United States: Private Placement Life Insurance Planning

Article by Leslie C. Giordani , Michael H. Ripp and Amy P. Jetel

A. Introduction: "Big Picture" Estate and Tax Planning

This article will examine two strategies that fall outside the bounds of a traditional estate planning framework, although they are well within the "big picture" that clients wish their estate planners to address; and in many ways, these two strategies go hand-in-hand. The first is private placement variable universal life insurance ("PPVUL"), an investment-oriented strategy that can dramatically improve the tax efficiency of a client's investment portfolio. The second is hedge fund investing, an investment strategy that has rapidly gained popularity among taxable investors in today's equity market environment due to its ability to deliver superior risk-adjusted returns in both bull and bear markets.

B. Private Placement Variable Universal Life Insurance

1. Introduction

As the investment power of high-net-worth individuals continues to grow, legal and financial advisors are frequently asked about tax-advantaged structures for passive investments. A life insurance policy that is U.S.-tax compliant, especially one offered by an established carrier, presents a conservative and cost-effective investment opportunity. By virtue of the substantial lobbying influence of powerful interest groups, including the U.S. life insurance industry, life insurance as a financial product has had a long history in the United States as a tax-advantaged investment vehicle with minimal legislative risk. Certain carriers with well-established operations both inside and outside of the U.S. offer "private placement" (or, more appropriately, "customized") policies that are fully compliant with U.S. tax rules and are, therefore, fully entitled to the preferential tax treatment that life insurance enjoys. With proper policy design, an investor can place wealth in a tax-free investment environment at a low cost, achieve protection against future creditor risk and local economic risk, gain financial privacy, and enjoy superior flexibility with regard to the policy's underlying investments.

Despite the long-standing availability of variable universal life insurance products in the retail market, the PPVUL market is still in its growth and development phase, and there are significant traps for the unwary. Accordingly, it is important for the advisor who counsels high-net-worth clients for whom private placement life insurance planning is advantageous to understand the tax, investment, and pricing aspects of life insurance generally, and to be able to weigh the advantages and disadvantages of an offshore private placement policy against a domestic private placement policy or a domestic retail policy. It is equally important for the advisor to be attuned to jurisdictional issues when planning the life insurance ownership structure and for the advisor to engage the services of a knowledgeable intermediary, such as an experienced insurance broker that dedicates itself to the private placement marketplace, to be involved in the design of the product, the selection of the carrier (and the attention to related due diligence issues), and the ongoing service and compliance matters related to the policy itself.

2. What PPVUL is Not

There are currently two insurance structures other than PPVUL on the market that have recently come under a significant amount of scrutiny by the Internal Revenue Service (the "Service" or "IRS"). These structures are Internal Revenue Code ("IRC") § 501(c)(15) insurance companies and equity acquisitions of offshore insurance company stock. It is essential to understand that these structures are unrelated to the PPVUL structure discussed in this article.

The first structure mentioned, an IRC § 501(c)(15) insurance company, is statutorily defined in the Internal Revenue Code. IRC § 501(c)(15) was originally passed as a way to assist farmers who lacked easy access to the insurance market. The goal of IRC § 501(c)(15) was to allow these farmers to set up small insurance companies that would be considered tax-exempt, provided that they collected less than $350,000 in premiums a year and did not underwrite life insurance. Recently, however, ultra-high-net-worth investors, seeking to shelter assets from income taxation, have availed themselves of the tax benefits available to IRC § 501(c)(15) insurance companies. That is, as long as such an insurance company does not collect more than the $350,000 premium limit per year, it is allowed under IRC § 501(c)(15) to accumulate earnings on its investments income tax-free. Moreover, appreciated assets may be transferred to the corporation in exchange for stock when the company is initially capitalized. These insurance companies are legal under the letter of the law, and several of them have accumulated millions of dollars of tax-free earnings for their investors. However, the IRS apparently now perceives the use of IRC § 501(c)(15) insurance companies to be investor abuse in some cases. Accordingly, the IRS issued Notice 2003-35 in May 2004 to remind the public that an IRC § 501(c)(15) insurance company's primary purpose is to provide insurance, not investment opportunities.¹ Notice 2003-35 also advises that the IRS will begin active investigation of these entities in the near future.

