Usually, clients buy private placement life insurance more as an investment vehicle than because they actually want life insurance. But unfavorable rulings and regulations have detracted from PPLI's allure as an investment. Moreover, because high-net-worth individuals often don't need to access the money in their policies for a long time, if ever, those policies become part of their estates.1
For wealthy clients, therefore, all insurance, including PPLI, should be evaluated from an estate-planning perspective. And from this vantage point, conventional life insurance products often are the better deal. Unlike PPLI, they can offer a guaranteed death benefit as well as riders that increase the face amount by the amount of premiums put in and an interest factor. Conventional policies also can be priced better.
PPLI is clearly for the wealthy. There's a bare minimum of $1 million in premiums and most require payments of at least $5 million. Membership has its privileges. The benefits PPLI enjoys that off-the-shelf life insurance does not:
Its sub-accounts can be invested with money managers and/or strategies that are available only to very high-net-worth investors.
The policy seller's commissions are negotiated and generally lower.
Mortality costs are low compared to most commercially available life insurance policies; it's the difference between getting it wholesale versus retail.
PPLI also makes the most of the benefits that all insurance policies enjoy. Investments in sub-accounts that would otherwise be tax-inefficient2 instead have no tax consequences.3 Holders can access their policy's funds without paying income tax (so long as the policy is not a modified endowment).
This is the sizzle that sells PPLI. But there's also some fizz about which clients should be made aware.
RAIN ON THE PARADE
The most dramatic drawback is that the Treasury Department and Internal Revenue Service have purposely made PPLI less appealing to potential investors. Beginning with a private letter ruling in 2002,4 followed by two revenue rulings5 and a proposed regulation6 in 2003,, the feds have hampered the ability of PPLI policies to invest in hedge funds. Now, hedge funds might no longer satisfy the diversification required of insurance policies' investments. With Revenue Ruling 2003-91, the IRS also essentially warned investors to stay out of, indeed not even discuss with their advisors, the strategy decisions made for their insurance's sub-accounts.
Clearly, the government wants people to buy life insurance so they can have the death benefit, and not to create wealth tax-free or to treat the policies just like another investment account. The feds have reiterated this stance in their recent pronouncements on split dollar arrangements,7 Internal Revenue Code Section 412(i) pension plans, and the valuation of life insurance when sold or transferred.8 As IRS Commissioner Mark W. Everson put it in the press release accompanying the move on life insurance valuations: “Today's action sends a strong signal to those taking advantage of certain insurance policies that these abusive schemes must stop.”9
The result of the recent rulings and proposed regulations: If a PPLI is funded with an account that owns a limited partnership interest in a hedge fund, the PPLI may no longer be considered “life insurance.” That means that any investment gain in the policy — even if it comes from qualified dividends or long-term capital gains — will be taxed as if it's ordinary income. Also, the basis for determining gain will be reduced by the cost of insurance paid. The only way to avoid this result is to change the way the PPLI is funded by the last day of the second calendar quarter after the effective date of the regulations (as of presstime, they have not been finalized).
So what should a holder do with his old PPLI? One possibility: Cash out the policy. Of course, this option might be unappealing, because the IRS will tax any gain as ordinary income. What's more, if the owner cashes out at a loss, he won't be able to deduct that loss from his income.
Another option is for policyholders to change the nature of the accounts. For instance, if the insurance company added an insurance-only product as a sub-account using the same managers as before, the policyholder could transfer money from the hedge fund into the other sub-account. Then, the insurance company could eliminate the non-registered partnership interest from the policy.
The more conservative approach is simply to exchange the problematic PPLI for another policy — either a conventional policy or another PPLI — but one that will qualify as life insurance. Of course, this assumes that the insured is still insurable at an attractive rate.
How to choose from these options? The answer depends on whether the holder intends to access the policy while he's alive or intends it as a death benefit for his heirs. If he anticipates needing the money during his life, a PPLI is probably the better choice — provided it's not a modified endownment contract (MEC). MECs are policies in which holders have paid higher premiums than an amount specified by the Internal Revenue Code.
If the holder wants the policy for his heirs, a more conventional arrangement is probably better.
Say the owner chooses to get another PPLI. His first priority should be to maximize the investment return, which can be accomplished by minimizing the so-called mortality cost. This is done by getting the least posssible death benefit.
If the holder wants the option of accessing a policy's cash without the income tax hit, he'll have to structure the policy so it's not an MEC. MECs are taxed like annuities with gain coming out first and taxed as ordinary income.10 If the holder is under 59 1/2 years old, there will probably be a 10 percent penalty.11
To both ensure a contract is not an MEC and minimize death benefits, owners have to pay the premiums over several years. But if accessing the cash is not a major concern, clients should consider MECs.
Owners should keep in mind that the investment results will be different than if all the money was paid up front.
THE ESTATE PLAN
As with all insurance, PPLI must be factored into the estate plan. If the purpose is to benefit heirs, rather than access the money during life, the holder will want the greatest death benefit. To obtain this result, the owner should consider exchanging the old PPLI for a policy that emphasizes the death benefit rather than investment feature. The holder also can exchange the PPLI for an annuity and use the payments to purchase conventional life insurance.
