A Primer on Private Placement Life Insurance
To some extent, the game is changing in traditional estate planning. We now face $5.34 million transfer tax exemptions (adjusted for inflation) and a 40 percent transfer tax rate, on the one hand, and a 39.6 percent top marginal income tax rate and 3.8 percent net investment income tax rate, on the other hand. As such, it is the income tax — not the estate, gift, and generation-skipping transfer (GST) taxes — that is of increasing concern for many of our clients. One solution tailor-made for this concern is private placement life insurance (PPLI).
PPLI is a form of variable universal life insurance. Variable life insurance is a type of permanent life insurance that builds a cash value in which the policy owner can allocate to various investments within the insurance company’s portfolio. PPLI is a variable life insurance that is privately offered. In contrast to traditional variable universal life insurance products sold by insurance companies, which have generalized investment offerings, the investment options within PPLI are highly customized. This customization allows the policy’s cash to be invested in alternative types of investments, such as hedge funds, funds of funds, real estate, commodities, and financial derivatives. As discussed below, these investments are made through a segregated account of the insurer, often through an insurance dedicated fund (IDF). PPLI is also less expensive than traditional, publicly offered life insurance because agent commissions on PPLI are much lower. Additionally, while PPLI can be underwritten under the laws of the various U.S. states, non-U.S. PPLI is often even less expensive. Given the greater investment options and lower costs, PPLI becomes an attractive option for clients who are looking for the income tax benefits available through life insurance.
This article examines the use of PPLI for income tax and estate planning. As explained below, PPLI must satisfy certain common law and statutory requirements of life insurance. In addition, to avoid current taxation on the buildup of cash value within the policy, PPLI must be particularly sensitive to certain requirements for diversification. This article examines strategies for purchasing and funding PPLI and additional considerations potential purchasers need to keep in mind when evaluating this as a planning technique.
Tax Benefits of Life Insurance
Federal tax law generally provides favorable income tax treatment of life insurance for both the policy owner and the beneficiary of the death benefit. During the life of the insured, the owner is not taxed on income generated within the policy. This allows investments inside the policy to grow at a much faster rate than taxable investments. Additionally, a policy owner is generally permitted tax-free access to a portion of the policy’s cash value through withdrawals (tax-free up to the owner’s investment in the contract).1 Any amounts withdrawn in excess of the policy owner’s investment in the contract will be taxed to the policy owner at ordinary income rates.2 Furthermore, a policy owner is generally permitted to borrow from the policy (up to the policy’s cash surrender value) without reducing the death benefit, provided that the loan is repaid prior to the policy owner’s death.3 The beneficiary of the death benefit also receives favorable tax treatment, as the death benefit is excluded from income unless the policy has been sold subject to the transfer for value rule.4
In order to qualify for the favorable tax treatment afforded to life insurance, a life insurance policy must satisfy several requirements. First, it must constitute life insurance under applicable state or foreign law. Second, it must satisfy certain statutory tests. Third, the underlying investments must be adequately diversified.
Life Insurance Under Applicable Law
To constitute life insurance under applicable state or foreign law, the policy must present an adequate degree of risk shifting, risk distribution, and absence of investor control.
• Risk Shifting — Risk shifting means there must be some shifting of mortality risk from the insured to the insurer and a distribution of mortality risk among a group of insureds.5 Authority addressing risk shifting has focused only on the actual presence of risk; the magnitude of risk has not been an issue.6 Risk shifting occurs if a person facing the possibility of an economic loss transfers some or all of the financial consequences of the potential loss to the insurer so that the actual loss will not affect the insured because the loss is offset by the insurance payment.
• Risk Distribution — Risk distribution allows the insurer to reduce the possibility that a single costly claim will exceed the amount received as premiums and set aside for the payment of such a claim. Risk distribution necessarily entails a pooling of premiums so that a potential insured is not contributing a significant part for his or her own risks.
• Investor Control — Assets held in a segregated account underlying a life insurance policy must be considered owned by the insurer and not the policy owner. This is often referred to as the “investor control doctrine.” The investor control doctrine is violated if the policy owner is deemed to have control over the investment decisions of the segregated account. This may occur when the policy owner directs investment strategy or makes investment decisions for the segregated account, or if there is a prearranged agreement between the policy owner and the manager of the segregated account to invest in any particular investment.
Beginning in the late 1970s, the IRS issued a series of revenue rulings in an attempt to clarify the parameters under which a policy owner will be treated as the actual owner of the assets of a variable life insurance policy or a deferred variable annuity (virtually all of the rulings related initially to deferred variable annuities, but have now been extended to variable life insurance policies) on account of the level of the policy owner’s control over investments within a segregated account. The validity of the investor control doctrine has also been recognized by the courts.
