to the benefit of the policies.
The money in the separate accounts was used to purchase investments in startup companies with which Webber was intimately familiar and in which he otherwise invested personally and through private-equity funds he managed. He effectively dictated both the companies in which the separate accounts would invest and all actions taken with respect to those investments.
On audit, IRS concluded that Webber retained sufficient control and incidents of ownership over the assets in the separate accounts to be treated as their owner for Federal income tax purposes under the "investor control" doctrine.
The Tax Court finding that IRS's Revenue Rulings enunciating the "investor control" doctrine were entitled to deference and weight and concluded that Webber was the owner of the assets in the separate accounts for Federal income tax purposes. Accordingly, he was taxable on the income earned on those assets during the tax years in issue.
The Court noted that the powers that Webber retained included the power to direct investments; the power to vote shares and exercise other options with respect to these securities; the power to extract cash at will from the separate accounts; and the power in other ways to derive "effective benefit" from the investments in the separate accounts.
However, the Tax Court held that Webber wasn't liable for the accuracy-related penalties under Code Sec. 6662(a) because he relied in good faith on professional advice from competent tax professionals.
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144 T.C. No. 17
UNITED STATES TAX COURT
JEFFREY T. WEBBER, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 14336-11. Filed June 30, 2015.
P, a U.S. citizen, established a grantor trust that purchased
“private placement” variable life insurance policies insuring the lives
of two elderly relatives. P and various family members were the
beneficiaries of these policies. The premiums paid for the policies,
less various expenses, were placed in separate accounts whose assets
inured exclusively to the benefit of the policies. The money in the
separate accounts was used to purchase investments in startup
companies with which P was intimately familiar and in which he
otherwise invested personally and through private-equity funds he
managed. P effectively dictated both the companies in which the
separate accounts would invest and all actions taken with respect to
these investments.
R concluded that P retained sufficient control and incidents of
ownership over the assets in the separate accounts to be treated as
their owner for Federal income tax purposes under the “investor
control” doctrine. See Rev. Rul. 77-85, 1977-1 C.B. 12. The powers
P retained included the power to direct investments; the power to vote
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shares and exercise other options with respect to these securities; the
power to extract cash at will from the separate accounts; and the
power in other ways to derive “effective benefit” from the
investments in the separate accounts. See Griffiths v. Helvering, 308
U.S. 355, 358 (1939).
1. Held: The IRS revenue rulings enunciating the “investor
control” doctrine are entitled to deference and weight under Skidmore
v. Swift & Co., 323 U.S. 134, 140 (1944).
2. Held, further, P was the owner of the assets in the separate
accounts for Federal income tax purposes and was taxable on the
income earned on those assets during the taxable years in issue.
3. Held, further, P is not liable for the accuracy-related
penalties under I.R.C. sec. 6662(a) because he relied in good faith on
professional advice from competent tax professionals.
Robert Steven Fink, Megan L. Brackney, and Joseph Septimus, for
petitioner.
Steven Tillem, Shawna A. Early, and Casey R. Kroma, for respondent.
LAUBER, Judge: Petitioner is a venture-capital investor and private-equity
fund manager. He established a grantor trust that purchased “private placement”
variable life insurance policies insuring the lives of two elderly relatives. These
policies were purchased from Lighthouse Capital Insurance Co. (Lighthouse), a
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Cayman Islands company. Petitioner and various family members were the beneficiaries
of these policies.
The premium paid for each policy, after deduction of a mortality risk premium
and an administrative charge, was placed in a separate account underlying the
policy. The assets in these separate accounts, and all income earned thereon, were
segregated from the general assets and reserves of Lighthouse. These assets inured
exclusively to the benefit of the two insurance policies.
The money in the separate accounts was used to purchase investments in
startup companies with which petitioner was intimately familiar and in which he
otherwise invested personally and through funds he managed. Petitioner effectively
dictated both the companies in which the separate accounts would invest and all
actions taken with respect to these investments. Petitioner expected the assets in
the separate accounts to appreciate substantially, and they did.
