WHAT’S OLD IS WHAT’S NEWBy Robert G. