A primer on private placement life insurance.

• Author: Bowman, Scott A.
• Position: Tax Law

To some extent, the game is changing in traditional estate planning. We now face $5.34 million transfer tax exemptions (adjusted for inflation) and a 40 percent transfer tax rate, on the one hand, and a 39.6 percent top marginal income tax rate and 3.8 percent net investment income tax rate, on the other hand. As such, it is the income tax--not the estate, gift, and generation-skipping transfer (GST) taxes--that is of increasing concern for many of our clients. One solution tailor-made for this concern is private placement life insurance (PPLI).

PPLI is a form of variable universal life insurance. Variable life insurance is a type of permanent life insurance that builds a cash value in which the policy owner can allocate to various investments within the insurance company's portfolio. PPLI is a variable life insurance that is privately offered. In contrast to traditional variable universal life insurance products sold by insurance companies, which have generalized investment offerings, the investment options within PPLI are highly customized. This customization allows the policy's cash to be invested in alternative types of investments, such as hedge funds, funds of funds, real estate, commodities, and financial derivatives. As discussed below, these investments are made through a segregated account of the insurer, often through an insurance dedicated fund (IDF). PPLI is also less expensive than traditional, publicly offered life insurance because agent commissions on PPLI are much lower. Additionally, while PPLI can be underwritten under the laws of the various U.S. states, non-U.S. PPLI is often even less expensive. Given the greater investment options and lower costs, PPLI becomes an attractive option for clients who are looking for the income tax benefits available through life insurance.

This article examines the use of PPLI for income tax and estate planning. As explained below, PPLI must satisfy certain common law and statutory requirements of life insurance. In addition, to avoid current taxation on the buildup of cash value within the policy, PPLI must be particularly sensitive to certain requirements for diversification. This article examines strategies for purchasing and funding PPLI and additional considerations potential purchasers need to keep in mind when evaluating this as a planning technique.

Tax Benefits of Life Insurance

Federal tax law generally provides favorable income tax treatment of life insurance for both the policy owner and the beneficiary of the death benefit. During the life of the insured, the owner is not taxed on income generated within the policy. This allows investments inside the policy to grow at a much faster rate than taxable investments. Additionally, a policy owner is generally permitted tax-free access to a portion of the policy's cash value through withdrawals (tax-free up to the owner's investment in the contract). (1) Any amounts withdrawn in excess of the policy owner's investment in the contract will be taxed to the policy owner at ordinary income rates. (2) Furthermore, a policy owner is generally permitted to borrow from the policy (up to the policy's cash surrender value) without reducing the death benefit, provided that the loan is repaid prior to the policy owner's death. (3) The beneficiary of the death benefit also receives favorable tax treatment, as the death benefit is excluded from income unless the policy has been sold subject to the transfer for value rule. (4)

In order to qualify for the favorable tax treatment afforded to life insurance, a life insurance policy must satisfy several requirements. First, it must constitute life insurance under applicable state or foreign law. Second, it must satisfy certain statutory tests. Third, the underlying investments must be adequately diversified.

Life Insurance Under Applicable Law

To constitute life insurance under applicable state or foreign law, the policy must present an adequate degree of risk shifting, risk distribution, and absence of investor control.

* Risk Shifting--Risk shifting means there must be some shifting of mortality risk from the insured to the insurer and a distribution of mortality risk among a group of insureds. (5) Authority addressing risk shifting has focused only on the actual presence of risk; the magnitude of risk has not been an issue. (6) Risk shifting occurs if a person facing the possibility of an economic loss transfers some or all of the financial consequences of the potential loss to the insurer so that the actual loss will not affect the insured because the loss is offset by the insurance payment.

* Risk Distribution--Risk distribution allows the insurer to reduce the possibility that a single costly claim will exceed the amount received as premiums and set aside for the payment of such a claim. Risk distribution necessarily entails a pooling of premiums so that a potential insured is not contributing a significant part for his or her own risks.

* Investor Control--Assets held in a segregated account underlying a life insurance policy must be considered owned by the insurer and not the policy owner. This is often referred to as the "investor control doctrine." The investor control doctrine is violated if the policy owner is deemed to have control over the investment decisions of the segregated account. This may occur when the policy owner directs investment strategy or makes investment decisions for the segregated account, or if there is a prearranged agreement between the policy owner and the manager of the segregated account to invest in any particular investment.

Beginning in the late 1970s, the 1RS issued a series of revenue rulings in an attempt to clarify the parameters under which a policy owner will be treated as the actual owner of the assets of a variable life insurance policy or a deferred variable annuity (virtually all of the rulings related initially to deferred variable annuities, but have now been extended to variable life insurance policies) on account of the level of the policy...