High net worth families constantly evaluate mechanisms for growing and transferring wealth in a tax-efficient manner. With increasing state and federal individual income tax rates, enacted and anticipated legislative tax changes and increasing administrative complexity accompanying private (hedge fund) investments, life insurance may be an attractive strategy for families to consider, not only for its asset protection and death benefits, but also for its tax-efficiency and simplicity. In particular, using private placement life insurance (PPLI) as the ownership vehicle for private investments provides tax-efficient death benefits and non-taxable cash value accumulation potential, attributes that may benefit families with sufficient liquidity and sophisticated planning needs. Families should consider the unique benefits of PPLI, coupled with trust and investment planning, in advance of or in connection with proposed and anticipated tax laws changes and future wealth transfers.
Life Insurance Tax Benefits
Life insurance provides significant tax advantages relative to other ownership structures. These benefits include: (1) the deferral of investment gains (dividends, interest and capital gain); (2) the ability to withdraw and borrow from the policy cash value free of income tax; (3) the transfer of policy proceeds to the beneficiaries after the insured’s death on an income tax-free basis, eliminating all deferred gains; and (4) the absence of Forms K-1 to the policyholder. While variable universal life (VUL) policies were developed to provide benefits to the policy owners for the investment returns inside the policy, the investment choices under VUL policies are somewhat limited. PPLI policies, however, may provide the same benefits for its insured as under VUL policies, but with the added benefit of broader flexibility for the policy’s underlying investments. PPLI policies may invest in alternative investments, such as hedge funds, real estate, closely held businesses, intellectual property and other sophisticated investments. Therefore, PPLI policyowners can establish a tax-free investment vehicle with a lower possible cost, subject to certain structuring requirements and restrictions.
PPLI policies have a unique structure that differs from VUL policies because the cash value of the PPLI policy is invested and managed by a designated third-party investment manager. This cash value is held in a separate account, dedicated exclusively to the owner’s PPLI policy, which is then invested in a separately managed account (SMA) or insurance dedicated fund (IDF) with annual insurance premium amounts subsequently added over the insured’s lifetime. Cash can be disbursed from the SMA or IDF to the separate account to pay policy charges, disbursed to the policyowner as a withdrawal, loaned, or invested in a fixed account for a loan to the policyowner. Upon the insured’s death, the insurance carrier pays the death benefit proceeds (reduced by any prior withdrawals and outstanding policy loans) to the policy beneficiaries.
If properly structured, PPLI policies are treated like retail life insurance policies for tax purposes, despite having more options as an investment vehicle. For example, the annual income of the policy (any excess of the cash surrender value increase and cost of the life insurance protection less the annual premiums paid) is not taxable to the policyowner. Similarly, the cash value distributed from a properly-structured policy in the form of withdrawals, up to the cost basis or value of the loans, also do not result in the recognition of taxable income. The death benefit proceeds received because of the insured’s death are also not includible in the recipient’s gross income, and, if coupled with trust planning may be excludible from the insured’s gross estate for federal estate tax purposes. Furthermore, since the policy is not a taxpayer, investments in pass-through entities will not delay the filing of the taxpayer’s tax return because the Forms K-1 are issued to the policy, not the owner.
Using PPLI policies is an appropriate strategy for individuals who meet certain criteria and/or have certain goals. These criteria and/or goals include but are not limited to: (1) being an accredited investor or a qualified purchaser under Security Exchange Commission (SEC) regulations, and adequately insurable; (2) having at least $3 million in cash for annual premium commitments; (3) prioritizing cash value accumulation; and (4) desiring exposure to alternative investments, particularly when the policyowner is a resident of high income-tax state.
In addition to the rules to avoid being classified as a Modified Endowment Contract (MEC) like other insurance policies (and outside the scope of this Article), PPLI policies must also meet certain other requirements. First, the PPLI policy must be maintained with a minimum amount of mortality risk (death benefit) to be treated as life insurance. Second, the policy must satisfy the prohibition against investor control and the investment diversification test. To satisfy the “prohibition against investor control” test, the assets held in the SMA or IDF must be owned by the insurance carrier rather than the policyowner, and, therefore, the policyowner must surrender all control over the investment decisions for this account (the “investor control doctrine”). The policyowner must not have the power to: (1) select investment assets; (2) vote the securities or exercise rights pertaining to these securities; or (3) extract money from the account by a withdrawal. If a policyowner is held to have breached this investor control doctrine, the policyowner may be required to include all interests, dividends and other income earned by the policy assets in his or her gross income for the taxable year.
Then, to satisfy the diversification test, the PPLI policy must follow the Treasury Regulations regarding the minimum number of investments held in the account and the maximum asset values of such investments. Similar to the breach of the investor control doctrine, a breach of the diversification test may result in the PPLI policy not being considered life insurance and, thus, the income on the policy being treated as ordinary income received by the policyowner for the current and future taxable years. While these requirements may seem onerous, they are manageable by experienced SMA or IDF investment managers. Individuals have benefited from increased advisor understanding and experience in helping to satisfy the policies’ legal requirements.
