Journal of Financial Planning: September 2011
David M. Cordell, Ph.D., CFA, CFP®, CLU, is director of finance programs at the University of Texas at Dallas.
Thomas P. Langdon, J.D., LL.M., CFA, CFP®, is professor of business law at Roger Williams University in Bristol, Rhode Island.
Would your clients be interested in a life insurance policy that also has an investment element? No, this isn’t an ordinary pitch for whole life insurance. Nor is it a pitch appropriate for an ordinary client. For the right client, though, private placement life insurance (PPLI) can be an extremely useful tool with characteristics that rival so-called alternative investments.
Everyone knows that a life insurance policy can replace lost human capital when a premature death terminates the income stream. For wealthy individuals, life insurance can also be used to create and transfer wealth, often by purchasing life insurance in a trust outside of the insured’s estate so that the death benefit can be received on an income- and estate-tax-free basis.
Alternative uses of life insurance, such as private placement life insurance, offshore insurance, and the use of captive insurance companies allow very wealthy individuals the opportunity to leverage their wealth transfers to achieve tax savings and asset protection benefits. Recent, but temporary, changes in transfer tax laws have made these alternative life insurance products more attractive.
Private Placement Life Insurance (PPLI)
Private placement life insurance (PPLI) is a custom-designed variable universal life insurance policy tailored to meet the specific needs of the purchaser. The typical PPLI customer has a net worth of at least several million dollars and has a desire for legacy and/or asset protection planning. To purchase a private placement life insurance policy, the client must be an accredited investor. In the United States, an accredited investor is a person with a net worth of at least $1 million (not including the value of his or her personal residence), or a person who had income of at least $200,000 each year for the last two years ($300,000 if married) and has the expectation of making the same amount in the current year.
The cash value accumulation in a PPLI can be invested in traditional vehicles, such as mutual funds, but these policies are often structured to include hedge funds or private equity investments. According to Jonathan Blattmachr, a retired estates and trusts partner from the Milbank Tweed law firm in New York, PPLI is an investment wrapped inside a life insurance policy. Money placed inside the PPLI will grow income tax free, which can offer a significant advantage over other, non-qualified investments. Hedge fund strategies, for example, call for frequent trading of securities, causing many of the gains to be taxed at short-term capital gains rates, which, depending on a client’s income, could be as high as 35 percent under current law. Wealthy clients who would like to invest in hedge funds without incurring the tax expense generated by the fund annually could do so by purchasing the hedge fund inside a PPLI.
PPLI, when compared with traditional life insurance, offers very low mortality and expense fees. Low policy costs result in cash values and death benefits compounding at a quicker rate when compared with traditional life insurance policies. Unlike traditional life insurance policies criticized for their opaque and hidden fees, the purchaser of a PPLI knows exactly what the policy will cost, including the amount paid in commissions to the insurance provider.
Because the primary objective in using a PPLI is to obtain income-tax-free investment growth and, to the extent possible, avoid transfer taxes, the owner of the policy will want to put as much money into the policy as quickly as possible to establish the base for investment growth. Traditional life insurance trusts that use annual exclusion gifts (through the use of a Crummey provision) for funding the trust will not work with PPLI because the policy premiums will be large. To keep the policy outside of the owner’s estate, an allocation of the owner’s gift tax credit amount will be necessary, or more sophisticated estate planning techniques can be employed, such as private split dollar arrangements or the use of intra-family or trust loans to a separate life insurance trust holding the policy.
For situations in which asset protection is an objective, the trust holding the life insurance may have offshore situs (location for legal purposes) to prevent creditor access and maintain exempt status for transfer tax purposes. If properly structured, policy cash values may still be available to the clients if needed without triggering an inclusion in their taxable estate.
Recent Legislation Improves the Strategy
In 2010, Congress passed health-care and tax legislation that is likely to make PPLI a more attractive alternative for wealthy individuals. First, the health-care legislation imposed a Medicare sur-tax on investment income beginning in 2013 for individuals with adjusted gross income over $200,000 and married couples filing jointly with adjusted gross income over $250,000. Recall that these individuals are likely to meet the definition of an accredited investor to qualify to purchase PPLI.
Further, the Medicare sur-tax is 3.8 percent, which is added to the current tax rate on dividends, interest, and capital gains. This means that, beginning in 2013 (when the Bush tax cuts expire, barring future congressional action), short-term capital gains will be taxed at a highest rate of 43.4 percent (compared with 35 percent today), and long-term capital gains will be taxed at 23.8 percent (compared with 15 percent today). There should be no surprise that, as tax rates increase, more high-income taxpayers will be interested in PPLI.
The second change from 2010 that will make PPLI more attractive, at least for the remainder of 2011 through December 31, 2012, is the reunification of the gift and estate tax applicable credit amount and its current value of $5 million. As discussed above, to remove the death benefit on PPLI from a client’s taxable estate, the client will need either to allocate part of the gift tax exemption to the premium payments transferred to a trust, or engage in more sophisticated estate planning transactions to avoid the estate tax consequences. With a $5 million exemption through the end of 2012, a married couple splitting gifts could transfer as much as $10 million to a trust that holds the PPLI fully shielded by the exemption, thereby preserving the estate-tax-free nature of the policy death benefit. If Congress does not take further action, the estate exemption will revert to $1 million beginning in 2013, which only allows a married couple to transfer $2 million using its exemption amount.
Asset Protection with Offshore Arrangements
Clients concerned about potential litigation and creditor claims can obtain additional protection by structuring the trust or entity that holds the PPLI outside of the United States. Offshore jurisdictions are not subject to U.S. creditor protection laws, and are not required to follow the judgments of U.S. courts. Many offshore jurisdictions have shorter statutes of limitations for commencement of creditor actions to attach trust assets (the standard statute of limitations in the United States is three years), and impose additional requirements that make it difficult for creditors to gain access to the assets. For example, many offshore jurisdictions require that local counsel be retained to bring any action against trust assets, which increases the cost and complexity of the transaction from the creditor’s standpoint. Another impediment for creditors is the fact that many offshore trusts include flight clauses, which require the assets to be removed immediately to another offshore jurisdiction when a creditor files an action in the current jurisdiction to attach those assets.
Conclusion
For wealthy individuals, PPLI provides an opportunity to invest in alternative investments without triggering the income-tax and estate-tax consequences they would face if they owned these assets outright. In a rising tax rate environment, the popularity and use of PPLI to mitigate exposure to increased taxes will increase. Alternative investments provide diversification and portfolio allocation benefits to our clients. Use of a life insurance wrapper, in the form of PPLI, to hold those investments provides tax advantages that increase the after-tax rate of return on our clients’ investments.