In Christoffersen v. Commissioner, 749 F.2d 513 (8th Cir. 1984), the Eighth Circuit Court of Appeals held that because the policy owners of a deferred variable annuity had various investment rights with respect to the policy assets, the policy owners, not the issuing insurance company, owned the underlying assets for federal tax purposes. As a result, the policy owners were currently taxable on all income generated by the assets. The policy at issue gave the policy owners extensive investment rights, including the right to direct that their premium payments be invested in any one or all of six publicly traded mutual funds, to reallocate their investment among the funds at any time, and to make withdrawals, surrender the policy, and apply the accumulated value under the policy to provide annuity payments subject only to a nominal surrender charge.
More recently, the IRS concluded in Chief Counsel Advice 200840043 (Oct. 3, 2008) (CCA) that when an insurance company holds the assets of a segregated account and permits an independent investment manager directly to invest in investments available to the general public, the policy owner (and not the insurance company) is treated as the owner of the assets of the segregated account and is taxed accordingly. Although the CCA was harshly criticized at the time it was issued, it increases the attractiveness of IDFs in lieu of offerings available to the general public.
If a PPLI policy owner has full discretion to direct investment strategies or make investment decisions with respect to a segregated account, the policy owner may be deemed to have investor control over the policy. Accordingly, a PPLI policy is typically structured to permit the policy owner to direct the investment of the policy’s segregated account among various investment options preselected by the insurance company. These preselected investment options are then managed by investment managers selected by the insurance company. The policy owner is generally permitted to select an investment manager from a preapproved list provided by the insurance company. The ability of a policy owner to initially select the investments of the segregated account in such manner [should] not violate the investor control doctrine.7 However, the policy owner should be prohibited from allowing his or her own personal investment manager to manage the segregated account. Better yet, any communication between the policy owner and the investment manager should be prohibited. Additionally, the ability of a policy owner to select an investment manager from a list of investment managers preapproved by the insurance company should not violate the investor control doctrine.8
Statutory Tests for Life Insurance
In addition to constituting life insurance under applicable law, the policy must be considered life insurance for federal tax purposes. Specifically, the policy must satisfy at least one of a) the cash value accumulation test (CVAT); or b) the two-part guideline premium test (GPT) and cash value corridor test (CVCT). Furthermore, in order to benefit fully from preferential tax treatment, the policy must not be classified as a modified endowment contract (MEC).
• Cash Value Accumulation Test — A life insurance policy satisfies the CVAT if, by its terms, the cash surrender value of such policy may not at any time exceed the net single premium that would have to be paid at such time to fund future benefits under the policy.9 The cash surrender value of a policy is equal to its cash value determined without regard to any surrender charge, policy loan, or reasonable termination dividends.10 The net single premium is equal to the present value of the future death benefits under the policy.11 Thus, by requiring a policy at all times to have a large enough death benefit to prevent the cash value of the policy from exceeding the lump sum amount that a policy owner would have to pay to fund all future benefits under the policy, the CVAT effectively limits the policy owner’s ability to front load premiums into the policy.
• Guideline Premium Test and Cash Value Corridor Test — A life insurance policy satisfies the GPT if, on any given date (determination date), the sum of the premiums paid under the policy do not exceed the greater of a) the premium that the policy owner would be required to pay on the date that the policy is issued to fund the policy’s future benefits (guideline single premium);12 or b) the sum of the level annual premium amounts (through the determination date) necessary to fund the policy’s future benefits, payable until the insured attains age 95 (guideline level premium). 13 The GPT, in effect, limits the amount of premiums that can be paid into the policy over the life of the policy.
The CVCT is satisfied if the death benefit under the policy is at all times equal to at least an applicable percentage of the policy’s cash surrender value.14 Until the insured attains age 45, the applicable percentage is 250 percent.15 After the insured attains age 45, the applicable percentage decreases incrementally to 100 percent upon the insured attaining age 95.16 The CVCT, in effect, regulates the relationship between a policy’s cash value and death benefit, limiting the buildup of cash value within the policy relative to insurance risk.