Petitioner planned to achieve two tax benefits through this structure. First,
he hoped that all income and capital gains realized on these investments, which he
would otherwise have held personally, would escape current Federal income taxation
because positioned beneath an insurance policy. Second, he expected that the
ultimate payout from these investments, including all realized gains, would escape
Federal income and estate taxation because payable as “life insurance proceeds.”
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Citing the “investor control” doctrine and other principles, the Internal Revenue
Service (IRS or respondent) concluded that petitioner retained sufficient
control and incidents of ownership over the assets in the separate accounts to be
treated as their owner for Federal income tax purposes. Treating petitioner as having
received the dividends, interest, capital gains, and other income realized by the
separate accounts, the IRS determined deficiencies in his Federal income tax of
$507,230 and $148,588 and accuracy-related penalties under section 6662 of
$101,446 and $29,718 for 2006 and 2007, respectively.1 We will sustain in large
part the deficiencies, but we conclude that petitioner is not liable for the penalties.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found. The stipulations of
facts and the attached exhibits are incorporated by this reference. When he
petitioned this Court, petitioner lived in California.
Petitioner’s Background and Business Activities
Petitioner received his bachelor’s degree from Yale College and attended
Stanford University’s M.B.A. program. He left Stanford early to start a
1All statutory references are to the Internal Revenue Code (Code) as in
effect for the tax years in issue. All Rule references are to the Tax Court Rules of
Practice and Procedure. All dollar amounts have been rounded to the nearest
dollar.
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technology consulting firm, and he later founded and managed a series of privateequity
partnerships that provided “seed capital” to startup companies. These
partnerships were early-stage investors that generally endeavored to supply the
“first money” to these entities. Separately, petitioner furnished consulting services
to startup ventures through his own firm, R.B. Webber & Co. (Webber & Co.).
Each venture-capital partnership had a general partner that was itself a partnership.
Petitioner was usually the managing director of the general partner. The
venture-capital partnership offered limited partnership interests to sophisticated
investors. These offerings were often oversubscribed.
As managing director, petitioner had the authority to make, and did make,
investment decisions for the partnerships. To spread the risk of investing in new
companies, petitioner often invested through syndicates. A syndicate is not a
formal legal entity but a group of investors (individuals or funds) who seek to
invest synergistically. Generally speaking, the syndicate’s goal was to make earlystage
investments in companies that would ultimately benefit from a “liquidity
event” like an initial public offering (IPO) or direct acquisition.
Before investing in a startup company, petitioner performed due diligence.
This included review of the company’s budget, business plan, and cashflow model;
his review also included analysis of its potential customers and competitors
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and the experience of its entrepreneurs. Because petitioner, through Webber &
Co., provided consulting services to numerous startup companies, he had access to
proprietary information about them. On the basis of all this information, petitioner
decided whether to invest, or to recommend that one of his venture-capital partnerships
invest, in a particular entity. Having made an early-stage investment, petitioner
usually sought to find new investors for that company, so as to spread his
risk, enhance the company’s prospects, and move it closer to a “liquidity event.”
Having supplied the “first money” to these startup ventures, petitioner and
his partnerships were typically offered subsequent opportunities to invest in them.
These opportunities are commonly called “pro-rata offerings.” As additional
rounds of equity financing are required, a pro-rata offering gives a current equity
owner the chance to buy additional equity in an amount proportionate to his existing
equity. This enables him to maintain his current position and avoid “dilution”
by new investors. Depending on the circumstances, petitioner would accept or
decline these pro-rata offerings.
Petitioner invested in startup companies in various ways. He held certain
investments in his own name; he invested through trusts and individual retirement
accounts (IRAs); and he invested through the venture-capital partnerships that he
managed. To help him manage this array of investments, petitioner in 1999 hired
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Susan Chang as his personal accountant. She had numerous and diverse responsibilities.
These included determining whether petitioner had funds available for a
particular investment; ensuring that funds were properly transferred and received;
communicating with lawyers, advisers, paralegals, and others about investments in
which petitioner was interested; and maintaining account balances and financial
statements for petitioner’s personal investments.
