Author: DOUGLAS MOORE, ATTORNEY, AND MITCHELL K. HIGGINS, SENIOR INVESTMENT OFFICER
DOUGLAS MOORE is an attorney and
National Director of Estate and Charitable Planning for Citigroup
Trust and The Citigroup Private Bank, based in New
York City. MITCHELL K. HIGGINS is the Senior Investment Officer for Citigroup Trust in
When investments that are not income tax-efficient (such as hedge funds) are held inside a private placement life insurance policy, the income tax advantages of the life insurance can enhance the performance of the underlying investments.
Life insurance has traditionally been used in estate planning to provide (1) liquidity to pay estate taxes and administration expenses, (2) replacement of income, and/or (3) funds for a buy-out of closely held business interests. In certain instances, clients analyze the internal rate of return provided by the tax-deferred build-up of income inside a policy (coupled with the estate tax exclusion benefit of owning the policy inside an irrevocable trust), and decide to purchase insurance in order to increase the wealth that will pass to succeeding generations.
Recently, attention has been given to an alternative life insurance design—private placement life insurance (PPLI). 1 PPLI is used primarily as an investment vehicle and financial product to enhance the performance and rate of return of either mainstream investments (such as mutual funds) or more sophisticated investments (such as hedge funds). Mutual funds, and particularly hedge funds (depending on numerous factors), can be effective investment vehicles that offer good return and diversification. However, they are not designed to be income tax-efficient. For instance, hedge funds are structured as limited partnerships with underlying investments that generate substantial short-term capital gains to the partners. By maintaining these investments inside a life insurance product with its income tax advantages, one can combine the best of both worlds.
There is flexibility within the PPLI structure to allow policyowners to change fund managers and investment styles within their policies to meet individual investment objectives. This may be accomplished by reallocating assets among investment funds available within the PPLI contract. Investor control limitations do not apply to investment managers that are not affiliated with the policyowner. For example, one investor may choose to invest in a taxable fixed income portfolio. Another investor, with a higher risk tolerance, might invest some assets in a heavily traded equity portfolio. Both of these investors can reallocate their investments to a hedge fund strategy at any time, assuming the hedge fund is approved by the insurance carrier and is structured properly.
The key advantage of PPLI is that it permits income tax-deferred buildup of the investments maintained inside the insurance product 2 during the insured's lifetime, while providing an income tax-free death benefit. 3 Moreover, there are no immediate income tax consequences on asset reallocations within the policy.
The performance of most policies allows the underlying investments to grow income tax-deferred—and possibly income tax-free—even in the event of a withdrawal or distribution during the insured's lifetime. Depending on a client's potential or anticipated need to access cash during the term of the policy, a client should weigh the advantages and disadvantages of purchasing either a non-modified endowment contract (non-MEC) or a modified endowment contract (MEC).
Under most policies (non-MEC), income tax is imposed based on a "first in—first out" method. Loans from a non-MEC policy are income tax-free, but interest is charged by the insurance carrier. Withdrawals from the contract are a return of premium to the extent of basis, and then are taxable as ordinary income. Hence, if an owner of a non-MEC policy makes a withdrawal via a loan against the policy, or receives a distribution of cash from that policy, the funds are considered to be first a return of investment up to the policy's basis, and there are no income tax consequences for loans or distributions up to that amount. 4
The policy's basis consists of the aggregate amount of premium payments (excluding the portion attributable to supplemental benefits) plus dividends applied to premiums or received in cash. Because the exact amount of basis is not easily ascertainable, the policyowner should request the amount of basis from the insurance carrier when planning to receive distributions or withdrawals. If the owner receives withdrawals or distributions that exceed basis, those distributions are subject to ordinary income tax. Nevertheless, the owner has the advantage of receiving distributions from assets that were permitted to increase in value through the deferral of income tax while they were held in the policy. Again, the beneficiary of the policy receives the death benefit income tax-free.
If a client does not foresee a need (or anticipates a minimal need) to access the policy's cash, a MEC may be a viable alternative to the more commonly used non-MEC. Under certain circumstances, the MEC may be a more desirable product design.
