Cash value life insurance — through its tax-deferred growth of the cash value, tax-free access to that cash value and a tax-free death benefit — can provide tax-sensitive investors with benefits that include income tax deferral, conversion and diversification. These benefits can enable life insurance to compare favorably with other forms of investment that generate significant taxable income annually and upon disposition. But of course, the astute investor making that comparison has to be convinced that the favorable tax characteristics of the life policy overcome its inherent frictional costs.

Any type of cash value product can generate these benefits. Indeed, some of the most financially savvy clients I've worked with, including some hedge fund investors, have eschewed the more obvious choices of variable universal life (VUL) and private placement variable universal life (PPVUL) in favor of a well-constructed whole life/term blend or universal life product in which a carrier controls the investments. They thought so much of the way certain carriers invested that they viewed the general accounts as a worthy component of their asset allocation. The focus here, however, is on VUL and PPVUL. That's because recent pronouncements from the Treasury Department and the Internal Revenue Service have resolved some, albeit not all, of the technical issues that have troubled some purchasers of PPVUL; the government has also shed more light on where conservative practice ends and brinksmanship begins. These pronouncements make it timely to revisit PPVUL, which can offer the high-net-worth client an attractive, tax-efficient way to invest in tax-inefficient products. Estate planners need to understand how these products work, where they are most appropriate, and how planners can work with agents through the due care process.

VUL FUNDAMENTALS

It's impossible to understand or appreciate PPVUL without first understanding and appreciating VUL. Like its sibling universal life, VUL is a flexible premium policy that allows the policyholder to buy term and invest the rest within the same policy.

Unlike the traditional policy, however, VUL allows a policy owner to invest the cash value in accounts that are much like mutual funds. Many of these policies offer an array of stock, bond, managed and money market funds. This investment flexibility theoretically enables the policyholder to capture the historic performance advantage of equities over the fixed income investments that comprise most of the insurer's general account. The general account holds the assets that the insurer uses to support its traditional, fixed-dollar products, such as whole life and universal life. Some VUL policies do offer a guaranteed interest account, which is part of the insurer's general account. This account offers stability and assured income, but may impose significant restrictions on the timing of withdrawals or reallocation to the other funds.

VUL is a security-based policy. Indeed, the policy itself is a security because the lifetime values and (possibly) its death benefits are determined by the “investment” choices made by the policy owner. A prospectus must accompany the proposal, and the proposal format is dictated by the Securities and Exchange Commission's guidelines.

Unlike traditional cash value policies, the funds in the VUL policy are held, not as part of the insurer's general account, but rather in a separate account that offers policyholders some protection against carrier insolvency not available with traditional products. However, the carrier must be able to pay the death benefit in excess of the cash value, so its ability to meet that obligation is a policyholder's legitimate concern.

VUL policy fee structures are an important basis of comparison among products. First, there are charges and fees assessed against the premium before that premium is deposited into the separate account. These include the sales load to cover expenses associated with putting the policy in force, paying commissions and other internal costs. In addition, the carrier is reimbursed for the tax it has to pay to the state in which the policy is sold. The state premium tax is usually about 2 percent of the premium. Some states have very low premium taxes, so planners will use a trust or limited liability company (LLC) with a properly established situs in one of those states as the applicant and owner of the policy.1

After the deductions for those loads and taxes, the premium is deposited into the separate account and allocated among the funds in accordance with the policyholder's designated allocation. Much like the participant in a 401(k) plan, the policyholder can periodically change the allocation of the premium among the funds, and transfer sums among the various funds. Each month the carrier charges the separate account with the cost-of-insurance (COI) for the amount at risk, which is the difference between the death benefit and the cash value. The carrier can increase the COIs up to a contractual maximum. The carrier also deducts a mortality and expense (M&E) risk charge. The M&E charge is supposed to compensate the carrier for certain risks it assumes under variable life insurance policies. In reality, it's a profit item for the carrier. Carriers differ widely in the way they impose the M&E charge. But, like the COIs, the carrier illustrates the current charge, yet can increase that charge up to a contractual maximum.