Because of his expertise, knowledge of technology, and status as managing
director of private-equity partnerships, petitioner served as a member of the board
of directors for more than 100 companies. As relevant to this opinion, petitioner
through various entities invested in, and served on the boards of, the following
companies at various times prior to December 31, 2007:
Company Name
Board
Member or
Officer
Petitioner Individually
or Through a Private
Equity Partnership
Invested In
Petitioner Through an
IRA Invested In
Accept Software Yes Yes Yes
Attensity Corp. Yes Yes No
Borderware Tech. Yes Yes Yes
DTL Plum Investments No Yes No
JackNyfe, Inc. Yes Yes No
Lignup, Inc. Yes Yes Yes
Links Mark Multimedia No Yes No
Lunamira, Inc. No Yes No
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Medstory, Inc. No Yes No
Milphworld, Inc. No Yes No
Nextalk, Inc. Yes Yes No
Prevarex, Inc. Yes Yes No
Promoter Neurosciences No Yes No
PTRx Media, LLC Yes Yes Yes
Push Media, LLC No Yes No
RJ Research, Inc. No Yes No
Reactrix Systems, Inc. No Yes No
Renaissance 2.0 Media No Yes No
Signature Investments No Yes No
Soasta, Inc. Yes Yes Yes
Techtribenetworks, Inc. Yes Yes No
Vizible Corp. Yes Yes Yes
Weldunn Restaurant Group No Yes Yes
Webify Solutions Yes Yes No
Petitioner’s Tax and Estate Planning
By 1998 petitioner had enjoyed success in his investing career and accumulated
assets in excess of $20 million. An attorney named David Herbst, who furnished
petitioner with tax advice, recommended that he secure the assistance of an
experienced estate planner. One of petitioner’s college classmates referred him to
William Lipkind, a partner in the law firm Lampf, Lipkind, Prupis and Petigrow.
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Petitioner met with Mr. Lipkind for the first time in 1998 at Mr. Herbst’s
office. Mr. Lipkind laid out a complex estate plan that involved a grantor trust and
the purchase of private placement life insurance policies from Lighthouse. He
explained that private placement insurance is a type of variable life insurance that
builds value in a separate account. (The details of this strategy are discussed more
fully below.) Mr. Lipkind acknowledged that this tax-minimization strategy had
certain tax risks, but he orally assured petitioner that the strategy was sound. After
several followup conversations, petitioner hired Mr. Lipkind to do his estate planning
and stated his intention to purchase the private placement life insurance. Mr.
Lipkind then undertook a series of steps to implement this strategy.
The Grantor Trusts
The first step was the creation of a grantor trust, which had three iterations
between 1999 and 2008. On March 24, 1999, petitioner established the Jeffrey T.
Webber 1999 Alaska Trust (Alaska Trust), a grantor trust for Federal income tax
purposes. Mr. Lipkind recommended Alaska as the situs in part because that State
has no income tax; he was concerned that certain tax risks could arise if the trust
were formed in California, where petitioner resided. Mr. Lipkind’s firm drafted
the trust documents and customized them to petitioner’s needs.
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The trustees of the Alaska Trust were Mr. Lipkind and the Alaska Trust Co.
Petitioner could remove the trustees at any time and replace them with “Independent
Trustees.” The beneficiaries 2 were petitioner’s children, his brother, and
his brother’s children. Petitioner was named a discretionary beneficiary of the
Alaska Trust, which was necessary to achieve grantor trust status.3
In 1999 petitioner contributed $700,000 to the Alaska Trust. The trustee
used these funds to purchase from Lighthouse two “Flexible Premium Restricted
Lifetime Benefit Variable Life Insurance Policies” (Policy or Policies). Petitioner
timely filed Form 709, United States Gift (and Generation-Skipping Transfer) Tax
Return, reporting this $700,000 gift. He attached to this return a disclosure
statement explaining that the Alaska Trust “purchased two variable life insurance
policies * * * for an aggregate first year’s premium of $700,000” and noting that
2Independent Trustees could include any bank or an attorney who was not
“within the meaning of section 672(c) * * * related or subordinate to the Grantor.”
3The Alaska Trust provided that “any one Independent Trustee acting alone”
may distribute to petitioner as Grantor “such amounts of the net income and/or
principal * * * as such Independent Trustee deems wise.” In determining whether
to make any such distribution, the trustee was required to take into consideration
“the Grantor’s own income and property and any other income or property which
may be available to the Grantor.” The trustee was empowered to exercise such
discretion without regard to the interest of remaindermen.