• Modified Endowment Contracts — A modified endowment contract (MEC) is a policy that otherwise meets the definition of life insurance, but fails a test known as the “7-pay test.”17 A policy fails the 7-pay test if the accumulated amount of premiums paid into the policy at any time during the first seven years of the policy exceeds the sum of the premiums that would have been paid on or before such time if the contract provided for paid-up future benefits after the payment of seven level annual premiums.18 The 7-pay test restricts the policy owner’s ability to fund the policy during the first seven policy years. If a life insurance policy is characterized as an MEC, the policy owner will be taxed at ordinary income rates on any withdrawals or loans taken from the policy, up to the amount of gain in the policy assets prior to the withdrawal or loan.19 Furthermore, any withdrawal or loan from an MEC prior to the insured attaining age 59½ is generally subject to a penalty equal to 10 percent of the amount includible in the insured’s gross income.20
Avoiding MEC classification is of particular concern in the case of PPLI, where the object is to invest as much in the policy as quickly as possible so that the return can begin accumulating tax-free. Generally, PPLI policy owners will want the ability to access policy cash values tax-free, either through withdrawals or loans. In such circumstances, avoiding MEC classification is essential. However, if the PPLI policy owner has no intentions of accessing policy cash values, MEC classification may be beneficial. This permits a larger up-front infusion of premiums into the policy, resulting in an accelerated ability to invest tax-free.
Adequate Diversification
To benefit from preferential tax treatment, the investment of a policy’s segregated account must meet certain diversification requirements. If a life insurance policy runs afoul of these requirements, the policy owner will be deemed to own all of the policy’s assets and will be subject to tax at ordinary income tax rates on all income generated by the policy assets.21 The adequate diversification test essentially provides an additional layer to the investor control doctrine.
The adequate diversification rules provide that a variable policy will not be treated as life insurance unless the segregated account is adequately diversified. A segregated asset account is adequately diversified if such account contains at least five investments and a) no single investment accounts for more than 55 percent of the value of the account; b) no two investments account for more than 70 percent of the value of the account; c) no three investments account for more than 80 percent of the value of the account; and d) no four investments account for more than 90 percent of the value of the account.22 Adequate diversification is tested on the last day of each calendar quarter ( i.e., March 31, June 30, September 30, and December 31) or within 30 days of such last day.23
In determining whether a segregated account is adequately diversified, such account will be treated as holding a pro rata portion of the assets of any regulated investment company, partnership, or trust (instead of an interest in such entity) if a) all beneficial interests in such entity are held by one or more insurance company segregated asset accounts, and b) public access to such entity is available exclusively through the purchase of a variable contract.24 This look-through rule permits segregated accounts to invest in a single entity so long as such entity is itself adequately diversified. The application of this rule also makes IDFs attractive underlying investments within PPLI.
The adequate diversification requirements apply only to life insurance policies that constitute variable policies under §817. A variable policy is one that meets the following requirements: a) The policy must provide for the allocation of all or part of the premiums received to an account which, pursuant to state law or regulation, is segregated from the general accounts of the company; b) the policy must be a life insurance contract; and c) the amount of the death benefit under the policy must be adjusted on the basis of the investment return and the market value of the segregated account.25 A variable policy that fails to be adequately diversified in any year is not treated as life insurance for that year and all subsequent years, even if the investments are subsequently diversified.26
Purchasing and Funding PPLI
Even if a policy satisfies the above requirements so that it produces the intended income tax benefits, there are considerations related to purchasing and funding life insurance that are unique to PPLI.
• Costs — The primary reason that PPLI is more cost effective than traditional life insurance is that agent commissions are lower. A commission on a traditional policy may be as high as 120 percent of the first year premium; PPLI commissions tend to range from 0.2 percent to 0.5 of cash surrender value.27 When evaluating the costs of structuring PPLI, the purchaser must also be sensitive to various taxes imposed on the purchase of life insurance. Domestically, the purchaser will be liable for a deferred acquisition costs (DAC) tax and a state premium tax. The DAC tax is a charge passed on by domestic insurance companies to the purchaser. It typically ranges from 0.3 to 1.5 percent of premiums paid. The state under which a policy is written also imposes a tax on the issuance of the policy, which typically ranges from 1 to 3.5 percent of premiums paid and is passed along to the purchaser. Internationally, most commonly in Bermuda, the costs are often much lower. However, the U.S. imposes a 1 percent excise tax on premium payments to non-U.S. insurance companies with respect to life insurance policies issued on the life of a U.S. citizen or resident, unless the insurance company has elected to be taxed as a U.S. insurance company (in which case, the DAC tax will apply instead).28
• Ownership — Because PPLI is predominantly structured for income tax purposes, many clients choose to purchase and fund PPLI directly, rather than through a trust structure. From a pure income tax perspective, this is certainly the cleanest and simplest option (in addition to the fact that the PPLI itself will already simplify reporting by taking certain taxable investments out of the client’s portfolio and reallocating the capital in the nontaxable PPLI). For a younger client who anticipates an exit from the policy, this is often the preferred option. However, direct ownership produces no estate or GST tax benefit. Accordingly, trust structures should be considered.