There are additional expenses for the management and administration of the separate account investments, just as there are with mutual funds. Any investment returns are earned as a net of these expenses. Also, any surrender charges help a carrier recoup unrecovered sales commissions and other expenses. These charges are generally imposed during the first 10, 15 or 20 policy years. The charges decline over the years that they are in force.

The client who is considering using VUL for accumulation will seek to design the VUL policy for utmost efficiency. For example, many insurers allow policyholders to blend the VUL policy into base and term components. In other words, a $10 million death benefit would have $2 million of base and $8 million of term. The term component can make the policy more efficient, because it can have lower COIs than the base, the premium attributable to it will not be a part of the target commissionable premium for the agent, or both. The term rider also may reduce the M&E and the surrender charge. If the term rider is well designed, meaning that it creates permanent savings for the policyholder, then the policyholder will minimize the base, maximize the term, and pay as much additional premium into the policy as is needed to meet the objective. Note that not all term riders offer permanent savings to the policyholder, so their use should be evaluated on a case-by-case basis.

Another approach to making the product more efficient is to “levelize” the agent's compensation. The agent doesn't get less commission, but she receives it over time rather than getting a bulk of it in the first year. In this way, any surrender charge is mitigated and more of the policyholder's dollar goes to work earlier. Finally, a policy might be “banded,” meaning that certain policy costs are reduced for higher levels of premiums or death benefits.

KEY TAX ASPECTS

While estate planners don't need to be insurance tax technicians, it is helpful for them to have some familiarity with the rules that govern the tax packaging of life insurance. For example, the rules set boundaries for policy design that are wide enough to shape policies differently in different situations. That's why planners should understand what the client wants to accomplish with the policy so they can work with the agent to illustrate and shape the policy accordingly.

If a policy qualifies as life insurance under Internal Revenue Code Section 7702, the build-up of the cash value is deferred as long as it stays in the policy. If the policy does not so qualify, the annual increase in cash value will be taxable to the policyholder. A policy can comply with IRC Section 7702 under either the cash value accumulation test (CVAT) or the guideline premium test (GPT). A policy designed under the CVAT will develop a different pattern of cash value and death benefit than a policy designed under the GPT. Also, the choice of test could impact the amount of premiums that the policy owner can pay into the policy, as well as the amount of cash that the policy owner will be able to withdraw from it. Accordingly, one design may be preferable when the objective is to maximize the death benefit relative to the premium, while the other may be better when the objective is to maximize cash value accumulation. Many insurers permit their products to be designed under either test, and the agent should illustrate the product under both tests to determine if one presents any advantage over the other.

In addition to meeting the requirements under IRC Section 7702, VUL has its own rules that it must comply with, such as the requirements for diversification under IRC Section 817(h) and the guidelines for the degree of control the policyholder can have over the investment of the cash value.

TAKING CASH

A buyer who is interested in using VUL primarily as an investment vehicle will obviously be interested in how he can access the cash value without surrendering the contract. The primary methods for accessing cash value are policy loans and partial withdrawals. The income tax treatment of loans and withdrawals depends upon whether the policy is a modified endowment contract (MEC) or a non-MEC. An MEC is not a kind of policy; it is a creature of the IRC.

Both the MEC and the non-MEC allow the same tax-deferred inside build-up and tax-free death benefit. If the policy is a non-MEC, proceeds of policy loans are not taxable income. Partial withdrawals of cash value are tax-free to the extent of the policy owner's basis; that is to say, the premiums she has paid. On the other hand, loans and withdrawals from MECs are taxed to the extent of income in the contract, meaning any excess of cash value over premiums paid. In addition, there is a 10 percent tax on the amount of income borrowed or withdrawn from an MEC if the taxpayer is below age 59 1/2. The 10 percent tax is also imposed upon the gain on full surrender of the policy.