The other insurance structure attracting the IRS's attention has as its purpose the conversion of hedge fund earnings from ordinary income and short-term capital gain income into long-term capital gain income. As mentioned above, hedge funds have become increasingly popular over the last several years due to their consistent outperformance of other investment strategies. This performance has driven investors to seek ways to avoid paying the high level of income tax typically attributed to hedge fund returns. The strategy involving the acquisition of offshore insurance company stock, sometimes referred to as the "equity transaction," involves a hedge fund manager or other investment service provider setting up an offshore insurance company. The organizer then seeks equity investors for the insurance company (i.e., investors interested in hedge funds), promising to allocate the investor's equity to a specified investment account, typically the investor's preferred hedge fund(s). The primary argument made by the IRS in connection with this structure is that the insurance company is not actually taking on insurance risk and therefore does not meet the definition of an insurance company.²

Both IRC § 501(c)(15) insurance companies and the equity transaction differ greatly, in design and purpose, from a PPVUL structure. Potential PPVUL purchasers may hear the buzzwords "offshore insurance company" and "hedge fund" and immediately worry that PPVUL policies issued by offshore carriers are subject to the IRS scrutiny they have read about in recent newspaper articles.³ This, however, is not the case.

3. The U.S. Client

PPVUL insurance offers to U.S. qualified investors⁴ the ability to select asset management beyond the limited asset-management choices offered in retail variable life insurance products. This is attractive to high-net-worth clients who may have investment mandates that involve more sophisticated strategies such as hedge funds. Due to the expense associated with regulatory pressures imposed by federal and state securities laws and by state insurance boards, some domestic companies have more limited investment platforms than their offshore counterparts. Because offshore insurance companies are not subject to the same bureaucracy and regulations imposed within the U.S., they are able to engage investment managers with greater ease.

Generally, the client's motivations for investing in a PPVUL policy differ quite a bit from the reasons that U.S. persons typically purchase life insurance. Its value in the high-net-worth market is as an investment vehicle, optimally used for the most tax-inefficient asset classes in an investor's portfolio. The purchase of death benefit is secondary. Usually, therefore, the core goals for acquiring a PPVUL insurance product are to take advantage of the income-tax and possible estate-tax savings, to maximize investment choices, and to incur as little cost as possible in doing so. There are additional advantages of investing in a PPVUL insurance policy issued offshore that will be discussed in detail below.

4. Foreign Trusts with U.S. Beneficiaries

Private placement life insurance products offered by offshore carriers are also beneficial for other types of clients, such as foreign persons who have created foreign trusts with U.S. beneficiaries. Prior to the enactment of the Small Business Job Protection Act of 1996 (the "1996 Act"),⁵ a foreign person could, with relative ease, establish a grantor trust with one or more U.S. beneficiaries. As with all grantor trusts, the foreign grantor was essentially treated as the owner of the trust for U.S. federal income tax purposes.⁶ This was advantageous for several reasons. First, as long as the trust's assets were invested in property producing income from foreign sources or capital gain income from domestic or foreign sources, the income derived by the trust would generally be treated, for U.S. income tax purposes, as that of the foreign person who was the grantor and would not be subject to U.S. federal income tax. Second, distributions from the trust to U.S. beneficiaries were classified as distributions from a grantor trust, so U.S. beneficiaries who received distributions from the trust were not subject to U.S. federal income taxation on such distributions. Finally, under the terms of the trust, there was usually no requirement for trust income to be distributed each year, so monies could accumulate in foreign grantor trusts as long as desired and be distributed to the beneficiaries income-tax-free at some later time.

The 1996 Act effectively eliminated the grantor trust status of these foreign trusts by treating a person as owning assets of a trust only if that person is a U.S. citizen, U.S. resident, or domestic U.S. corporation.⁷ As a result, a foreign person who creates a trust is no longer considered the owner of the trust's assets, and the trust is classified as a non-grantor trust for U.S. federal income tax purposes.⁸ When a trust has been classified as a foreign non-grantor trust, it is possible for the trust to defer U.S. federal income taxation because, ordinarily, the earnings of such a trust would not be taxed directly by the U.S., with certain exceptions.⁹ However, when income is distributed from the trust to a U.S. beneficiary, it is taxable to such U.S. beneficiary. Specifically, a U.S. beneficiary is taxable on amounts of income currently distributed from the trust's worldwide distributable net income ("DNI").¹⁰ The character of the income on trust assets when distributed to the U.S. beneficiary is determined at the trust level, even though the trust itself may not pay U.S. income tax on such income or gain.¹¹

Furthermore, distributions from foreign non-grantor trusts of undistributed net income ("UNI") are classified as accumulation distributions and taxed according to the "throwback" rules. In general, the throwback rules tax accumulation distributions to a U.S. beneficiary at the tax rate that would have been paid if the income had been distributed in the year that the trust originally earned such income. The net result is that, at the time of distribution, a U.S. beneficiary would be subject to tax first on the trust's current year DNI and, if current year distributions exceed DNI, then on the trust's UNI. Additionally, when a distribution is made that is classified as UNI, an interest penalty is assessed and applied to the tax on the accumulation distribution. The effect of the interest charge can cause an effective tax rate of 100 percent to apply after several years of accumulation.