• Trust Structures — A traditional irrevocable life insurance trust (ILIT) is the obvious choice for ownership of the policy when estate and GST tax considerations are at issue. However, there are two significant challenges when using an ILIT with PPLI that are less often faced in traditional life insurance planning.
The first challenge is funding the trust. Because PPLI requires substantial cash contributions over a relatively short period of time, annual exclusion gifting is generally not sufficient. Assuming the client has not used his or her entire exclusion amount, a large seed gift to the trust may provide the necessary cash for investment in the policy. But even then there may not be sufficient funds. An attractive solution to the funding issue is a private split-dollar arrangement. A split-dollar arrangement is one where two or more parties share the costs and benefits of a life insurance policy. Although a discussion of private split-dollar arrangements is beyond the scope of this article, it should be noted that a method known as the loan regime (or collateral assignment method) is highly effective when someone other than the insured, such as an ILIT, is the owner of the policy.29 This, in essence, allows the ILIT to borrow the premiums from the insured.
The second challenge is allowing the insured, who creates the ILIT, to have access to cash withdrawals or loans from the policy. One strategy is for the ILIT to lend the cash withdrawal or loan proceeds back to the insured. However, there can be no formal agreement in advance of the planning that this take place, and great caution should be taken to avoid any potential argument that the insured and the trustee of the ILIT had an implied agreement that the insured would be able to borrow from the ILIT at will. The existence of an actual or implied agreement would cause estate tax inclusion to the insured either under §2036, which causes inclusion when a transferor (the insured) has retained the enjoyment of transferred property, or §2042, which causes inclusion when an insured has retained incidents of ownership over the policy. One way to mitigate this risk is for the insured to create an ILIT for the benefit of his or her spouse. The trustees of the ILIT could withdraw or borrow funds from the PPLI policy and distribute those funds to the insured’s spouse, thereby giving the insured indirect access to the policy cash values. Of course, if the beneficiary spouse predeceases the insured spouse, this technique loses its effectiveness.
Additional Considerations
• Federal Securities Requirements — In order to be eligible to purchase U.S.-issued PPLI, the purchaser must be a “qualified purchaser” and an “accredited investor” under federal securities law. A qualified purchaser is generally any individual whose net worth exceeds $5 million, trusts with $25 million or more in assets, and trusts with less than $25 million in assets if the trustee and each contributor of property to the trust is a qualified purchaser.30 An accredited investor generally includes any individual whose individual net worth, or joint net worth with that individual’s spouse, exceeds $1,000,000.31 It also includes any trust with total assets in excess of $5,000,000 that was not formed for the specific purpose of acquiring the offered securities and whose purchase is directed by a “sophisticated person.”32 A sophisticated person is any person who has such knowledge and experience in financial and business matters that he or she is capable of evaluating the merits and risks of the prospective investments.33 These same requirements technically do not apply to the purchase of non-U.S. issued PPLI, because the policy is outside the jurisdiction of U.S. securities law. However, if the policy will be used to acquire underlying investments that are U.S. regulated, then practically it is necessary for the purchaser to qualify under U.S. securities laws.
• Asset Protection — For Florida residents, PPLI offers the additional benefit of asset protection. F.S. §222.14 provides that the cash surrender value of life insurance issued upon the life of a Florida resident is not subject to the claims of the insured’s creditors. The death benefit payable on the policy is also exempt from creditors, so long as the death benefit is not payable to the insured’s estate. As with any asset protection planning, the potential purchaser must tread lightly to avoid fraudulent conveyance laws; yet when this planning is done in advance of a creditor’s claim, it can be a very powerful way to shield sizeable investments.
• Foreign Reporting — Several reporting requirements may apply with respect to non-U.S. issued PPLI. First, if the cash surrender value of the policy exceeds $10,000 at any time during the calendar year, the legal or beneficial owner of, or any person with signature authority over, the policy must file FinCEN Form 114 (Report of Foreign Bank and Financial Accounts), commonly known as the FBAR.34 Second, if the cash surrender value of the policy exceeds $50,000 on the last day of the tax year (or $75,000 at any time during the tax year), the owner of the policy for tax purposes must file Form 8938 (statement of specified foreign financial assets). Finally, if the policy is owned through an non-U.S. entity or trust, additional caution should be taken regarding filing requirements, which may include, by way of example, Form 3520 (Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts), Form 3520A (Annual Information Return of Foreign Trust with a U.S. Owner), Form 5471 (Information Return of U.S. Persons with Respect to Certain Foreign Corporations), Form 8858 (Information Return of U.S. Persons with Respect to Foreign Disregarded Entities), and Form 8865 (Return of U.S. Persons with Respect to Certain Foreign Partnerships).