The distinction between the two contracts is of no particular concern to the policyholder using the policy for pure wealth transfer. But a policyholder who intends to use the policy for retirement planning, for example, will be very interested in the distinction between the two contracts. The flexibility of the non-MEC from a tax perspective is not without some cost. The non-MEC has to carry an initial death benefit that is considerably higher at a given premium than the MEC, which only has to qualify as life insurance under Section 7702. Although the death benefit of the non-MEC can in some cases be reduced after the seventh year, the incremental death benefit for even those seven years will retard the growth of cash value. Therefore, the common approach is to select a death benefit that is high enough for the policy to qualify as life insurance under Section 7702 and just high enough to avoid MEC status. In that way, the tax flexibility is preserved and the frictional costs of the incremental death benefit kept to a minimum. Note that even a closely cropped non-MEC design might allow the policyholder to pay (invest) more premium than originally anticipated. The MEC design is not likely to do the same.

PPVUL

The VUL product is often referred to as a carrier's “registered” or “off-the-shelf” product. The registered product is sold “as is,” meaning that aside from the aspects of the policy that can be designed to improve performance already mentioned here, there is no negotiation of such items as policy charges or inclusion of investment managers/products in the separate account.

When the buyer is willing to invest at least $1 million in a VUL policy, either initially or over several years, he may be able to qualify for the purchase of a PPVUL product. The PPVUL might offer a lower cost structure and more individual product design flexibility than a VUL. The ability to negotiate the cost structure and product design is very meaningful to the high-net-worth buyer. But by far the most important point of comparison is the investment flexibility, because the PPVUL buyer is typically a sophisticated investor looking to increase her after-tax return through the favorable characteristics of a life insurance policy. The PPVUL will typically offer several of the basic (or not so basic) stock and bond funds offered by the VUL. But the primary attraction of PPVUL is generally, though not always, the ability to invest in hedge funds that are simply beyond the reach of today's VUL.

The PPVUL product is “unregistered,” meaning that it's not registered under federal or state securities laws. The PPVUL policy is available only to purchasers who can demonstrate that they have the business or financial experience to understand what they're buying, can pay at least the substantial initial premium for the policy and, presumably, can tolerate the risks associated with the product. A prospective purchaser must be an “accredited investor” under the Securities Act of 1933 or a “qualified purchaser” under the Investment Company Act of 1940, or both. An individual is an accredited investor if he has a net worth in excess of $1 million or an income greater than $200,000. There are also guidelines for trusts (such as irrevocable life insurance trusts), companies and other entities. An individual is a qualified purchaser if he owns $5 million in investments. There are also guidelines for trusts and other entities. The carrier requires documentation to qualify a prospective policyholder under the applicable rules. One practical problem created by these rules is that it can be difficult to qualify an irrevocable life insurance trust to hold PPVUL.

Compared to the VUL product, and depending upon the size of the premium and other factors, the PPVUL product can offer several advantages. But there are caveats and practical considerations that, in the end, are likely to cause PPVUL to be attractive primarily to hedge fund investors and not to the vast majority of those high-net-worth clients who simply want an efficient policy for accumulation or estate-planning purposes. The points of comparison, the caveats and some suggestions for both planner and agent during the due care process include:

  • Sales Loads — The PPVUL buyer can negotiate considerably lower sales loads (or none at all) compared to VUL.

  • Agent Compensation Compen-sation to the agent can be negotiated between the buyer and the agent. A common compensation scheme for PPVUL calls for the agent to receive 1 percent of the premium paid and a trail commission of 10 basis points (.10 percent) on the cash value after the premium payment period. The PPVUL policyholder can choose to compensate the agent on a fee-only basis outside of the product or on a commission/trailer basis inside the product. The VUL pays its compensation only through the product. The main point is that, by controlling both the amount of the compensation and the mode of payment (inside or outside the policy), the PPVUL policyholder does not have to compensate the agent as a money manager for the life of the policy with a constant percentage of the (hopefully) increasing cash value. Rather, the policyholder can choose to tailor the compensation to reflect actual services being provided by the agent on an annual basis.

  • Surrender Charges — The PPVUL is likely to have no surrender charges. This too is a meaningful point to the high-net-worth buyer who, give or take some investment results, likes to know that he can get his money out without a contractual hit to the cash value. As noted, the term rider on the VUL can reduce the surrender charge. Other policy features in the VUL may be available to reduce or eliminate the surrender charge, but they may come into play only upon an actual surrender and not upon a tax-free exchange to a new product. An exchange can be an important risk mitigator for a policyholder, so the absence of surrender charge in all events can be a meaningful advantage.