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his “contributions to the Trust were completed gifts and the Trust assets will not
be includible in [his] gross estate.”
The Alaska Trust was listed as the owner of the Policies from October 28,
1999, to October 8, 2003. During 2003 petitioner became concerned about protecting
his assets from creditors because Webber & Co. was encountering financial
problems, he was going through a divorce, and he feared lawsuits from unhappy
private-equity investors following the “dot.com” crash. With the goal of achieving
asset protection, petitioner asked Mr. Lipkind to move the Alaska Trust assets
offshore. Mr. Lipkind advised against doing this because of the tax disadvantages
it could entail. Petitioner nevertheless persisted in his desire for asset protection,
and Mr. Lipkind complied with his wishes.
On October 9, 2003, Mr. Lipkind established the Chalk Hill Trust, a foreign
grantor trust organized under the laws of the Commonwealth of the Bahamas. The
Alaska Trust then assigned all of its assets, including the Policies, to the Chalk
Hill Trust. Petitioner filed a timely Form 3520, Annual Return To Report Transactions
With Foreign Trusts and Receipt of Certain Foreign Gifts, reporting this
transfer and signing the return as “owner-beneficiary” of the Chalk Hill Trust.
Petitioner was the grantor of the Chalk Hill Trust and is treated as its owner
for Federal income tax purposes. The trustee was Oceanic Bank & Trust, Ltd.; the
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U.S. protector was Mr. Lipkind; and the foreign protector was an entity from the
Isle of Man. Petitioner and his issue were the beneficiaries of the Chalk Hill
Trust. During petitioner’s lifetime the trustee had “uncontrolled discretion” to
distribute trust assets to the beneficiaries. Mr. Lipkind, as the U.S. protector,
could remove and replace the trustee at any time.
The Chalk Hill Trust was listed as the owner of the Policies from October 9,
2003, through March 6, 2008. It was thus the nominal owner of the Policies during
the tax years in issue. In early 2008 petitioner became confident that the credit
risks had passed and decided to move the trust assets back to a domestic grantor
trust. The Delaware Trust was established for that purpose, and all assets of the
Chalk Hill Trust, including the Policies, were assigned to it. The salient terms of
the Delaware Trust arrangement did not differ materially from the terms of the
prior two grantor trust arrangements. We will sometimes refer to the Alaska Trust,
the Chalk Hill Trust, and the Delaware Trust collectively as “the Trusts.”
Lighthouse
Lighthouse is a Cayman Islands class B unlimited life insurance company
established in 1996 and regulated by the Cayman Islands Monetary Authority.
Lighthouse issues annuity and variable life insurance products. During 1999 it
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issued 70 to 100 policies with a total outstanding face value of $250 to $300
million. Petitioner had no direct or indirect ownership interest in Lighthouse.
Lighthouse is managed by Aon Insurance Managers (Aon), a wholly owned
subsidiary of Aon PLC, a major insurance company headquartered in London.
Aon was responsible for the day-to-day operations of Lighthouse, including its
recordkeeping, compliance, and financial audits. Lighthouse reinsures mortality
risk arising under its policies with Hannover Rückversicherung-AG (Hannover
Re), a well-respected reinsurer. Lighthouse generally reinsures all but $10,000 of
the mortality risk on each policy, as it did with these Policies. For some elderly
insureds, such as those under petitioner’s Policies, Lighthouse reinsured virtually
100% of the morality risk.
Before issuing a policy Lighthouse would conduct an underwriting analysis
and seek medical information about the prospective insured. Where (as here) the
policyholder was not the insured, Lighthouse performed due diligence regarding
the source of funds. It also confirmed the existence of an insurable interest.
The Policies
The Policies, initially acquired by the Alaska Trust and later transferred to
the Chalk Hill Trust, insured the lives of two of petitioner’s relatives. The first
Policy insured the life of Mabel Jordan, the stepgrandmother of petitioner’s then
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wife. Ms. Jordan, who was 78 years old when the Policy was issued, died in November
2012 at age 92. The second Policy insured the life of Oleta Sublette, petitioner’s
aunt. She was 77 years old when the Policy was issued and was still alive
at the time of trial. Each Policy had a minimum guaranteed death benefit of
$2,720,000.
