By Joel J. Karp, Karp & Genauer, Coral Gables, USA
I remember a time when our high net worth clients believed that life insurance was unnecessary, expensive, non-productive and boring. How attitudes have changed.
It is interesting, that in a time when the Internal Revenue Service generally has nothing nice to say about tax flavored financial products, it has nothing really bad to say about private placement variable life insurance products, provided that these products conform with the normal format.
A private placement variable life policy is a policy which is directly negotiated with and designed for the policyholder to meet his specific needs. Generally, since the product is not admitted for sale in any state, all solicitation and sales take place outside of the U.S. in a place where solicitation and sale is lawful. The policy values and death benefits are very large involving premiums ranging from a minimum of $1 million to $2 million.
The normal format for a private placement life policy is really very simple. First, it is life insurance policy. This means that its primary purpose is to provide a benefit on the death of the insured to the persons designated as beneficiaries under the policy. It appears that the policyholder, who may, but need not be, also the insured, must have an insurable interest in the insured. This means the policyholder must be someone who would be injured (generally economically) by the death of the insured. For U.S. income tax, the receipt of the death benefit is income tax free provided the policy qualifies as a life insurance contract under the statutory guidelines. Also with certain exceptions, the policyholder must not have acquired the policy in a transaction, which qualifies, in what is called a transfer for value, i.e., the policyholder did not purchase the policy from someone else. The policy is variable in that the cash value of the policy and the death benefit under the policy fluctuates depending on the investment success or failure of a segregated account backing the policy. A segregated account may be an accounting entry on the books of the insurance company or an actual entity where, in each case, the assets credited to the account are segregated from the general assets of the insurer under State law or regulation. These laws or regulations normally result in the assets backing a particular policy being segregated from the claims of the creditors of the insurance company and other policyholders. For this purpose, State law or regulation must clearly include foreign law or regulation. The IRS has ruled that to hold otherwise would be contrary to the manifest intention of Congress.
There are two other tax requirements. The segregated account backing the policy must be properly diversified by regulatory standards and the policyholder must not exercise improper control over the investments in the segregated accounts.
Recently, IRS considered a variable life insurance policy with obvious investment overtones. The policy had twelve investment options, among which the policyholder could allocate, at any time, the premiums invested in the policy. The policyholder was, however, limited to one free reallocation per month. Once re-allocations exceed one per month, a transaction fee would be imposed. There would never be more than twenty investment options available in the segregated account.
The policy was fashioned on a managed account model. This meant that each investment option was managed by a separate investment advisor and that by choosing investment options, the policyholder could, in fact, choose the investment manager he wished to manage the funds allocated to that option. The managed account option should be compared with a “wrapper model”, which was considered unfavorably in a companion ruling (the sole-called hedge fund ruling).
The IRS held that as long as there was no arrangement, plan, contract or agreement between the policyholder and the insurance company or between the policyholder and the advisor regarding the availability of a particular investment option, the investment strategy of any option or the specific securities to be held under any investment option, the insurance company rather than the policyholder would be deemed to be the owner of the assets underlying the policy. Accordingly, the insurance company, rather than the policyholder would be taxable on the income, gain or loss derived from the investments underlying the policy. This favorable result presupposed that the policyholder would not be able to communicate directly or indirectly with any investment officer or the insurance company or its affiliates or with any investment advisor, regarding the selection, quantity, rate of return on any specific investment or group of investments held under a particular investment option in the segregated account backing the policy.
The investment model in the second ruling reflected what we call a “wrapper model”. Effectively, the funds invested in a policy backed by a segregated account with ten separate sub accounts. Each sub account contained a position in a private investment partnership interest, which was publicly available. The IRS’ position was that notwithstanding that the diversification requirements had, in fact, been met with respect to the investments, the policy failed because effectively the policyholder was considered to have prohibited controls over the underlying investments. In the case of the managed account investment model, the prohibited control was not considered present.
Now let’s take a step back for a second. An insurance policy is what the name implies. The policyholder transfers a lump sum, or, over a period of time, capital sums called premiums to the insurance company and, in return, the insurance company issues a contract under which it agrees to pay to designated beneficiaries, a capital sum determined under the policy agreement, upon the death of the insured. The policyholder can designate himself, his family or his children or trust for their benefit as the beneficiaries. Often, the policyholder and the insured are the same person.
The United States has a statutory definition of what qualified life insurance is for federal income tax purposes. The purpose of this definition is to insure that the policy retains significant traditional life insurance attributes and is not too much of an investment. Normally, this definition requires reasonable premiums to fund a death benefit. The death benefit can be a discrete sum or it can be variable, based upon the investment performance of an underlying segregated account. The Internal Revenue Code of 1986, as amended (the “Code”), provides two tests, either one of which must be passed for the policy to be qualified. These are the cash value accumulation test or the guideline premium/cash value corridor test. Variable policies are normally designed to comply with the latter test. For example, normally, in order to be qualified, the death benefit at age 40 would have to be two and a one-half times the cash surrender value. Thus, there would have to be a net amount at risk to the insurance company and an added charge in addition to the investment fees for managing the money, for mortality and administration.