  • Cash Value — Despite the absence of surrender charges and the potentially lower agent compensation, the PPVUL will not necessarily illustrate more cash value or death benefit for the premium dollar than VUL. I compared several illustrations provided by insurance professionals, all using a standard set of assumptions about the insured, the premium stream, the product design and the net return on the cash value. The bottom line was that the differences in the internal rates of return on cash value and death benefit, respectively, between the VUL and the PPVUL were, in the words of one insurance professional, “statistically insignificant.” These results, which may be attributable to additional costs in the PPVUL, squared with my experience over the years. They continue to suggest that an investor who is satisfied with an array of more conventional stock and bond funds has little reason to turn to PPVUL over VUL.

  • Flexibility — The chief point of comparison, therefore, is not the numbers. It's the investment flexibility. PPVUL prospects become PPVUL policyholders because PPVUL accommodates their investment objectives and VUL does not. The fact that VUL might “out-illustrate” PPVUL at a hypothetical 8 percent net return is of no consequence to the prospective PPVUL buyer who wants to invest the cash value in otherwise tax-inefficient hedge funds that she believes will outperform the markets with lower risk. The hedge funds may be so-called insurance dedicated funds (IDFs), meaning that they are available exclusively through the purchase of a variable insurance product or publicly available funds (PAFs), which the investor could purchase outside of a variable insurance policy. Note that there is no restriction on the ability of PPVUL to offer PAFs. But the prospective purchaser, the planner and agent will have to pay special attention to, and get expert advice on, the applicable rules for diversification and investor control.

  • Complexity — The process of evaluating and purchasing PPVUL is much more complicated and expensive than for VUL. The estate planner is likely to want to engage counsel familiar with these transactions to review the ample documentation involved in the PPVUL process. Counsel also will negotiate the terms of the carrier's side letter, which contains important representations and warranties, indemnifications on tax matters, as well as restrictions on the carrier's ability to increase certain charges in the policy, such as the M&E, beyond a certain level. The complexity and expense of the process is another reason that PPVUL tends to be right for clients who seek to boost the after-tax returns of their tax-inefficient (hedge fund) investments, and wrong for clients who just want an efficient product for their retirement and estate-planning needs.

  • Risk — Commentators frequently suggest that PPVUL should be designed as an MEC to generate more robust cash value growth. While they might be right on the numbers, they may be too hasty with that conclusion. The favorable tax characteristics of the non-MEC can, in some circumstances, reduce some of the risks, both tax and non-tax, associated with owning any life insurance policy. For example, if the carrier's ratings slip to a level of concern to the policyholder, he can pull cash value from the policy on a tax-free basis. Even if the carrier's ratings remain stellar, the company might increase the charges on the policy, perhaps reflecting slow growth of its PPVUL business or discontinuance of that line of business altogether. A healthy insured could do a tax-free exchange to another product or carrier. But an unhealthy insured might not have that option, thereby leaving her exposed to the higher charges. Also, the government might further tighten the investor control rules so as to preclude use of certain types of investment by the separate account. The disenchanted policyholder of a non-MEC might then decide to pull out what cash he can on a tax-free basis, reallocate the policy in accordance with the new rules, reduce the death benefit to a supportable minimum, and leave well enough alone. The MEC policyholder would have some, but not all, of those choices.

  • Rules — The diversification and investor control rules are generally not of concern to the VUL buyer, because the investment choices are limited to diversified mutual funds selected by the carrier and available exclusively through the purchase of a VUL product. But these rules can be critical to the prospective PPVUL buyer. They will certainly impose some restrictions on the use of the product and, in some cases, be enough to dissuade a highly selective investor from purchasing the product altogether.

DIVERSIFICATION

For a variable life policy to qualify as life insurance for tax purposes, the investments in the separate accounts must be adequately diversified.2 The rules generally require that on the last day of each quarter of a calendar year no more than 55 percent of the cash value is represented by any one investment, no more than 70 percent is represented by any two investments, no more than 80 percent is represented by any three investments, and no more than 90 percent is represented by any four investments. Therefore, the separate account must be invested in at least five different investments.