Each Policy required Lighthouse to establish a separate account pursuant to
section 7(6)(c) of the Cayman Islands Insurance Law to fund benefits under that
Policy. On receiving the initial premiums in 1999, Lighthouse debited against
them the first-year policy charges (a one-year mortality risk premium and one
year’s worth of administrative fees). Lighthouse kept the administrative fees and
transferred most of the mortality risk premium to Hannover Re. The remainder of
each premium was allocated to the relevant separate account. On an annual basis
thereafter, Lighthouse debited each separate account for that year’s mortality and
administrative charges. If the assets in the separate account were insufficient to
defray these charges, the policyholder had to make an additional premium payment
to cover the difference; otherwise, the policy would lapse and terminate.
The annual administrative fee that Lighthouse charged each Policy equaled
1.25% of its separate account value. There was an additional fee to cover services
nominally provided by the Policies’ “investment manager.” (As explained below,
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that fee was modest.) The mortality risk charge was determined actuarially, but it
rapidly decreased as the value of the separate accounts approached or exceeded the
minimum death benefit of $2,720,000. The mortality risk charges debited to the
separate accounts during 2006-2007 totaled $12,327.
The minimum death benefit was payable in all events so long as the Policy
remained in force. If the investments in the separate account performed well, the
beneficiary upon the insured’s death was to receive the greater of the minimum
death benefit or the value of the separate account. The Policies provided that the
death benefit would be paid by Lighthouse “in cash to the extent of liquid assets
and in kind to the extent of illiquid assets (any in kind payment being in the sole
discretion of Lighthouse), or the Death Benefit shall be paid by such other arrangements
as may be agreed upon.”
The Policies permitted the policyholder to add additional premiums if necessary
to keep the Policies in force. On September 7, 2000, the Alaska Trust
made an additional premium payment of $35,046 to cover a portion of the secondyear
mortality/administrative charge. The assets in the separate accounts performed
so well that no subsequent premium payments were required. Thus, the
total premiums paid on the Policies by the Alaska Trust (and by its successor
grantor trusts) amounted to $735,046.
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The Policies granted certain rights to the policyholder prior to the deaths of
the insureds. Each Policy permitted the policyholder to assign it; to use it as collateral
for a loan; to borrow against it; and to surrender it. If the policyholder
wished to assign a Policy or use it as collateral for a loan, Lighthouse had the
discretion to reject such a request.
However, the Policies significantly restricted the amount of cash the policyholder
could extract from the Policies by surrender or policy loan. This restriction
was accomplished by limiting the Cash Surrender Value of each Policy to the total
premiums paid, and by capping any policy loan at the Cash Surrender Value. For
this purpose, “premiums” were defined as premiums paid in cash by the policyholder,
to the exclusion of mortality/administrative charges debited from the
separate accounts.
Thus, if the separate accounts performed poorly and the policyholder paid
cash to cover ongoing mortality/administrative charges, those amounts would
constitute “premiums” and would increase the Cash Surrender Value. By contrast,
if the separate accounts performed well and ongoing mortality/administrative
charges were debited from the separate accounts, those amounts were not treated
as premiums that increased the Cash Surrender Value, but as internal charges paid
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by Lighthouse. The result 4 of this restriction was that the maximum amount the
Trusts could extract from the Policies prior to the deaths of the insureds, by surrendering
the Policies or taking out policy loans, was $735,046.
Investment Management of the Separate Accounts
Lighthouse did not provide investment management services for the separate
accounts. Rather, it permitted the policyholder to select an investment manager
from a Lighthouse-approved list. For most of 2006 and 2007 Butterfield
Private Bank (Butterfield), a Bahamian bank, served as the investment manager
for the separate accounts. The Policies specified that Butterfield would be paid
$500 annually for investment management services and $2,000 for accounting.5 In
November 2007 Experta Trust Co. (Bahamas), Ltd. (Experta), became the
investment manager. No one testified at trial on behalf of Butterfield or Experta.
We will refer to these entities collectively as the “Investment Manager.”