A life insurance policy is a MEC if it fails to meet the "seven-pay test" defined in Section 7702A . Generally, the seven-pay test prescribes guidelines for the maximum premium funding to be paid over a seven-year period to meet the insurance carrier's obligations to pay the death benefit. Typically, a policy fails to meet this test if the total premiums paid in the first seven contract years exceed the seven-pay premium limit established under the test—that is, if the policy's cash value is excessive relative to the death benefit provided based on the aggregate amount of premiums paid.
There are two different methods that may be applied by the insurance carrier to determine if a policy is a MEC: the "Guideline Premium Test" (GPT), and the "Cash Value Accumulation Test" (CVAT). Each test will produce different results in terms of the maximum amount of premiums that may be paid without causing the policy to become a MEC. If only a single premium is projected to be paid, the policy will usually be a MEC under either test. A policy may become a MEC at any time during the first seven years, or later if there is a "material change" in the policy. 5 The MEC rules were enacted by Congress to reduce the incentive of investors who purchased short-term investments through life insurance contracts in order to defer income tax on the contract's underlying investments, while other investors who purchased investments directly were not accorded the same favorable income tax deferral.
During the insured's lifetime, MEC policies differ from non-MEC policies as to the occurrence, timing, and amount of income tax payable on amounts received by the policyowner. However, MEC death benefits are subject to the same income tax treatment as non-MEC policies. More specifically, MEC policies differ from non-MECs in the following ways:
It is uncertain whether a MEC can be pledged as collateral without triggering income tax to the extent of gain in the policy. While the authors are not aware of any authority directly on point, a strong argument can be made that the pledge of a policy can be distinguished from a withdrawal in the form of a loan because in the case of a pledge, no actual withdrawals are made from the policy's account and no payments are made by the insurance carrier. The pledge simply facilitates the policyowner's ability to have access to funds from another source. This issue is pertinent to premium financing or split-dollar arrangements.
One of the most important decisions from an investment and income tax perspective is whether a policy should be structured as a MEC or a non-MEC. If a policy is a MEC, the cost of insurance (COI) and mortality and expense charges (M&E) (discussed later) can be significantly less than in the case of a non-MEC policy, which is required to meet the seven-pay test. A MEC policy does not have to be funded to provide for a higher death benefit to satisfy the non-MEC requirements. As a result, payments may be reduced or a greater proportion of the premiums will be used for the investment portion of the contract instead of for COI and M&E. Because PPLI is used primarily for investment and income tax planning, the decision of whether to purchase a MEC or non-MEC PPLI policy is far more significant than with traditional life insurance planning.
A MEC may be more advantageous if the policyowner expects he will not need access to the funds for at least five years from the issuance of the policy. MEC policies generally have a large cash account because more funds are invested earlier (premium payments in excess of the seven-pay test) and because COI is less than in a non-MEC policy since there is less death benefit "at risk."
PPLI contracts are usually issued as variable universal life insurance policies. This permits a number of features that make the product particularly effective for investment purposes:
The policy must be structured to satisfy requirements relating to diversification and investor control. In order for the policyowner to receive the income tax advantages of holding investments inside the policy, the owner must have limited control over the investments. The policyowner cannot dictate to the fund manager what specific assets should be owned by the policy. But the policyowner can choose the fund manager based upon the manager's asset allocation model and investment philosophy.
When deciding to purchase PPLI, potential policyowners should balance their desire for control over the investments with (1) the requirements pertaining to diversification and investor control, as well as (2) insurance costs and expenses. The policyowner's financial commitment toward the payment of policy premiums can favorably affect the cost efficiency of the policy and the policyowner's ability to select fund managers.
The fund manager is required to meet specific diversification requirements. 8 Insurance carriers and professionals who structure PPLI provide stringent due diligence to ensure that the diversification requirements for the underlying assets of the funds are met. Thus, some fund managers work in conjunction with insurance carriers and offer "clones" of existing hedge funds, which are specifically designed and managed to be a part of PPLI. This is a sound and necessary approach in light of past and recent rulings.
Hedge funds are the investment of choice for many PPLI policyowners. Hedge funds can be an effective investment holding due to their potential appreciation and low correlation to the public market—especially in today's volatile markets.
