Customized Private Placement Life Insurance: an Asset Protection and Investment Tool
| Publication year | 2012 |
| Pages | 85 |
| Citation | Vol. 41 No. 7 Pg. 85 |
2012, July, Pg. 85. Customized Private Placement Life Insurance: An Asset Protection and Investment Tool
July 2012
Vol. 41, No. 7 [Page85]
Tax Law articles are sponsored by the CBA Taxation Law Section to provide timely updates and practical advice on federal, state, and local tax matters of interest to Colorado practitioners.
Coordinating Editors
Adam Cohen, Denver, of Holland and Hart LLP-(303) 295-8000, acohen@hollandhart.com; Steven Weiser, Denver, of Foster Graham Milstein and Calisher, LLP-(303) 333-9810, sweiser@fostergraham.com
About the Author
Alan R. Jahde is a co-founder of Anderson and Jahde, P.C., a Littleton tax law firm that focuses on tax litigation and controversy, income and estate tax planning, asset protection planning, domestic and offshore private placement life insurance planning, and defined benefit pension planning. He thanks Erin Stearns for her contributions to this article.
This article explains how customized private placement life insurance can provide significant investment and tax benefits for high-net-worth clients when used as an estate planning and asset protection tool.
Traditional cash value life insurance often is used as part of an estate plan solving an insurance need, such as providing liquidity to the decedent-insured's estate through a death benefit to his or her family. Over the last twenty years, a new life insurance product-private placement life insurance (PPLI)-has been offered by onshore and offshore carriers. PPLI is a specialized form of variable life insurance that is not registered by the U.S. Securities and Exchange Commission (SEC) and is available to high-net-worth clients.
When purchasing traditional cash value life insurance, the purchaser may pay less attention to the investment return of the cash value portion of the life insurance policy than to the death benefit. In contrast, the purchaser of PPLI generally has two goals: meeting an insurance need for death benefit protection, and accumulation through increased buildup of the inside cash value. As an investment tool, PPLI can hold a variety of investments, such as stocks, bonds, hedge funds, and other private equity investments that, over time, will enhance the policy owner's accumulation goal.(fn1)
When fully compliant with all applicable tax laws, life insurance (including PPLI) receives advantageous tax treatment, which allows policy investments to grow free of income tax and, with proper estate planning, to pass to beneficiaries free of estate tax on the insured's death.(fn2) Life insurance also may be owned by certain vehicles, such as trusts or limited liability companies, which can offer significant asset protection to the policy assets. The combination of several features makes customized PPLI particularly well-suited to achieving the investment, estate planning, and asset protection goals of high-net-worth clients:
1) advantageous income and estate tax treatment;
2) focus on accumulation and growth;
3) nontaxable access to cash value during one's lifetime;
4) asset protection options; and
This article explores how advisors and clients can use customized PPLI to meet these goals5) meeting an insurance need of providing liquidity to the policy owner's estate.
PPLI and Customized PPLI
PPLI is a specialized type of cash value variable universal life insurance.(fn3) PPLI policies must fully satisfy the requirements for "life insurance" under the Internal Revenue Code (Code).(fn4)
PPLI policies differ from traditional non-PPLI cash value life insurance policies because they are specialized and offer more customizable features. These features include negotiated (and often reduced) fees, a customized death benefit, and selection of either a modified endowment contract or non-modified endowment contract, as described below. Certain insurers permit policy owners to further customize PPLI policies to meet their objectives. Such customized PPLI policies may be referred to as "customized PPLI" or "custom-designed life insurance" policies.
Although they once required a premium investment of at least $25 million, PPLI policies now are available to customers willing to make a total premium commitment of at least $1 million.(fn5) Policies may be purchased from either domestic or foreign insurers. Domestic insurers are subject to SEC regulations, which require purchasers of domestic PPLI policies to be "accredited investors" and generally to also be "qualified investors."(fn6) In effect, purchasers must have annual income of at least $200,000 and minimum net worth of $5 million.(fn7)
General Taxation Effects and Benefits of Life Insurance
Life insurance policies have several tax benefits. These are discussed below.
No Income Taxation
Earnings on a policy's cash value, including interest, dividends, and capital gains, generally are not taxable to the policy owner as they accumulate within the policy.(fn8) This tax-free growth environment permits income to accumulate at a higher rate than if the assets were held in a taxable portfolio outside a policy. If a policy is classified as a "non-modified endowment contract," as described in more detail below, any withdrawals by the policy owner up to the amount of premiums paid before the death of the insured will not be subject to income tax.(fn9)
To ensure that the policy retains its status as life insurance and that policy earnings will not be subject to income taxation to the policy owner, policy investments must not be subject to any level of investor control by the policy owner.(fn10) This means the policy owner cannot have any control over the specific selection or retention of policy investments.(fn11)
No Estate Taxation With Proper Estate Planning
Policy ownership may be structured so that death benefits are excluded from the taxable estate of the insured and/or policy owner.(fn12) To avoid estate tax inclusion, policy proceeds cannot be paid to the executor of the insured's estate.(fn13) The insured also must not retain any incidents of ownership over the policy.(fn14) In addition, contributions to the policy made within three years of death are subject to estate tax inclusion.(fn15)
No Beneficiary Taxation
Life insurance proceeds payable to beneficiaries on the death of the insured generally are excluded from the beneficiaries' taxable income for federal tax purposes.(fn16) These proceeds also pass free of any capital gains taxation.(fn17)
Basic Terminology of Life Insurance
A basic understanding of life insurance terminology is important. Some terms are defined below.
Cash value: Cash value is the balance of an account maintained by the insurer equaling the sum of life insurance premiums paid plus investment earnings, less policy expenses, reinsurance costs, partial surrenders, and loans.
Death benefit: This is the amount paid by the insurance company on the death of the insured. Depending on policy design, the death benefit may be a set amount or an amount that, after the end of seven years, decreases as a multiple of cash value based on the age of the insured.(fn18)
Modified endowment contract (MEC) versus non-modified endowment contract (non-MEC): A life insurance contract is categorized as either a MEC or a non-MEC, depending on whether it satisfies the criteria of Code § 7702A.(fn19) Withdrawals from a MEC policy are included in the policy owner's gross income and are taxed at ordinary income tax rates to the extent of policy earnings.(fn20) Withdrawals from MECs also may be subject to an additional 10% penalty tax.(fn21) If a policy is a non-MEC, no penalties or taxes apply to withdrawals up to the amount of premiums paid.(fn22)
Although non-MEC classification often is preferable to MEC classification, the distinction matters only if the policy owner will withdraw funds from the policy during the insured's lifetime. If the policy owner intends not to withdraw funds from the policy during lifetime and the primary purpose of the policy is to pass wealth from one generation to the next, MEC status may be preferable, because the overall cost of insurance will be less.(fn23)
Net amount at risk (NAR): This is the amount of actual risk borne by the insurer. It equals the difference between the death benefit and the cash value of the policy.(fn24) Most insurers reinsure some or all of the NAR.(fn25)
Mortality and expense (MandE) charges: This is an expense charged by the insurer to cover its operating costs and still yield a profit.(fn26) An annual charge of between 40 basis points (0.40%) and 125 basis points (1.25%) of cash value generally applies to small and medium-sized policies after the policy is fully funded.(fn27) MandE charges often decrease as policy size increases.(fn28)
Cost of insurance (COI): COI charges are determined based on assumptions made by the insurer about the insured's age, sex, and health status.(fn29) COI...
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