There are additional considerations in purchasing PPLI. There are incremental costs, such as the Federal Deferred Acquisition Charge, State Premium Tax, Structuring Fees, Mortality Charges and an Administration Fee (M&E Fee). As with all tax-advantaged structures, PPLI-based structures are subject to changes in the law and/or changes in the IRS’s interpretation and application of the relevant tax rules. These additional considerations may be discussed with a financial advisor or attorney, and are outside the scope of this article.
Why PPLI Now
Individuals may consider discussing a PPLI policy as an investment, tax planning and wealth transfer strategy because of changes in tax laws, increasing combined state and federal individual income tax rates, estate and inheritance tax exclusion, and a growing market of products informed advisors. Unlike with “typical” insurance policies where the owners try to stretch out premiums for as long as possible, the owner of a PPLI policy will attempt to fund as large an amount as possible into the policy as one of the goals, maximizing the tax-free growth potential.
To avoid taxpayers overfunding or excessively pre-funding policies, Congress adopted rules aimed at scaling back this potential abuse. For example, Internal Revenue Code (IRC) Section 7702 limited the permitted amount of funding in order for the policy to retain its character as insurance. More recently, however, PPLI policies benefitted from changes to IRC Section 7702 that introduced a formulaic interest rate for determining the maximum amount of premium that can be paid into a policy and meet certain tests and non-MEC classification. IRC Section 7702 now incorporates a dynamic interest rate model for defining the statutory minimum interest rates. This model allows the interest rates to change over time to align with changes in market rates. Therefore, this change increases reserve levels and cash value levels for new policies, such that taxpayers can fund these policies more quickly.
Combined state and federal income tax rates, along with proposed increases to the federal rates and wealth transfer goals, make PPLI a beneficial strategy for consideration by individuals and families. As of January 1, 2022, California (13.30%), New York (10.90%), New Jersey (10.75%), DC (10.75%), Oregon (9.90%) and Minnesota (9.85%) have some of the highest marginal state individual income tax rates. With the highest marginal federal individual income tax rate of 37% plus the Net Investment Income Tax of 3.8%, the combined marginal state and federal income taxes for some individuals could reach or exceed 50%. Therefore, individuals may seek tax-efficient vehicles for their investments. Rather than pursuing only tax-free or tax-efficient asset classes, using a PPLI policy may help individuals stay diversely invested in multiple asset classes, including hedge funds and other alternative investments.
As previously mentioned, life insurance may be excluded from an insured’s taxable estate if the insured held no incidents of ownership up to three years prior to his or her death. Currently, the value of retail life insurance may not seem to be important for estate tax planning for many individuals and families. In 2022, the federal estate tax exemption amount is at an all-time high of $12.06 million for a decedent (or $24.12 million for a married couple), which will likely be further adjusted for inflation in 2023. Therefore, many individuals and families, even with retail life insurance policies with large valuations, may not become subject to the federal estate tax. However, by January 1, 2026, absent Congressional action, this exemption reverts to $5.45 million (or $10.9 million for a married couple) (indexed for inflation), and more decedents may be subject to the federal estate tax of 40% on their gross estate in excess of this exemption. Decedents with large investment portfolios may benefit from transferring some of this wealth into a PPLI policy.
In some states that have a state inheritance tax, such as Pennsylvania and New Jersey, life insurance proceeds, including the death benefits from PPLI policies, are also exempt for state inheritance tax purposes. Furthermore, by transferring the ownership of the PPLI policy into an irrevocable life insurance trust, the insured may exclude the value of the PPLI policy from his or her gross estate for federal estate tax purposes. Now, prior to the potential estate tax changes, individuals may want to structure their planning in order to start the three-year look-back period for this exclusion applicable to existing policies.
Finally, the number of investment managers with knowledge and experience in managing the SMA or IDF for a PPLI policy have grown significantly over the past few years. This growth offers individuals more options, with negotiable fees and costs, and greater flexibility in their customized PPLI policy strategy. The collaboration among these investment managers with tax and estate planning attorneys and accountants results in a better understanding, construction, and management of these policies and this PPLI strategy for individuals and families.
Families realize that their investment, tax planning and wealth transfer strategies require regular review and analysis with their trusted advisors. Subject to high state and federal individual income tax rates, along with proposed and scheduled future increases, and with sophisticated investment portfolios, families may consider private placement life insurance as a tax-efficient vehicle for accumulating and transferring wealth. Advisors are more educated with expanding resources, such as increased coordination, tax law changes to interest rate calculations and customized investment mandates, to accommodate families’ unique needs in using PPLI as a tax and wealth strategy.