Recently, the IRS issued Ltr. Rul. 200244001 , which sets forth parameters for investors and insurance carriers to follow when hedge funds are the underlying investment of a PPLI policy. Viable and effective opportunities continue to exist with hedge funds, but forewarned is forearmed. Taking into account this letter ruling and Rev. Rul. 81-225 , 9 certain insurance carriers require the underlying funds in the policies to be maintained in one of the following ways:
In Ltr. Rul. 200244001 , the IRS relied heavily on Rev. Rul. 81-225 , which set forth five situations in which insurance carriers used mutual funds as investments for their variable annuities. In the fifth situation only, the insurance carrier had exclusive investor control and incidents of ownership so as to allow the income from the mutual funds to be attributed to the carrier and not to the policyowner (allowing for the tax-deferred treatment). In the first four situations of Rev. Rul. 81-225 , the policyowners had sufficient control and other incidents of ownership to be considered owners of the mutual fund shares for income tax purposes. Therefore, the annuity did not provide the intended beneficial income tax deferral on the gain in the policy.
The Revenue Ruling reached an opposite conclusion in situation 5, because the sole function of the mutual fund in that situation was to provide an investment vehicle to allow the insurance carrier to meet its obligations under the annuity contracts. A critical factual distinction in situation 5 was that the mutual fund shares were available only through the purchase of the annuity contact and were not otherwise available to the public.
In Ltr. Rul. 200244001 , the IRS again focused on the exclusivity of the underlying fund as critical. Accordingly, carriers and investment managers should consider structuring the product to meet the exclusivity requirement—that is, the underlying fund is available exclusively through the purchase of a PPLI. Certain insurance carriers and fund managers are committed to designing specific funds that satisfy the investor control and diversification requirements because of the significant premium payments made to support these policies.
The more conservative approach to satisfy the requirements regarding investor control and diversification is for the policy's investment structure to be available only within an insurance product and not to be easily mirrored in a structure outside the insurance product. Policyowners must understand from the outset that they must forego the ability to select particular investments or to determine the asset allocation of the investment holdings. The fund manager or insurance carrier is required to use independent judgment as to the holdings and must not be directed by the policyowner. Therefore, it is essential that the policyowner understand (1) his right to have access to the holdings, (2) the liquidation events of the funds, and (3) the fund manager's investment philosophy, especially if the investments do not perform up to expectations or if the policyowner's investment objectives change.
Because the goal of PPLI is to provide a greater after-tax dollar return on the owner's investment, the cost of providing the investments inside the insurance product must be carefully examined. The income tax advantage of PPLI should not be negated by the cost of the life insurance product.
The cost of providing life insurance reduces the overall return so the product must be structured in such a way that four categories of expenses of providing life insurance [cost of insurance (COI), mortality and expense charges (M&E), policy loads (commissions), and insurance-specific taxes] are less than the expenses of traditional life insurance products. One major advantage of PPLI is that these costs are substantially less than the costs of typical life insurance products. The COI is generally the largest expense of providing insurance, and includes underwriting expenses and the insurance company's profit margin. The medical underwriting and the proposed insured's rating will affect the COI. In the case of PPLI, these charges are greatly reduced from the costs of traditional insurance to make the product more attractive to policyowners. M&E generally includes sales expenses, and can vary in amount depending on the particular insurance carrier.
In addition to COI and M&E, there are two
separate taxes associated with obtaining a domestic life insurance policy.
First, the federal deferred acquisition cost (DAC) tax is applied to each
premium payment. Each carrier calculates the DAC tax and may pass through
different levels of DAC tax charge to the policyowner.
This tax cannot be avoided. The second tax is a state premium tax. Each state
imposes its own premium tax. This tax varies considerably from state to state.
Some carriers charge "state specific" taxes, while other carriers
charge a level amount for all states. This can have a dramatic effect on
premium tax costs. Hence, the state in which the policy is issued may be an
important factor. States such as
The return on the investments of the policy is then reduced by traditional investment management fees and administration expenses of the fund managers that would ordinarily apply. The better the investment performance, the less significant the COI and M&E are to the overall return. To a large extent, there is transparency to the COI and M&E, which allows the product to be vetted. Consequently, the COI and M&E, in the aggregate, often are similarly and competitively priced by insurance carriers actively involved with PPLI in the high-end of the market.
Many investment vehicles that are not tax-efficient could benefit from a PPLI structure. These include mutual funds, taxable fixed-income portfolios, heavily traded equity accounts, hedge funds and, to a lesser extent, private equity funds. However, the most popular type of investment used with PPLI is hedge funds.
Traditional stock and bond portfolios also can be used in a PPLI structure. As previously noted, policyowners have flexibility in choosing managers. This flexibility also allows flexibility in determining asset classes.