Thus, in order for the arrangement to qualify as insurance for federal income tax purposes, it is necessary that there be a real insurance element in the policy, which must be paid for on the basis of reasonable, recognized mortality rates.
What is so wonderful about life insurance from a tax perspective? For one thing, prior to the maturity of the policy, on death, the inside buildup of investment income is not subject to federal income tax, until such time as there are actual distributions from the policy. Even the income tax aspect of distributions can be mitigated, if the policy is funded under the so-called “Seven Pay Rule”, whereby the aggregate premiums paid into the policy annually do not exceed a certain formula amount for the first seven years that the policy is in effect. In addition, if and when the death benefit is paid on the death of the policyholder, the death benefit is received by the beneficiaries free of income tax. Thus, the investment income accumulating inside of the policy is never exposed to income tax, provided it is never distributed before the insured’s death. Also, if one can try to avoid the gift tax implications of an absolute transfer of the policy, it is possible that the beneficiaries could receive the death benefit free of estate tax as well. In other words, there is the possibility here of a tax home run for funds held in a managed account inside an insurance policy, whereby the policyholder can, at least, have some input as to how the sums backing the policy are invested.
While the IRS has implicitly approved the basic format of private placement life insurance using the managed account investment model, they have seemingly rejected a policy backed by interests in hedge funds, which are also publicly available. This ruling leaves us with many questions. Some will be resolved by new regulations, which will remove the so-called look through treatment for hedge funds unless investment in the fund is available only through investment in a qualified policy; but other issues remain.
Why are these policies so attractive to hedge fund investors? Well, of course, there are many reasons. One of the principal reasons is that hedge funds produce high returns. However, generally these returns are ordinary income taxable at high income tax rates. Tax deferral becomes quite valuable and these products can produce that and more.
Hedge fund investors remain an important constituency as purchasers and holders of these policies. Many purchasers acquire policies with holdings in certain hedge funds, which are otherwise closed. How are these investors to be accommodated in light of the IRS rejection of the “wrapper model”?
In order to know this, one must analyze exactly what the IRS really held in the hedge fund or “wrapper” ruling. What the IRS appears to have said is that the investor control rules are violated when a policyholder can allocate his premium dollars directly to participation in an investment vehicle, which is also publicly available. By publicly available the IRS means available other than through investment in the policy or through certain permitted entities such as qualified pension and certain other qualified deferred compensation plans.
As a result of the recent rulings, there is some confusion on certain points. For one thing, for some people it is not entirely clear that the policyholder may recommend an investment advisor to the insurance company. It is clear and indeed has been clear, that if a policyholder were to recommend an investment advisor, that investment advisor could be accepted or rejected by the insurance company at its discretion and, if accepted, would be an investment advisor of the insurance company, not of the policyholder. Also, as indicated above, the policyholder would have no right to discuss policy investments with the investment advisor or otherwise seek to direct the management of the investment options underlying the policy, by the investment advisor. The ruling itself describes the policy under examination as providing that the policyholder could have no hand in selecting an investment advisor, with respect to a particular investment option. However, when analyzing the facts to determine which facts were essential, the lack of power to recommend an investment advisor was not apparently considered to be an essential fact. Moreover, the Internal Revenue Service had previously ruled that where a policyholder had the opportunity to recommend an investment advisor, that fact in and of itself would not disqualify the policy. While private letter rulings are not binding on the Internal Revenue Service, the United States Supreme Court has held that they can be used to reflect and demonstrate what the IRS considers to be acceptable.
Private placement variable life insurance is interesting to U.S. investors, in part, because it provides tax advantages that one would hope for from a foreign corporation or foreign trust, but cannot achieve. Insurance policies also have asset protection aspects, as well as tax advantages. In many States of the Unites States, the cash surrender value and death benefit, under a life insurance policy, are exempt from the claims of policyholder and beneficiary creditors. The same is true under some foreign laws such as the laws of the Commonwealth of the Bahamas.
For U.S. persons, the interest in foreign issued products is not really tax motivated. It is, rather that investment rules in foreign jurisdictions tend to be more relaxed than they are under State laws applicable to U.S. issued products. There are also investments available to offshore companies, which are simply not available to domestic companies for reasons relating to United States securities laws. Also these variable insurance products may provide a means whereby U.S. persons may, through a policy invest in so called passive foreign investment companies (“PFIC’s”) without the related penalties. It may be also true (although much debated) that the overall cost of foreign issued products tend to be lower than that of domestic products.
