Private Placement Life Insurance: The Best of Both Worlds
July 27, 2021
By Brent Lipschultz
With the federal and state budget deficits at all-time highs and international tax compliance increasingly complex, high net worth individuals and family offices may want to consider private placement life insurance (“PPLI”) as a way to hold alternative investments in insurance dedicated funds (“IDFs”). It is those individuals who are residents of certain jurisdictions, including New York and California, who realize only 50% of their investment returns as a result of federal and state taxes, making PPLI an ideal tool to address these and other concerns, including a potentially higher federal estate tax and higher capital gains tax.
Private placement life insurance accounts invest in insurance dedicated funds that grow on a tax-free basis and are paid out income tax-free at the passing of the insured. Over the years, a significant increase in the number of investment options became available in registered and non-registered formats that were previously not available when clients first examined the product. The industry continues to grow alongside investor demand. Several private letter rulings have improved the transparency (PLRs 201323003 and 201417007), while PLR 201417007 has sanctioned IDFs that are similar to taxable hedge funds.
The cost of PPLI has been significantly reduced as the products are funded with the lowest insurance amount to prevent the policy from becoming a modified endowment contract and using the reinsurance market in certain cases to reduce the insurance cost. With the legislative fix to IRC §7702, all life insurance policies, including universal life, will have more efficient cash value growth, making them more attractive for those using the policies for increasing cash value. IRC §7702 changed recently by incorporating a dynamic interest rate model for defining the statutory minimum interest rates, allowing the interest rates to change over time to be in line with changes in market rates. This change will have the effect of increasing reserve levels and cash value levels for new policies.
IDFs accumulate returns on an income tax-deferred basis and can be re-allocated among a large group of investments tax-free. Investor withdrawals from the policy are income tax-free to the extent of the policy owner’s contributions, and properly structured loans up to 80-85% can be accessed without income taxation. Finally, investments by the IDFs in offshore companies would not require the international tax reporting that would be required if there was no wrapper. If a PPLI account is fully surrendered, deferred investment gains are subject to ordinary income tax rates. Life insurance benefits received by a beneficiary, including any accumulated investment gains, are fully exempt from income taxation and can be used in the context of estate planning solutions. Because of the new re-engineered way PPLI is structured, when there is a need or desire for a death benefit, it can now be purchased at the lowest guaranteed rate available and paid for with pre-tax growth on the client’s investments. This can be useful in buy-sell or estate planning, especially if clients have used their lifetime exemption.
The IDF must be structured as a separate legal entity attached to the life insurance company’s segregated account with proper diversification. The separate accounts are segregated from the insurer’s general account and not subject to credit risk. Investor control has always been an issue with PPLI, because no account owner can directly or indirectly influence the fund manager with respect to the selection of funds or securities to fulfill the investment mandate. The doctrine of investor control has been developed over several years through IRS private letter rulings as well as a recent tax court case of Webber v. Comm., 144 TC 17. In setting the parameters for what investor control is acceptable, policyholders can allocate and re-allocate among existing funds at the policy owner’s discretion. An investment manager can also create a custom mandated fund for their policyholders and can manage the fund. A fund manager cannot buy assets from the policyholder or pay premiums in kind.
Now could be the right time to consider PPLI, given forecasted tax increases and changes in the dynamics of interest rates, for accumulated tax-free growth while leaving a legacy for your family.