Traditionally, a policy was structured as a separate account that was managed similarly to mutual funds, taxable fixed income portfolios, or heavily traded equity portfolios. These types of accounts have the following characteristics:
Hedge funds are not considered traditional investments. When discussing this very broad asset class, it is important to keep in mind that the term "hedge fund" refers to investment structure—not strategy. Hedge funds are structured as private limited partnership investments, restricted to accredited investors and qualified purchasers. Because of this structure—and the fact that hedge funds are generally unregulated by government agencies—these funds offer much greater flexibility in strategy than traditional investment funds, including the use of leverage, derivatives, and short-selling. Hedge funds encompass a broad array of fund styles, from risk diversification to return enhancement strategies.
Absolute return hedge funds offer the potential for higher returns with volatility (risk) similar to bonds. These styles tend to have very low correlation with equity and bond markets. For example, the market-neutral style generates performance through stock selection, and has minimal exposure to the direction of the equity markets; long and short stock holdings are balanced to neutralize the impact of market direction. Arbitrage funds, on the other hand, exploit mis-pricing between two related assets by investing long in undervalued assets and short in overvalued assets. The objective is to lock in profits when prices move closer to fair value. There are also multi-strategy funds involving several styles and strategies.
Performance-oriented hedge funds differ from absolute return funds in that they offer the potential for equity-type returns with lower volatility than equities. For instance, the long/short equity style consists of mostly long equity positions with a short position acting as a hedge. This allows greater participation in the market's upside potential, while protecting against downside risk. Global macro is a very opportunistic style characterized by investment decisions based on analysis of fundamental economic, political, and market factors. Fund managers using the global macro style make leveraged directional bets on anticipated price movements in global currency, equity, bond, and commodity markets.
All these strategies can be implemented within a PPLI structure. The individual policyowner's investment philosophy and objectives always need to be taken into account.
Other considerations that affect the determination of whether PPLI is appropriate for a particular client include:
In certain states, the cash value of a life insurance policy is generally free from the claims of the policyowner's creditors (e.g., Florida), or the insurance proceeds are not subject to the policyowner's or beneficiary's creditors as long as the purchase of the policy was not a fraudulent conveyance or subject to a creditor's attack on other grounds. Therefore, a policyowner can fund a PPLI policy with a significant amount of money, which may insulate the cash value or the insurance proceeds from the policyowner's creditors.
When structuring the policy, the policyowner should keep in mind the potential need to tap the funds inside the policy, and should arrange for liquidity-producing events accordingly. As in the case of many hedge funds, there is access to liquidity at certain times (e.g., quarterly). Distributions from a hedge fund may also be made in kind or in cash, depending on the particular fund. The termination arrangements available with regard to a particular fund within the PPLI may be an important factor, as with any investment. A policyowner should be aware of these issues and plan for any anticipated liquidity needs. Depending on the amount used to fund the policy, the policyowner may be able to negotiate with the insurance carrier for greater flexibility regarding liquidation or termination events.
Some individuals may consider whether to purchase the product on-shore or offshore. Each of these options has advantages and disadvantages. Offshore products may be less costly initially because the state premium tax and DAC tax may be avoided. However, offshore life insurance and reinsurance are subject to excise taxes (under Section 4371 ) which may offset the benefit of avoiding the DAC and state premium taxes. In addition, the underwriting and application process must be conducted offshore, which may create added expense and logistical problems for the insured or policyowner.
Once the decision has been made to obtain PPLI, it is important for the policyowner to make informed, deliberate choices that will increase the likelihood of a favorable outcome. The policyowner must select a quality carrier with substantial experience in issuing PPLI. Not all carriers have sufficient experience with this product; this is especially important in the high-end market, where the flexibility of funds or managers and the availability of "clone" funds are necessary or desirable. The insured must undergo medical underwriting, as with any traditional life insurance product. If there is a question of insurability or rating, the medical underwriting must be considered early-on to ensure that a potentially higher COI does not negate the benefits of the tax-deferred investment return on the policy.
The policyowner should consider carefully which type of investments, "clone" funds, and fund manager(s) the insurance carrier will make available to the policyowner. Usually, the greater the upfront investment in the contract, the broader the range of investment opportunities that will be made available to the policyowner. Review the investment plan as one would review any stand-alone investments.