Conclusion
The increase in the transfer tax exemptions and the convergence of the transfer tax rate and income tax rate has begun to shift some of the thinking in estate planning. With more clients looking for income tax deferral and avoidance techniques, planners should carefully consider PPLI. PPLI certainly presents a host of complex legal issues and practical funding issues. However, if structured properly, this can be a powerful technique to produce income and transfer tax savings.
1 I.R.C. §72(e)(5). An owner’s investment in the contract is equal to the sum of the premiums and other consideration paid, minus the aggregate amount received under the policy prior to the withdrawal that was not subject to tax. I.R.C. §72(e)(6). All citations herein are to the Internal Revenue Code of 1986, as amended, and the Treasury Regulations promulgated thereunder (unless otherwise indicated).
2 Id.
3 I.R.C. §7702(f)(7).
4 I.R.C. §101(a).
5 See, e.g. , Helvering v. Le Gierse, 312 U.S. 531 (1941).
6 See, e.g., Rev. Rul. 2003-92, 2003-2 CB 350; Rev. Rul. 2003-91, 2003-2 CB 347; Rev. Rul. 81-225, 1981-2 CB 12; Rev. Rul. 80-274, 1980-2 CB 27; Rev. Rul. 77-85, 1977-1 CB 12.
7 See Rev. Rul. 2003-92, 2003-2 CB 350; Rev. Rul. 2003-91, 2003-2 CB 347; Priv. Ltr. Rul. 200244001; Priv. Ltr. Rul. 9752061.
8 Priv. Ltr. Rul. 9752061.
9 I.R.C. §7702(b).
10 I.R.C. §7702(f)(2)(A).
11 The present value of the future death benefits is determined by using a) an interest rate of 4 percent, or the rate guaranteed in the policy; b) the mortality charges specified by the policy; and c) any other charges specified by the policy. See I.R.C. §7702(b)(2).
12 I.R.C. §7702(c)(3). The guideline single premium is similar to the net single premium discussed above, and is determined using a) an interest rate of 6 percent, or the rate guaranteed in the policy; b) the mortality charges specified by the policy; and c) any other charges specified by the policy.
13 I.R.C. §7702(c)(2); I.R.C. §7702(c)(4). The guideline level premium is computed on the same basis as the guideline single premium, except that a 4 percent interest rate is substituted for the 6 percent interest rate used in calculating the guideline single premium.
14 I.R.C. §7702(d).
15 I.R.C. §7702(d)(2).
16 Id.
17 I.R.C. §7702A(b).
18 I.R.C. §7702A(b).
19 I.R.C. §72(e)(1)(A).
20 I.R.C. §72(v).
21 Treas. Reg. §1.817-5(a)(1); I.R.C. §7702(g).
22 Treas. Reg. §1.817-5(b)(1)(i). A segregated asset account is not treated as failing the diversification requirements if such failure results solely from market fluctuations. Treas. Reg. §1.817-5(d).
23 Treas. Reg. §1.817-5(c)(1). The regulations provide a grace period pursuant to which a segregated account that is not a real property account is not required to meet the diversification requirement until its first anniversary date.
Treas. Reg. §1.817-5(c)(2)(i).
24 Treas. Reg. §1.817-5(f)(2).
25 I.R.C. §817(d).
26 Treas. Reg. §1.817-5(a)(1).
27 See Giordani, Offshore Private Placement Life Insurance and Annuity Applications for U.S. and Non-U.S. Taxpayers, 13th Annual ALI-ABA Course of Study for International Trust and Estate Planning (August 19-20, 2010).
28 See I.R.C. §4371(2); I.R.C. §953(d).
29 See Zaritsky & Leimberg, Tax Planning with Life Insurance, Analysis with Forms ¶6.05 (2d ed. 2004) (detailed discussion on split-dollar life insurance).
30 Section 2(a)(51) of the Investment Company Act of 1940.
31 17 C.F.R. 230.501(a)(5).
32 17 C.F.R. 230.501(a)(7).
33 17 C.F.R. 230.501(b)(2)(ii).
34 FinCEN Form 114 superseded the former FBAR, TD F 90-22.1.
Scott A. Bowman and Nathan R. Brown are attorneys at Proskauer in Boca Raton. They practice in the areas of domestic and international estate planning.
This column is submitted on behalf of the Tax Law Section, Cristin Conley Keane, chair, and Michael D. Miller and Benjamin Jablow, editors.