Despite the effective elimination of foreign grantor trusts (created by foreign persons) and all of the attendant benefits, all is not lost. When planning on behalf of a trust to which these rules apply, the goal is to reclassify trust income as something that is exempt from income tax in order to mirror the structure of the old foreign grantor trusts. Life insurance achieves this goal because income earned inside the policy is not taxed currently to the owner of the policy. Moreover, income distributed from the policy during the life of the insured is generally nontaxable under current law, if properly structured.¹² Finally, all amounts paid out of the policy to the policy beneficiary as death benefit proceeds are not subject to U.S. income tax.

For existing foreign non-grantor trusts with undistributed net income (and previously classified foreign grantor trusts with income accumulated after the 1996 Act), offshore PPVUL insurance can be an effective tool to stem the ever-increasing accumulation of taxable income inside these trusts. In a typical situation, trust assets are used to pay life insurance premiums. As trust assets are gradually depleted by annual premium payments, the further accumulation of distributable net income ceases. Note that the trust may still contain pre-existing undistributed net income that is taxable to the U.S. beneficiary (and subject to the interest penalty) whenever the trustee makes a distribution in excess of DNI. Over time, however, cumulative distributions to the beneficiaries may exhaust this pre-existing UNI. Thereafter, the trustee may generally withdraw or borrow funds from the policy on a tax-free basis and then distribute those proceeds (also on a tax-free basis) to the U.S. beneficiary.

5. Tax Considerations

a. U.S. Federal Income Tax Benefits

The U.S. federal income tax advantages of life insurance are the same whether the policy is acquired onshore or offshore. First, earnings on policy cash values, including dividends, interest, and capital gains, are not taxable to the policy owner as they accumulate within the policy.¹³ Because earnings on policy cash values are generally not taxable, the policy's cash value grows much quicker than when compared to a taxable investment portfolio. Consider the following example of a taxed investment versus accumulation inside a private placement life insurance policy. The hypothetical example assumes single-life coverage on a 45-year-old male, with a $2.5 million annual premium for four years, a 10 percent rate of return net of investment management fees (all of which is taxed as ordinary income [at 40 percent, which represents a hypothetical federal-plus-state income-tax rate] in the taxed scenario, as would be the case with a hedge fund investment).

In addition to the tax-free accumulation of the policy's cash value, withdrawals and policy loans by the policyholder can be used to access policy assets during the lifetime of the insured. Generally, such withdrawals and loans are received income-tax-free.¹⁴ Finally, the proceeds payable at the death of the insured are excluded from the taxable income of the beneficiary,¹⁵ and with proper structuring, may also be excluded from the taxable estate of the owner insured.¹⁶

b. Other Potential Tax Benefits

Enhanced tax advantages are available to a client who, by completing all aspects of the transaction offshore,¹⁷ acquires a PPVUL policy issued by an offshore carrier. First, no state premium tax is payable when a PPVUL insurance policy is issued offshore. This results in a savings, in most states, of approximately two to three percent of the premium. Second, the federal deferred acquisition cost ("DAC") tax and/or federal excise tax that is assessed on the premium of a policy issued by a foreign company will be less than the DAC tax paid on a similar policy issued onshore. The DAC tax on a policy issued onshore is generally about one to one and a half percent of premiums paid. The overall tax paid on a policy issued offshore will be less; however, the actual amount of the tax will depend on whether the policy is issued by a company that has elected to be taxed under IRC § 953(d) as a domestic corporation (the "953(d) election"). If the insurance company has made the 953(d) election, a reduced DAC tax of less than one percent of premium will normally apply. If the insurance company has not made the 953(d) election, no DAC tax will apply; however, a one percent U.S. federal excise tax on premium payments will be payable.¹⁸ Overall, the absence of the state premium tax and reduced or no federal DAC tax offshore, along with no or low premium sales loads, contributes to the substantially improved yields compared to taxable investments, as illustrated above.