4For 2006 and 2007 the separate accounts paid Lighthouse $130,000 and
$161,500, respectively, to cover annual mortality/administrative charges. The
2007 charges were higher because the separate accounts’ values had increased.
5It appears that the separate accounts paid Butterfield $8,500 in overall fees
for 2006 and 2007, but there is no evidence that any amount in excess of $500 per
year was allocable to investment management. Petitioner directs the Court’s attention
to an accounting entry showing “Administrative Fees” of $20,500 paid in
2007, but there is no evidence to establish what these were paid for.
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As drafted, the Policies state that no one but the Investment Manager may
direct investments and deny the policyholder any “right to require Lighthouse to
acquire a particular investment” for a separate account. Under the Policies, the
policyholder was allowed to transmit “general investment objectives and guidelines”
to the Investment Manager, who was supposed to build a portfolio within
those parameters. The Trusts specified that 100% of the assets in the separate
accounts could consist of “high risk” investments, including private-equity and
venture-capital assets. Lighthouse was required to perform “know your client”
due diligence, designed to avoid violation of antiterrorism and moneylaundering
laws, and was supposed to ensure that “the Separate Account investments [were
managed] in compliance with the diversification requirements of Code Section
817(h).”
Besides setting the overall investment strategy for a separate account, a
policyholder was permitted to offer specific investment recommendations to the
Investment Manager. But the Investment Manager was nominally free to ignore
such recommendations and was supposed to conduct independent due diligence
before investing in any nonpublicly-traded security. Although almost all of the
investments in the Policies’ separate accounts consisted of nonpublicly-traded
securities, the record contains no compliance records, financial records, or busi-
19-
ness documentation (apart from boilerplate references in emails) to establish that
Lighthouse or the Investment Manager in fact performed independent research or
meaningful due diligence with respect to any of petitioner’s investment directives.
Lighthouse created a series of special-purpose companies to hold the investments
in the separate accounts. The Lighthouse Nineteen Ninety-Nine Fund LDC
(1999 Fund), organized in the Bahamas, was created when the separate accounts
were initially established. During the tax years in issue the principal special-purpose
company was Boiler Riffle Investments, Ltd. (Boiler Riffle), likewise organized
in the Bahamas. These investment funds were owned by Lighthouse but were
dedicated exclusively to funding death benefits under the Policies through the
separate accounts. These special-purpose vehicles were not available to the
general public or to any other Lighthouse policyholder.
The “Lipkind Protocol”
Mr. Lipkind explained to petitioner that it was important for tax reasons that
petitioner not appear to exercise any control over the investments that Lighthouse,
through the special-purpose companies, purchased for the separate accounts. Accordingly,
when selecting investments for the separate accounts, petitioner followed
the “Lipkind protocol.” This meant that petitioner never communicated--by
email, telephone, or otherwise--directly with Lighthouse or the Investment Mana-
20-
ger. Instead, petitioner relayed all of his directives, invariably styled “recommendations,”
through Mr. Lipkind or Ms. Chang.
The record includes more than 70,000 emails to or from Mr. Lipkind, Ms.
Chang, the Investment Manager, and/or Lighthouse concerning petitioner’s “recommendations”
for investments by the separate accounts. Mr. Lipkind also
appears to have given instructions regularly by telephone. Explaining his lack of
surprise at finding no emails about a particular investment, Mr. Lipkind told
petitioner: “We have relied primarily on telephone communications, not written
paper trails (you recall our ‘owner control’ conversations).” The 70,000 emails
thus tell much, but not all, of the story.
Investments by the Separate Accounts
In April 1999, shortly after the Alaska Trust initiated the Policies, the 1999
Fund purchased from petitioner, for $2,240,000, stock that petitioner owned in
three startup companies: Sagent Technology, Inc., Persistence Software, Inc., and
Commerce One, Inc. Petitioner was unsure how the 1999 Fund could have paid
him $2,240,000 for his stock when the Alaska Trust at that point had paid premiums
toward the Policies of only $700,000 (before reduction for very substantial
first-year mortality charges). He speculated that he might have made an installment
sale.
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Petitioner testified that he expected the stock in these three companies to
“explode” in value. The