News & Articles

Foreign Trust Used to Purchase Offshore Life Insurance is Sham

07 / 25 / 2019

Tax Form:    Form 8886; Schedule K-1

Tax Troubles:  Audits triggered by filing of a Form 8886 (on a DAT transaction), when coupled with "mis-matched" K-1s being issued without regard to the accuracy of the information being submitted.


Wegbreit v. Commissioner, T.C. Memo 2019-82 (July 8, 2019)

Taxpayers faced with an anticipated tax hit in a given year will often look to mitigate that hit by engaging in tax planning. 

This case out of the Tax Court serves as a reminder of a myriad of problems created when one is involved in overly agressive tax planning, coupled with the use of backdated documentation and the use of a DAT (distressed asset trust) transaction that generated losses in 2007 that were disallowed because the losses were generated by a listed transaction that is otherwise reported on a Form 8886 per the Kenna Trading, LLC v. IRS case, 143 T.C. 322 (2014), aff'd, 911 F.3d 854 (7th Cir. 2018).  Far more importantly, it further serves as a reminder as to what problems can be created when a Form 8886 or other tax form is filed, when the rest of the house is not in order.  It also focuses on how important it is for LLC tax returns and K-1s to be prepared accurately, and for schedules on trusts to be properly prepared to reflect on assets and when they are funded into any trust.  All of these "bad facts" were on display in this case.

Another aspect of the case that is of interest is the discussion of how the use of backdated documentation can turn a case into a tax fraud case.  Also, the use of a layer of LLCs, with money seeming to fly around everywhere, just further adds to the problems.  Finally, the Tax Court duly noted that how the IRS properly sought leave to amend their answer and assert the civil fraud penalty when certain information came to light during discovery.

A detailed discussion of the facts shows how the Tax Court was able to dissect all of the layers of LLCs and trusts and determine that it was appropriate to throw the proverbial book at the taxpayers in this case.  Far too often, it is perhaps thought it is good "asset protection" planning to create these layers of LLCs and trusts. The lesson of this Wegbreit case might be that asset protection, as such, done with little attention to the details of the plan, won't be of help, and actually might adversely impact, a taxpayer who is then audited by the IRS.

In 1989, the taxpayer Wegbreit was a part owner in an investment advisory services company with over $1 billion of funds under management.   Oak Ridge Investments, Inc. was a retail broker.  Klaskin, his partner, focused on marketing and the investment side of the business.  By 1997, they formed Oak Ridge, LLC, to shield the value of the registered investment adviser business from any litigation risks involving the broker-dealer portion of the business.  In other words, Oak Ridge, LLC handled the registered investment adviser portion, and the broker-dealer portion and office assets were in Oak Ridge, Inc. The LLC was owned 50% by Klaskin, 37.5% by Wegbreit, with the remaining 12.5% owned by 5 minority interest members.  From 1997 to 2002, Wegbriet served as the TMP; and he dealt with the accountants and lawyers for the Oak Ridge companies.  While his supervisory role continued thereafter, Klaskin became the TMP in 2002.  Wegbreit would give Klaskin big-picture views of how the company was doing year-to-year.

When in 2000, the partners looked at possibly selling a portion of the LLC business, they had the company valued--it was determined to be worth $30 million.  They then retained an investment banking firm to assist with finding a partner firm.

In June 2003, an investment firm Pioneer, expressed an interest in buying an equity stake in the LLC, and by 2004, a plan of reorganization was approved by which assets of each fund would be transferred to Pioneer solely in exchange for stock.

At about this time, Wegbreit invited his partner to attend a tax planning meeting with financial planner Rob Leon and Colorado attorney Thomas J. Agresti.  Leon and Agresti recommended using a trust to purchase an offshore life insurance policy for tax planning, and that Wegbreit assign his LLC interest (and distributions with respect thereto) to a trust, and then, that trust would transfer the LLC interest to an offshore life insurance policy as a purported premium payment, but with Wegbreit still in "control" of his LLC interest while directing investments the insurance company and trust made.  No independent research was conducted or independent advice sought regarding the legality of this plan.

By March, 2004, Pioneer proposed to acquire a 49% interest in Oak Ridge, LLC, which included all of Wegbreit's and the minority interest members for $14.7 million, with a premium of $2.5 million paid to Wegbreit to induce him to sell his entire interest.  Press releases went out announcing the purchase and Wegbreit's intended retirement from the company.  Wegbreit would sign a 1-year consulting agreement to assist with transition and he signed a 3-year noncompetition agreement.