c. Transfer Tax Planning

In addition to the considerable income tax benefits of life insurance planning, many clients also desire a flexible framework for transferring wealth to their children or multiple future generations in a transfer-tax-efficient manner. For example, a senior generation can pass assets in a leveraged manner to the next generation with minimal transfer-tax liability by creating an irrevocable life insurance trust and by funding the insurance purchase through an alternative premium-paying arrangement, such as an intrafamily loan.¹⁹ When a client's net worth suggests the need for removing substantial assets from the estate tax base, private placement life insurance, a traditional irrevocable life insurance trust, and an alternative premium-paying arrangement can be a very effective combination.

d. Irrevocable Life Insurance Trust

An irrevocable life insurance trust ("ILIT") is a commonly used estate planning technique. When the ILIT will receive completed gifts which are in turn invested in an offshore private placement policy, the trust should be a foreign trust for legal purposes (because it is important that the policy have a foreign owner due to state regulatory concerns). Also, it may be best to structure the trust as one that is domestic for tax purposes in order to avoid the onerous foreign trust reporting requirements, and more importantly, to avoid the potential negative application of IRC § 684.²⁰ The classification of a trust as domestic for tax purposes can be accomplished by satisfying the definitional requirements set forth in IRC § 7701.²¹

Because it is important for the settlor's gift to the irrevocable life insurance trust to be a completed gift for gift tax purposes, the settlor should not retain a testamentary power of appointment.²² In addition, the settlor should retain no powers under the trust agreement that would cause the trust assets to be includible in the settlor's estate for estate tax purposes.²³ Moreover, the allocation of generation-skipping transfer ("GST")²⁴ tax exemption (if available) to the initial funding (as well as ensuring that additional assets contributed to the trust also are GST tax exempt) permits the policy proceeds to be received and passed free of GST tax as well.²⁵ This planning effectively removes the death proceeds from the estate of the settlor/insured and exempts the assets in the trust from the GST tax as well.

As noted above, it is important that the trust, as owner of an offshore life policy, be foreign for ownership purposes to reduce the nexus between the policy and the U.S. jurisdiction where the client resides. This should negate an argument that the policy was acquired onshore and could possibly therefore be subject to state premium tax.

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Footnotes

1 IRS Notice 2003-35, I.R.B. 2003-23, May 9, 2003.

2 See IRS Notice 2003-34, I.R.B. 2003-23, May 9, 2003.

3 See, e.g., Johnston, David Cay, Insurance Loophole Helps Rich, N.Y. TIMES, April 1, 2003; McKinnon, John D., U.S. May Curtail Hedge-Tax Haven Tied to Insurance, WALL S. J., September 12, 2002.

4 Many offering memoranda for offshore PPVUL policies reference "qualified purchaser" or "accredited investor" standards, as used in U.S. securities law, to describe suitable investors. In the offshore context, this should be considered merely a guideline and not a strict requirement because offshore policies are not actually subject to SEC regulations. However, if the premiums of an offshore PPVUL policy are to be invested in funds that do require investors to be "qualified purchasers," then the policy owner must be a "qualified purchaser" for that purpose. In the domestic context, because private placement products in the U.S. are subject to SEC regulations, each purchaser generally must be a "qualified purchaser" under section 2(a)(51) of the Investment Company Act of 1940, 15 U.S.C. §80a-2(a)(51), and an "accredited investor" under section 501(a) of Regulation D of the 1933 Act, 17 C.F.R. 230.501(a).

5 The Small Business Job Protection Act was signed by President Clinton on 20 August 1996. The 1996 Act changed income tax law and reporting related to foreign trusts in two significant areas: (1) for U.S. beneficiaries who receive distributions from trusts created by foreign persons, and (2) for U.S. persons who create foreign trusts.

6 If a trust is classified as a grantor trust, the trust is essentially viewed as a pass-through entity, because the grantor is deemed to be the owner of part or all of the trust for U.S. federal income tax purposes. See IRC §§ 671-679.

7 Any foreign grantor trust that was in existence prior to September 20, 1995, is "grandfathered" and will continue to be a grantor trust as to any property transferred to it prior to such date provided that the trust continues to be a grantor trust under the normal grantor trust rules. Separate accounting is required for amounts transferred to the trust after September 19, 1995, together with all income and gains thereof.

8 There are exceptions to this rule that are beyond the scope of this article. See Treas. Reg. § 1.672(f)-3.

9 Exceptions include certain income, dividends, rents, royalties, salaries, wages, premiums, annuities, compensations, remunerations, and endowments or other "fixed or determinable annual or periodic gains, profits, and income" ("FDAP" income) derived from the U.S. and income that is effectively connected with the conduct of a U.S. trade or business.