These products are not only interesting to U.S. persons, but also to non-U.S. persons. Peripatetic executives, coming to the United States for a particular period of time, for one, can use private placement, variable life insurance products to shelter investment income while they are resident in the United States. Once they leave the United States, they can cancel the policy and withdraw the income and gain accumulated during their period of residency completely tax free, as far as the United Sates is concerned. This, of course, is possible only where the peripatetic executive invests in a foreign issued product. To do so with a domestic issued product, more often than not, could result in a 30% withholding tax on the accumulated income subject to the possible tax-free exchange approach discussed below. (For that matter, deferred variable annuities may be similarly useful, although that needs to be the subject of another paper).
In addition, a domestic variable life insurance policy is a good medium for avoiding the special capital gain tax on the disposition of U.S. real estate by foreign persons (“FIRPTA”). Real estate is a permissible investment for diversification purposes, provided that the segregated account backing the policy is properly diversified under applicable rules. A domestic insurance company (or a foreign insurance company engaged in U.S. business to which the policy involved is effectively connected) which owns U.S. real estate, pays no taxes on disposition because it gets a related deduction, since the amounts invested in real estate and also the profits derived there from can be treated as reserves. Reserves are deductible to a U.S. taxable life insurance company. (This does not work where the foreign person owns a foreign issued policy). The one drawback is that if the policyholder wishes to withdraw money from the policy on non taxable basis, he must fund the policy to meet the so-called “Seven Pay Rule” (which generally can be accomplished with good actuarial assistance over a period of approximately five years). This, however, only shelters the withdrawals from the policy up to the aggregate of premiums paid in. Withdrawals in respect “inside buildups” may be subject to 30% income tax as well as the early withdrawal penalty.
One way to bail out of a domestic policy is a tax-free exchange. The domestic policy can simply be exchanged on a non-taxable basis (under current law) for a foreign policy, which then can be canceled. It should be noted that a possible tax free exchange of policies could be brought to an end at any time by the promulgation of appropriate regulations. It was apparently thought that this problem could be avoided by having the policy issued by an offshore branch of a domestic company. However, a recent published ruling indicated that is not the case.
Where the policyholder is a foreign person and one or more of the beneficiaries is a United States person, it is possible, that the policy need not conform to U.S. statutory requirements for income tax qualifications and nevertheless produce favorable tax consequences for the United States beneficiaries. The interest in this type of approach is that the mortality cost would be much lower for a European style policy than it would be with regard to a United States policy. This approach is also useful given that it is sometimes difficult to obtain life insurance from U.S. companies on the lives of non-U.S. persons.
Yet another advantageous use for foreign persons is that it is a medium, whereby the so-called “surcharge” on tax deemed deferred on distributions from foreign trusts can be avoided. Simply put (hopefully), where a foreign trust with one or more U.S. beneficiaries makes a distribution out of accumulated income to a U.S. beneficiary, that beneficiary is not only subject to U.S. income tax on the distribution, but in addition is subject to an interest charge computed at compound market rates on the income tax deemed deferred during the accumulation period, when the same was held by the foreign trust in an undistributed state. Where the accumulation period for the benefit or possible benefit of the U.S. person has lasted for any extended period of time, the interest charge under certain circumstances can wipe out the entire distribution. By the simple expedient of investing the trust corpus in an insurance policy, no income is accumulated at the trust level (rather, it is accumulated tax free inside the insurance policy) and, accordingly, when distributions are made, they are made out of current revenue and, therefore, not subject to the accumulation interest surcharge.
It may be that insurance may be a way to avoid penalties on income already accumulated in the foreign trust. Thus, for example, a foreign grantor established a foreign trust for the benefit of his U.S. grandchildren with an initial corpus of $1,000,000. By the time the problem is discovered, the corpus is $2,000,000 consisting of $1,000,000 initial corpus and $1,000,000 of realized recognized and undistributed income. The Trustee acquired a Private Placement Life Insurance Policy with a death benefit of $5,000,000 and the grandchildren as beneficiaries and father, also a non-resident alien, as the insured. Father, in due course dies and the grandchildren receive the death benefit free of U.S. tax. IRS personnel have privately advised that the IRS will treat the payment of the death benefit as just that and not take the position that it is a constructive distribution from the trust carrying out undistributed net income. If this is true, then the beneficiaries indeed receive the entire corpus including the amount of undistributed accumulated income (and then some) tax-free. The trust without a corpus terminates and the accumulated undistributed income is never taxed. Strange, but perhaps true.
It is for these, and other reasons, that foreign issued and sometimes U.S. issued, custom-made private placement variable life insurance is a hot item, both among U.S. investors and also among investors having U.S. contacts or considering coming to the United States. You should look into it.