As part of the Agresti-led tax planning, Wegbreit forms a trust called the Samuel Wegbreit Trust Fund (SWTF).  Wegbreit explained to his partner, Klaskin, that he intended to use SWTF to "shelter" membership distributions he received, to then lower his tax liability.  Klaskin did not object, but was worried that outside parties were getting involved.  Klaskin understood that this was just "on paper"---that Wegbreit would remain involved in daily management of the Oak Ridge companies.  For these reasons, Klaskin did NOT exercise a right of first refusal he held under the operating agreement for the company.

The trust, and the 3 revisions or versions reviewed by the Tax Court had indications of backdating in which the attached schedules showing the funding of the trust were inconsistent with the notary certifications.  Agresti and Associates served as the initial trustee, but Wegbreit believed that it was Agresti himself, as other documents were executed bearing his name, individually, as trustee.  In 2006, Agresti's law license was suspended, and his law firm shut down.  Even though Wegbreit knew about Agresti's ceasing to practice law, he continued to seek his legal advice.  Agresti resigned as trustee in February 2008, with a CPA, Paul Lewandowski serving as successor trustee.  Lewandowski delegated part of his authority to Orchard Administrators, for trust administration.  That company was a subsidiary of Orchard Financial which was established to maintain premium financed life insurance policies purchased by Orchard Financial's clients.  These trustees did not act independently to identify assets for the trust to purchase or make investment decisions for the trust.

In 2002, Wegbreit had obtained a variable life insurance policy from Threshold, a Cook Islands based insurance company.  2 different policy statements,one suggesting a face amount of $2.8 million, and another, $4.7 milion, and listing the trust as beneficiary.  No illustrations calculating the value of the policy or premiums required were attached, nor was the policy itself signed by any officer of Threshold.

Agresti had formed numerous entities purporting to be the assets held by Threshold for SWTF (the trust)'s benefit.  Closing statements listing the purported cash surrender value and assets had a number of errors in them.  Later, Acadia, a Bermuda-based life insurance company, issues a variable life insurance policy to SWTF, as part of an "exchange" for the first Threshold policy (which had been issued to a family limited partnership and not SWTF).  A certificate purporting to have the managing member of Oak Ridge, LLC authorize a transfer of Wegbreit's LLC interest to Acadia for the benefit of its issued policy, pre-dated to February 16, 2004, and signed by Klaskin appears in the Tax Court records.  The Tax Court notes how no steps were taken to admit Acadia as a member of Oak Ridge, LLC or comply with the provisions of the LLC's operating agreement regarding restrictions on transfer.

Agresti formed Executive Placement Qsub-102, Inc. as a Wyoming corporation in 2002 and named himself VP.  It was later dissolved by the state in 2005, and Agresti would deny in a deposition ever having been involved with it.  

Wegbreit caused Oak Ridge, LLC to report Executive Placement as the owner of his interest in Oak Ridge, LLC on the Form 1065, Schedule K-1 issued in 2002, reporting distribtuions of $825,000.  In 2003, Wegbreit's interest is said to have been transferred from Executive Placement to the Threshold policy.  

Another entity Agresti formed in 2002 was Blackdog Fund, LLC, in Nevada.  It was a hedge fund.  Agresti formed another company that was discussed in the opinion, Grand Prix Jumpers, LLC, as a Colorado LLC, with Executive Placement as its sole member. In 2004, Agresti caused 100% of the GPJ LLC interest to be transfered to Acadia, but as the Tax Court notes, no representatives of Executive Placement participated in GPJ's activities or approved of the company's investments, or for that matter, approved the transfer.  More of interest to the Tax Court and its findings is that GPJ purported to be in the business of training and showing horses.  In 2003, Wegbreit is said to hae used $160,000, transferred from Threshold to GPJ, to purchase a showhorse named Tom Cruise, bought from Connie Stevens, a horse trainer and Wegbreit's children's riding instructor.   She also trained other horses for the children.  What the Tax Court then notes is how GPJ was used to disguised their purchase of 3 Florida condos, by and through the formation 3 additional Colorado LLCs, by and through which funds from Acadia were "repatriated" through.  While GPJ then obtained a $925,250 mortgage to acquire a Boca Raton property, the bank required both the SWTF trust and Wegbreit to guarantee the loan as a condition for its approval.