But if the goal is to keep the policy out of the estate, the holder will need to transfer it, either by gift or sale. Here are some divestment options. But keep in mind that the recent rulings make clear that holders can't undervalue the policy after divestment.
Transfer the policy into a limited partnership or LLC, based on an appraised value. If the policy is an MEC, there's an argument that the value should be reduced before taking partnership discounts for lack of control and marketability.
Loan the value of the policy to a trust. The trust then either pays (1) the former holder interest during life and principal at death, or (2) both accrued interest and accrued principal at death. The government considers this type of deal a split dollar arrangement and subjects it to split dollar rules.
Assign the death benefit to a trust. The value assigned is the economic benefit of term insurance as determined by the split dollar regulations.
Sell the policy to an individual or a trust. If the purchaser can't afford the entire policy, the seller can use a self-cancelling installment note, do an installment sale or sell the policy in exchange for a private annuity. The seller can also provide funding using a grantor retained annuity trust, charitable lead annuity trust, grantor retained unitrust or charitable lead unitrust.
PPLI VS. CONVENTIONAL
Before policyholders decide to exchange an old PPLI for a new one, though, they should keep in mind that there are other problems with PPLI:
For MECs, if the policyholder takes cash out of the policy, any profit is taxed as ordinary income rather than at the lower capital gains rate.
If the policy incurs losses, the owner can't deduct them from his taxes.
If owners cash in the life insurance while the insured is alive, any excess above the amout paid will be taxed the same as ordinary income.12
If an owner takes money out of the policy and then the policy lapses, any amount previously received in excess of basis will then be taxed as ordinary income.13
Because PPLI is life insurance, the amount of available coverage is limited. Right now, the maximum amount of death benefit available on an individual is approximately $150 million. For the very wealthy, this limit affects other types of planning that involve life insurance, especially estate planning.
In the end, if estate planning and transfer tax benefits are the primary goal, using a conventional life insurance policy may make the most sense. Such policies are invested in the life insurance company's general account, which is almost entirely comprised of bonds and mortgages. The average of the 100 largest life insurance companies had 91.1 percent of their assets invested in debt, including bonds (71.9 percent), mortgages (11.4 percent), policy loans (4.6 percent) and cash and short-term loans (3.2 percent) as of the end of 2002.14 Only 8.9 percent of assets were invested in stocks, other invested assets and real estate.15
Apart from the conservative investment strategy, there are other reasons to use a conventional policy. One is that in a properly designed policy, the expenses are low. Some even have a better cost structure than PPLI.
Secondly, most companies today have universal life policies with secondary guarantees. These ensure that if the premiums are paid on a timely basis, the death benefit will be paid as long as the insured dies during the guarantee period, regardless of the policy's actual earnings. Often, the guarantee period is very long — even beyond the age of 100.
Thirdly, some conventional policies, but not PPLI, offer riders that increase death benefits. With such riders, many taxes — including the tax on gifts, lifetime gifts, generation-skipping gifts, income and estates — can be mitigated or legally avoided.
Finally, the death benefit of a life insurance policy provides certainty. It can be used as a planning device unto itself with the return against the premiums providing substantial leverage. Ultimately, regardless of whether one is using PPLI or off-the-shelf products, the estate planning opportunities and consequences should be explored.
— The author thanks David Neufeld of Markuson and Neufeld, LLC, for his help with this article.
- Other articles about the topic include: The Lure of Private Placement,” Grant R. Markuson, Trust & Estates, May 2003; “The Keyport Ruling and the Investor Control Rule: Might Makes Right?” David S. Neufeld, Tax Notes, January 20, 2003; “New Guidance on Investor Control Rule: Road Map or Roadblock?” David S. Neufeld, Tax Notes, September 1, 2003; and “Investing in Hedge Funds Through Private Placement Life Insurance,” Leslie C. Giordani and Amy P. Jetel, The Journal of Investment Consulting, Winter 2003/2004.
- This assumes that the policy qualifies as life insurance under Section 7702.
- PLR 200244001, known as the “Keyport Ruling.”
- Rev. Ruls. 2003-91, 2003-33, IRB 347; 2003-92, 2003-33, IRB 350.
- [REG-163974-02] that has not been finalized as of presstime.
- Notices 2001-10 and 2002-8, and final regulations, [TD 9092], RIN 1545-BA44.
- Proposed regulation [REG-1126967-03], Rev. Ruls. 2004-20, 2004-10, IRB 546; and 2004-21, 2004-10, IRB 544; and Rev. Proc. 2004-16, 2004-10, IRB 549.
- “Treasury and IRS Shut Down Abusive Life Insurance Policies in Retirement Plans,” Feb. 13, 2004, Treasury Press Release JS-1172.
- 26 USCS 7702A.
- 26 USCS 72(v).
- 26 USCS 72(e).
- Source: VitalSigns, Copyright 2003, Life Link Corp.
Asger Jorn's “Fantasiens Torveplads/Fantasy Fair.” 1941, sold for about $390,000.