Hedge funds raise an interesting issue with respect to diversification. Section 817(h)(4) and Reg. Section 1.817-5(f) provide a look-through rule for assets held through certain investment companies, partnerships or trusts for purposes of testing diversification. The “look-through” means that instead of an asset such as an investment company (mutual fund) counting as only one investment for diversification purposes, each of the underlying holdings of that asset (the mutual fund) can count as one investment. Under Treasury Regulations Section 1.817-5(f)(2)(i), look-through treatment is available for any investment company, partnership or trust if all the beneficial interests in the investment company, partnership or trust are held by one or more segregated asset accounts of one or more insurance companies, and public access to the investment company, partnership or trust is available exclusively through the purchase of a variable contract. In other words, it's got to be an IDF. However, Treas. Reg. Section 1.817-5(f)(2)(ii) and Example (3) of Reg. Section 1.817-5(g) historically provided an important exception, which afforded look-through treatment to a partnership interest that was not registered under a federal or state law regulating the offering or sale of securities, that is to say hedge funds, which were operated as non-registered partnerships.

That said, regulations made final on March 1, removed the exception provided by Reg. Section 1.817-5(f)(2)(ii). Now, look-through treatment is available only for interests in a non-registered partnership if all the beneficial interests in the non-registered partnership are held by one or more segregated asset accounts of one or more insurance companies, and public access to such non-registered partnership is available exclusively through the purchase of a variable contract. In other words, look-through treatment is available only to a hedge fund if it is an IDF. If it is a PAF, it's counted as one investment, regardless of how many securities it may own. Again, denial of look-through treatment to PAFs does not mean that they can't be owned by the separate account of the PPVUL. It does mean that, for diversification purposes under IRC Section 817(h), a PPVUL could own one IDF that owns five or more investments, but any PAF that it owns can only count as one investment.

NVESTOR CONTROL

Investor control is an extremely technical area of the law that deserves a treatise. I can review only the general rules with which planners and agents should be familiar. I strongly urge estate planners to seek the advice of counsel who specialize in this area.

The policyholder can enjoy the tax-deferred build-up of the cash value only if the separate accounts are under the ownership of the insurer and not the policyholder. If the policyholder can exercise too much control over the investments, the policyholder will be treated as the owner of the assets and taxed on the income and gains of the investments as though he owned the investments outright. The policyholder can, however, direct the broad allocation among the funds.

The IRS has issued several revenue rulings discussing the concept of “investor control.”3 The IRS also has issued several private letter rulings holding that the owners of the variable policies were not owners of the assets in the separate accounts.4 The leading case in the area is Christofferson v. U.S., out of the U. S. Court of Appeals for the Eighth Circuit.5

Two recent revenue rulings are instructive for the planner looking to navigate this terrain. They are also fodder for debate among PPVUL marketers and commentators who market or favor one approach to PPVUL versus another.

In Revenue Ruling 2003-91, a life insurance company offered variable life contracts that qualified as variable contracts under IRC Section 817(d). The assets funding the contracts were segregated from the assets funding the insurer's traditional life insurance contracts. The separate account for the contracts was divided into various sub-accounts, the interests of which were not available for sale to the public. Each sub-account offered a different investment strategy. An individual (contract holder) purchased a life insurance contract and specified the allocation of premiums paid among the then-available sub-accounts. The contract holder was permitted one transfer between sub-accounts without a penalty every 30 days, and might change the allocation of premiums at any time. Other than the contract holder's right to allocate premiums and transfer funds in these ways, all investment decisions concerning the sub-accounts were made by the insurance company or its advisor. The insurance company made all decisions regarding the selection of an investment advisor without any input from the contract holder. The contract holder could not communicate, directly or indirectly, with the investment officer at the insurance company or the advisor hired by the insurance company to manage the funds.

The Service concluded that because the contract holder did not have control over the investments of the sub-accounts, and because the sub-accounts were not publicly available, the contract holder did not have control over the separate account sufficient to be treated as the owner of the assets for federal income tax purposes. The ability to allocate premiums and transfer funds among the sub-accounts does not give rise to investor control.