Details relating to the ownership of PPLI can
affect the availability or desirability of various planning opportunities or
the extent to which there will be a reduction in federal or state taxes, which
enhance investment return. For instance, situs
selection of the policy can affect the investment return. The state of
residence of the policyowner may afford the policyowner favorable state premium tax rates (e.g.,
PPLI may also be an appropriate investment for existing trusts (with significant assets). The issues surrounding gift giving and split-dollar arrangements for trusts that hold significant assets are less relevant in funding the PPLI. Because carriers issuing PPLI often require substantial minimum funding, it may be more cost-effective and tax-efficient to purchase PPLI in existing trusts with significant assets. Newly created trusts with insufficient assets which ultimately must repay the lender or grantor principal (with interest) on a note through a split-dollar arrangement or other premium financing arrangement may have a reduced overall return. In addition, it is probably more economically efficient to retire loan obligations from premium financing and split-dollar arrangements with larger death benefits (traditional plans), rather than with PPLI.
For irrevocable trusts with a situs in states that generally have no state income tax
The insured will normally be the policyowner if he wants flexibility to access cash or funds in the policy. This arrangement is not generally consistent with traditional estate planning for life insurance products. In most estate planning strategies that use life insurance, the insured is not the policyowner and does not have incidents of ownership under Section 2042 , in order to avoid inclusion of the insurance proceeds in the insured's estate for estate tax purposes. However, even if the insured is the policyowner, the death benefits are not subject to income tax (unless the transfer-for-value rule of Section 101(a)(2) applies). This result differs from the case of other income tax-deferred assets, which generally constitute income in respect of a decedent and are subject to income tax under Section 691(a) . Thus, an estate with insurance proceeds will have cash to meet all or a portion of its liquidity needs, without reduction for built-in income tax liability.
Another approach is having a partnership (with an independent business purpose other than solely to own life insurance) own the policy on a partner. There must, of course, be an insurable interest under state law. The partnership permits a pooling of assets to pay the premiums, and reduces the percentage of life insurance proceeds includable in the insured's estate. 12 Additional estate planning leverage is available if the partnership interests are owned by a grantor trust. The grantor (e.g., senior family member) will be liable for any income tax on taxable withdrawals or distributions from the policy (particularly with a MEC), leaving a greater amount for junior family members.
Another planning technique to consider is for the policyowner to be the trustee of a revocable grantor trust created by the insured in a jurisdiction with a favorable state premium tax. The grantor can have access to the funds inside the PPLI during his lifetime. Upon his death, the death benefit (cash) can be used to fund a charitable lead trust. The charitable lead interest will be eligible for an estate tax charitable deduction, which will reduce the estate tax attributable to the death benefit. The trust will be funded with cash, which will be reinvested to satisfy the lead interest payments and to produce growth for the noncharitable remainderman.
As with any investment, insurance, and tax plan, an analysis of all the relevant factors must be performed for each component of the plan. Once each aspect of the plan has been reviewed, the investment, insurance, and tax effects must be coordinated to optimize the structure of the policy.
The authors are not providing legal or tax advice. Opinions expressed here are solely those of the authors and may differ from the opinions expressed by departments or other divisions or affiliates of Citigroup. Although information in this article is believed to be reliable, Citigroup and its affiliates do not warrant the accuracy or completeness and accept no liability for any direct or consequential losses arising from its use.
For background, see Solomon and Saret, "Reaping the Benefits of Offshore Private Placement Life Insurance," 29 ETPL 435 (Sept. 2002) .
Section 817(h) ; Rev. Rul. 77-85, 1977-1 CB 12 ; Rev. Rul. 81-225, 1981-2 CB 12 ; Rev. Rul. 82-54, 1982-1 CB 11 (which provided that "the ability to choose among broad investment strategies such as stocks, bonds, or moneymarket instruments, either at the time of the initial purchase or subsequent thereto, does not constitute sufficient control over individual investment decisions so as to cause ownership of the private mutual fund shares to be attributable to the policies."
1981-2 CB 12.
Section 72(u)(1) . In some circumstances, a trustee is considered an agent for a natural person; this provides favorable income tax treatment for certain income tax-deferred investments. For instance, corporations and partnerships do not receive the income tax deferral benefits of certain income tax-deferred investments (e.g., deferred annuities).
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