Wegbreit lived in the condo 2-3 months a year from 2005-2008, but then it became a primary residence from 2008-2010, and in 2013 it was sold for $867,500.  The same for a second Florida condo in Sunny Isles Beach, Florida, with a Harris Bank loan originally prepared in the Wegbreit name, only to be "re-papered" in the name of GPAM, LLC, with Weigbreit quit claiming the condo on over to GPJ, with GPAM, LLC listed as the owner on the deed.  It was sold for $1,350,000, and the net proceeds from that sale were deposited into the GPAM, LLC account. A third condo was handled by and through a CitiMortgage loan in which Wegbreit was a coborrower but an entity listed as the owner.  Accounts were commingled in paying for condo expenses.

In other words, GPJ was used to channel funds from Acadia into other investments, and Wegbreit maintained control and access to the flow of funds through Smith Barney where personal IRA accounts were also being maintained.  Funds into which Acadia was invested were reviewed by Wegbreit, and the court discusses how he instructed Acadia on whether to make investments directly or through GPJ, how much money to invest, and when to invest.  On February 9, 2006, an Acadia employee warns Wegbreit against creating a paper trail for the IRS and to instruct Waltman, the Smith Barney rep, to contact her with questions going forward.

Wegbreit began to withdraw loans from the Acadia policy in 2004, taking out loans of $891,000 in 2005, $850,000 in 2006, $750,000 in 2007, and $672,000 in 2008, funded through the assets held by Acadia, and these funds were used to pay personal expenses, like phone bills, property taxes, and condo association fees.  At the same time, the Wegbreits reported income was not sufficient to support their family's lifestyle.

In 2007, the Wegbreits converted their personal IRA into a ROTH IRA.  Had the Wegbreits not engaged in the DAT transaction in 2006-2007, they would have had modified gross income of more than $100,000, which was the threshold for ROTH IRA contributions.  They did not file IRS Form 5329 and pay the excise tax otherwise that would be due under Section 4973 for the years 2007-2009.

No trust returns were prepared for the SWTF, so the IRS was compelled to prepare substitute returns.

The IRS began their audit in 2008, for the years 2005-2009, and eventually, in 2012, they issue a notice of deficiency, determining:

1. SWTF was the true owner of the assets allocated to the Acadia foreign life insurance policy, that it was a grantor trust, with its income taxable to the Wegbreits, and thus, they needed to recognize additional incoome of $10.5 million in 2005, $173,303 in 2006, $2,199,364 in 2007, $664,023 in 2008, and $159,960 in 2009, while at the same time, denying the 2007 Schedule E loss deductions  of $1,695,415 for the 2007 year and denying the NOL taken in 2008 for $,602,944.  Because these adjustments made the modified adjusted gross income of over $100,000 in 2007, they were not eligible for a non-taxable rollover of the personal IRA into a ROTH IRA that year.   This also rendered them subject to a 6 percent excise tax, and penalties for failure to file IRS Form 5329 in 2007, 2008, and 2009.

The IRS eventually conducted discovery, including depositions of the lawyer and Acadia representatives.  They then moved to amend their answer to assert a civil fraud penalty.   The Tax Court granted that motion.  

The Tax Court determined that no valid transfer occurred by Wegbreit of his Oak Ridge LLC interest, to SWTF, and the proceeds of the sale of his interest to Pioneer were includible in 2005.  SWTF was viewed as a sham, using the 4 factors under Markosian v. IRS, 73 T.C. 1235 (1980), lacking economic substance, and disregarded for Federal tax purposes, such that Wegbreit was taxable on its income for each of the years at issue.  The Threshold policy was viewed as an invalid life insurance policy, negating the "tax-free" exchange of the policies under 1035.  

The civil fraud penalty was supported by clear and convincing evidence.  According to the Tax Court, Wegbreits significantly understated their income, failed to cooperate with tax authorities during interviews, conspired with Agresti to produce falsified and back-dated documents to conceal assets and income and to mislead the government, and filed False Forms 1040 for the years 2005-2009.  Wegbreit was also found to have caused false and misleading information regarding the ownership of Oak Ridge, LLC to be included on Oak Ridge, LLC's Forms 1065 and Schedules K-1 for 2002-2005  Wegbreit was viewed as having offered up numerous documents that were back dated and otherwise unreliable. For these reasons, the civil fraud penalty was upheld.

If you have Abusive Tax Shelter questions, or questions about IRS Forms 8886 or 8919, please contact Mr. Scott Tufts at 407-647-7887.