"The Future Largest Landlords in America"

subsidiaries, they hope to avoid "tainting" the parent. The subsidiary can also protect the parent in more tangible ways. Most real-estate ventures show sizable losses in the early years of operation. If the parent owned the real estate directly, these losses would show up on its balance sheet. In the insurance business this might have serious consequences. The major insurance companies actively compete for the management of corporate pension money, and corporate officials generally choose among insurance companies on the basis of their "return on new money," defined as the amount earned by an asset during the first year it was acquired. Conceivably, real-estate losses could lower a company's return on new money sufficiently to cause it to lose a fat pension account. By placing all real estate in subsidiaries, however, the parent skirts the problem. In most states the income (or loss) of an insurance company's subsidiaries cannot be consolidated with the parent's income.

The subsidiary also shields the assets of the parent from the debts of the real-estate joint venture. According to some insurance-company executives, developers are not above ordering materials for the account of the joint venture and using them on other, unrelated projects. When this occurs, creditors of the joint venture can attach the assets of the subsidiary but may not be able to "penetrate the corporate veil" to threaten the parent's assets.

A rubbery restriction

Finally, some insurance-company executives view the subsidiary as a handy device for circumventing legal limits on the percentage of assets that can be invested in real-estate equities. In most states insurance companies are allowed to put no more than 5 or 10 percent of total assets into real estate. Finding these limits a bit confining, companies have been lobbying the legislatures for higher ceilings with some success. In New York, for example, Governor Rockefeller recently signed a bill raising the limitation from 5 to 10 percent.

But not all legislatures have moved fast enough to suit the more ambitious insurance companies. Stock companies like Aetna, Connecticut General, and National Life & Accident of Nashville have found a solution in using the holdingcompany umbrella. The life company and the real-estate subsidiary are no longer directly connected; both are now subsidiaries of the holding company. Since the real-estate subsidiary is divorced from the life company, it is unregulated and can operate without interference from the insurance examiner.

Mutual companies, however, cannot use the holding-company device, since, by definition, they are owned by their policyholders and cannot be owned by another enterprise. Instead, the mutuals set up wholly owned subsidiaries, which are subject to the scrutiny of state insurance departments. In New York the examiners have ruled that the parent life company cannot do through a subsidiary what it is prevented from doing on its own. If the parent cannot invest more than 10 percent of its assets in real-estate equities, parent and subsidiary together cannot breach this limit. But many states are more permissive. The amount that the parent can invest is regulated by statute, but the amount that the subsidiary can invest is subject to more or less informal negotiations between the company and the examiners.

Conceivably, if the parent advanced money to the subsidiary for a real-estate venture, it could label 30 percent of the

money "equity" and 70 percent "debt." The examiners might charge only the equity portion of the investment against the insurance company's asset limitation, enabling it to more than triple its involvement in real estate.

Having the best of both worlds

Although the subsidiary route offers many advantages, it also has a few drawbacks. The subsidiary pays the full corporate tax rate, 48 percent, whereas the life-insurance company itself pays its taxes at a much lower effective rate. And when the subsidiary passes dividends to its parent, a second tax must be paid on them. A number of insurance-company lawyers feel that the potential tax disadvantages cancel any gains in operational flexibility. They believe, moreover, that the insurance company can obtain positive tax benefits and limit its liability for debts by another arrangement-one that combines a direct parent-company interest and an indirect subsidiary interest in the joint venture.

According to this plan, an insurance company might negotiate a 50 percent equity interest and enter the joint venture itself as a 49 percent limited partner, while putting its subsidiary in as a 1 percent general partner. A general partner is entitled to participate in the management of the joint venture, but it is also liable for all the venture's debts. A limited partner has no liability, except for its initial investment, but neither has it the right to manage. By sharing its partnership interest with its subsidiary, the parent has the best of both worlds the right to manage without exposing its own assets.

This arrangement also provides a tax bonanza. As a limited partner the insurance company has an ambiguous relationship with the joint venture. On the one hand, it is a lender to the venture, receiving interest income from its mortgage; on the other hand, as a partner, it pays out mortgage interestin effect to itself. The income it gets as lender is taxable; the interest it pays as partner is deductible. The key to the tax advantage is that, for many insurance companies, the mar ginal tax bite on interest income is generally about 30 percent, while deductions for interest paid are usually worth close to the full corporate rate of 48 percent. The difference arises because the investment income of a life company is divided into two parts: the policyholders' share and the company's share. While the company pays the full corporate rate on its own share, it is not taxed on what belongs to the policyholder. So its effective tax rate is lowered substantially.

If the joint venture paid the insurance company $100,000 in mortgage interest, the company's tax liability on that would be about $30,000. But when the insurance company is a 49 percent limited partner in the fifty-fifty venture cited above, it is entitled to deduct $49,000 as its share of interest paid. That deduction would lower its tax from $30,000 to $6,480 (48 percent of $49,000 equals $23,520. If the insurance company were a 74 percent limited partner-in a seventy-five to twenty-five deal its share of interest paid by the partnership would more than wipe out its $30,000 tax obligation on the mortgage interest it received (48 percent of $74,000 equals $35,520). In other words, the more substantial its equity position, the more the insurance company makes on its loan. And if it takes a big enough equity position, it can even raise its after-tax yield on interest income above its pre-tax yield.

A number of insurance companies have only just discovered this bizarre tax wrinkle and are planning to use it for the first time this year. If the Internal Revenue Service acquiesces, those companies may become even more insistent in demanding equity participations. And as long as mortgage money remains as scarce as it has been, few doubt their ability to enforce this demand.

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