10 This situation applies to discretionary distributions from foreign complex trusts; the situation would be somewhat different for U.S. beneficiaries of foreign simple trusts or foreign complex trusts with mandatory distribution provisions.

11 Capital gain income is included in determining DNI, and retains its character in the hands of the U.S. beneficiary if distributed in the year that it was earned by the trust.

12 In general, this means making withdrawals from a non-modified endowment life insurance policy up to the policy basis, then switching to policy loans. See note 14, infra.

13 See IRC § 72; IRC § 7702(g)(1)(A). Some income (e.g., dividends) attributable to policy assets may nevertheless be subject to taxation (e.g., by source withholding).

14 Note that if a policy is a modified endowment contract ("MEC") as defined by IRC § 7702A, proceeds of a loan or withdrawal are taxed as ordinary income to the extent of any gain in the policy cash value before the loan or withdrawal. To avoid this taxation, therefore, it is crucial that MEC status be avoided when it is intended that the policy cash value be accessible during the insured's lifetime through loans or withdrawals. On the other hand, due to the higher insurance-related costs of non-MECs, MEC status does not need to be avoided when a policy is designed to pass wealth from one generation to the next without a need to access policy cash value during the insured's lifetime. Generally, non-MECs are characterized by a premium paid over five or six years, while MECs are characterized by a one-time, up-front premium payment.

15 See IRC § 101(a)(1).

16 See IRC § 2042. Generally, as long as the premium payor does not retain "incidents of ownership," the policy proceeds will be excluded from his or her estate for estate tax purposes.

17 Most states in the U.S. impose a premium tax on life insurance policies. However, as long as the policy is negotiated, applied for, issued, and delivered offshore, state insurance taxes should not apply to an offshore PPVUL purchase. Nevertheless, state laws applicable to the policy owner, insured, and beneficiary must be carefully examined on a case-by-case basis. Furthermore, although the constitutionality of such statutory provisions might be questionable, some states impose a "direct procurement tax" to collect the premium tax for transactions on the lives of state residents that take place out-of-state. Domestic producers have tried to capitalize on the fact that Alaska and South Dakota assess very low levels of premium tax, and thus offer prospective purchasers a low-cost alternative to offshore PPVUL. Recently, however, a major carrier reported that the Texas insurance authorities assessed a premium tax on premiums paid for an Alaska PPVUL policy issued on the life of a Texas insured and then successfully collected that assessment. As a result, the tax-savings opportunity offered by Alaska and South Dakota PPVUL policies has already been limited in Texas and is likely to see further limitation in other states.

18 See IRC § 4371.

19 A number of other transfer tax planning opportunities exist utilizing life insurance, but a full discussion of all of such opportunities is beyond the scope of this article.

20 Under some circumstances, a U.S. person transferring property to a trust that is considered a foreign trust for tax purposes may be required to pay income tax on the transferred property. Specifically, IRC § 684 treats a transfer of property by a U.S. person to a foreign trust as a sale or exchange for an amount equal to the fair market value of the property transferred. Thus, the transferor is required to recognize gain on the difference between the fair market value of the transferred property and its basis. The rules set forth in IRC § 684 do not apply to the extent that the transferor or any other person is treated as the owner of the trust under section 671, which will typically be the case with a foreign trust with U.S. beneficiaries. See IRC § 679. However, upon the death of a U.S. person who was treated as the owner of a foreign trust during that person's lifetime, gain will be recognized under IRC § 684 (unless that foreign grantor trust's assets receive a step-up in basis under IRC § 1014(a), which would not be the case in a traditionally structured irrevocable life insurance trust to which completed gifts have been made.) See Treas. Reg. §1.684-3(c).

21 Under the regulations to IRC § 7701(a)(31), a trust is a foreign trust unless both of the following conditions are satisfied: (a) a court or courts within the U.S. must be able to exercise primary supervision of the administration of the trust; and (b) one or more U.S. persons have authority to control all substantial decisions of the trust. See Treas. Reg. § 301.7701-7.

22 See Treas. Reg. § 25.2511-2(b).

23 See IRC § 2036 to 2041.

24 The GST tax is a transfer tax (in addition to the estate tax) that is imposed on transfers that skip a generation and at a rate equal to the highest marginal estate tax rate. The purpose of this tax is to prevent the avoidance of estate tax at the skipped generation. That is, in the absence of GST tax, clients could, for example, leave property directly to their grandchildren, without subjecting that property to a transfer tax at their children's generation.

25 See IRC § 2642.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.