From the July 2008 issue of Investment Advisor • Subscribe!

A Special Kind of Life Insurance

PPLI offers tax-advantaged hedge-fund investing and other benefits

One of the benefits of working with advanced planning networks is that they can add the right kind of specialist to deliver a better solution for the client than an advisor might be able to achieve working on her own. Private Placement Life Insurance is a powerful solution that's also powerfully intricate. In the late '90s PPLI was first offered by several small companies, and then, mainstream players such as New York Life, AIG, Sun Life, Prudential, and Mass Mutual joined in and the solution's appeal grew. At the same time, the use of PPLI expanded from seeking investment growth free of federal income tax in a cash value account to designing sophisticated estate planning solutions to mitigate estate taxes on the transfer of wealth using the death benefit. Now, PPLI solutions support wealth transfer, wealth creation, and philanthropic needs, by using the death benefit in tax-advantaged ways.

For several years, Robert W. Chesner, Jr., an attorney with Giordani Schurig Beckett Tackett LLP, Austin, Texas, has used PPLI with a variety of affluent clients. If a client with a net worth of $100 million comes to the firm, he or she will likely already have done some hedge fund or other alternative investing, he notes. Those investments are subject to ordinary income tax--federal, state, and municipal--however. When a 9% return nets more like 5% after taxes, the investment starts resembling a muni. For this kind of client and even those residing in states without a state income tax, investing in the same or similar portfolio within a PPLI offers a major advantage by eliminating the federal income tax.

Tax-free growth

Leslie C. Giordani and Michael H. Ripp, Jr., also attorneys with Giordani Schurig Beckett Tackett LLP, have demonstrated the advantages of accumulating returns inside a PPLI versus a taxed investment ("Private Placement Life Insurance Planning (Part 1)," ALI-ABA Estate Planning Course Materials Journal, 2006). In their hypothetical example, they show the side-by-side scenarios for a PPLI policy insuring a 45-year-old man with a $2.5 million annual premium for five years and a 10% rate of return net of investment management fees (taxed as ordinary income.) A hypothetical combined federal and state rate of 40% was used (see table, below).

Even after the first year, the PPLI cash value exceeds that of the taxed investment--plus the client's death benefit.

In addition to the features of a traditional policy, a PPLI policy provides:

  • Fee transparency to the client, unlike the "hidden" commissions of a traditional policy;
  • Investment options, such as hedge funds and private equity;
  • Very low cost for insurance and other policy fees (insurance, mortality and expense charges, commonly average around 1% or less over the life of the contract);
  • More efficient cash value compounding with the low cost of insurance, the potential performance of alternative investments, and no commissions reducing contributions to the cash value account--especially in the first year.

The interest in PPLI for asset protection has also increased. Asset protection in offshore insurance vehicles offers many additional advantages for high-net-worth clients. By using an offshore trust, you don't automatically eliminate federal income, since the client still needs to report worldwide income. However, if the offshore trust owns the PPLI, then those assets grow free of any federal income tax--and free of predators after the client's estate. At the death of the insured, those assets can distribute in a tax advantaged way to the next generation.

Paying premiums

PPLI policy premiums start from a low of $1 million ($250,000/year over four years, for example) to a more typical $5-10 million (paid in the early years of the policy or as a single premium). Larger PPLI policies have premiums of $25 million and even $100+million for multi-life contracts. To make the investment side of all PPLI policies efficient, early aggressive funding works best. The premiums usually represent less than one half of a client's net worth and are typically in the 10-40% range.

For those planners who regularly serve high-net-worth clients and have some experience structuring life insurance policies with multi-million dollar death benefits for wealth transfer, many of the steps in setting up a PPLI will sound familiar, but these policies have more details and a few twists.

Everyday insurance solutions such as an Irrevocable Life Insurance Trust with Crummey powers (a provision contained in certain irrevocable trusts that permits specified trust beneficiaries to withdraw gifts for a limited period of time) aren't sufficient to get an entire PPLI policy out of the matriarch's or patriarch's estate. Annual exclusions and unified credits don't offer much relief when dealing with a $10 million premium, so gift taxes still loom large. In order to improve asset protection, increase investment options, and avoid state premium taxes and the federal DAC tax, estate attorneys turn to offshore ownership and Alaska Trust solutions, among others.

Some clients keep a policy in the estate to avoid gift tax when they pay premiums, even buying larger policies than they would otherwise. Because these policies have potential income tax savings over many years, some clients view growing assets within a PPLI as highly preferable over a taxable investment account--even when considering the estate taxes eventually due.

To fund a PPLI policy, Chesner and Giordani favor using a private split dollar structure, which acts as intra-family loan. The attorneys on the advanced planning team set up two ownership entities in the form of trusts. The first one exists completely outside of the patriarch or matriarch's estate (and perhaps offshore) for income-tax and estate-tax purposes. It owns the policy.

The patriarch, for example, owns the second trust, which can be included for income tax purposes. This trust loans the money to the policy trust. The IRS establishes the loan rate, which is currently about 4% and that's what the policy trust must pay back along with the premiums. The real advantage of this arrangement is that the significant growth of the PPLI cash value and death benefit (minus the premiums and interest) occurs outside of the estate and free of income and estate taxes.

"You can start moving the needle to really help mitigate the transfer tax," says Chesner. "It depends on how much insurance the client buys"

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Setting up a PPLI Policy

After the client education stage, advanced planning teams focus on five areas:

  • Insurance underwriting--In the overall scheme of a PPLI policy, the cost of insurance is relatively inexpensive if the insured is in good health and doesn't bring underwriting baggage. If the insured's health or age remain an issue are an issue, advisors need to negotiate more aggressively.
  • Financial underwriting--The main carrier writing the policy sub-contracts chunks of the coverage with reinsurance companies, given the very large death benefits involved. Large PPLI face amount policies take longer to place than average-sized policies.
  • Investment research and selection--Selecting hedge funds and other alternative investment options, such as futures and commodities requires the advanced planning team's agreement. A PPLI is usually embedded within a comprehensive financial plan, complete with growth scenarios and cash flow projections.
  • Funding the policy--Substantial tax and planning questions lead to solutions such as private split dollar and other solutions.
  • Domestic vs. offshore ownership--The advanced planning group will need to analyze the benefits of domestic vs. offshore ownership--and the best ownership entity.

Obviously PPLI is not for everyone, but for those clients who are concerned about estate taxes and have sufficient assets to protect, it's an option worth exploring.

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