Rev. Rul. 2003-92 examined three scenarios. In the first, a life insurance company developed a private placement variable annuity contract. The assets supporting the annuity were held in a segregated asset account that was divided into 10 sub-accounts. The contract holder specified the premium allocation among the various sub-accounts. Each sub-account available under the annuity invested in interests in a partnership. None of the partnerships were publicly traded, and each had an investment manager that selected the partnership's specific investments. Scenario two was the same as scenario one, except that the contract holder purchased a variable life insurance contract (LIC). Scenario three is the same as scenario one, except that the contract holder purchased both an annuity and an LIC, and the interests in each partnership were available only through the purchase of an annuity, an LIC or other variable contracts from insurance companies.

The Service concluded that in scenarios one and two, because the sub-accounts held interests in partnerships available for purchase by the general public, the contract holder was the owner of the interests in the partnerships held by the sub-accounts. As such, the contract holder had to include in the gross income any interest, dividends or other income derived from the partnership interests. But in scenario three, the insurance company was considered the owner of the interests in the partnerships that fund the sub-accounts, because the sub-accounts held interests in partnerships available for purchase only by a purchaser of an annuity, a life insurance contract or other variable contracts from insurance companies.

Rev. Rul. 2003-91 generally outlined what most practitioners already considered to be the rules of the road for avoiding investor control. But Rev. Rul. 2003-92 has considerably more effect, because some taxpayers purchasing PPVUL as “wrappers” for hedge funds were relying on the position that Reg. Section 1.817-5(2)(ii), which specifically provided for “look through” treatment for unregistered partnerships for purposes of satisfying IRC Section 817(h)'s diversification requirements, should govern for purposes of investor control as well. The final regulations made it clear that the Treasury believes this reliance is misplaced.

A careful reading of these rulings, the foregoing authority and other articles on the topic, along with a probing discussion with experienced counsel will leave planners with a sense that some questions about investor control remain to be resolved. The same is true, by the way, in many areas of estate planning, where the line separating conservatism from brinksmanship can be more than a little fuzzy. But it certainly appears that a client can purchase a PPVUL product that will invest in IDFs and, assuming all parties follow the rules of the road, there will be no issue of investor control.

Some marketers and commentators still wonder whether the client can purchase a PPVUL product that will invest in PAFs. It seems that they can, with some caveats that they will have to explore with experienced counsel. My sense is that it's reasonable to assume that the IRS will look at the facts and circumstances of each situation. The agency will look to the furthest level at which the policyholder can control the investments. If there is an independent investment manager or “asset allocator” selected and engaged solely by the carrier, and that manager or allocator selects the investments (which can include PAFs) without the input or influence of the policyholder, there should be no issue of investor control. The investment manager should not be precluded from any communication with the policyholder. The manager just has to be independent.

In many cases, application of a facts-and-circumstances test will pose no concern for policyholders who are comfortable with the strictures imposed by these rules. But such a test can present challenges in certain situations. For example, the existence of a prior, private investment advisory relationship between the investment manager and the policyholder might tilt the case from conservatism to brinksmanship. Or, a prospective purchaser who doesn't like (or want to be restricted to) the IDFs offered by the carrier might simply feel that strict adherence to the investor control rules will be too controlling for his taste or risk tolerance. The bottom line is that only when the client understands the rules of the road and can live with them for the long-term, is it happy sailing.

Clients who want life insurance and are looking for a tax-efficient way to invest can choose from an array of cash value products that potentially offer the right solution for their situation. For the sophisticated investor, recent developments confirm that PPVUL can be a dynamic component of their wealth accumulation and capital transfer strategies.

Endnotes

  1. For example, Alaska and South Dakota.
  2. IRC Section 817(h), Treas. Reg. Section 1.817-5.
  3. Revenue Ruling 77-85, 1977-1 C.B. 12; Rev. Rul. 80-274; 1980 C.B. 27; Rev. Rul. 81-225; 1981-2 C.B. 13; and Rev. Rul. 82-54; 1982-1 C.B. 11.
  4. Private Letter Rulings 8427085, 9433030 and 200420017.
  5. Christofferson v. U.S. 84-2 USTC 9990 (8th Cir. 1984).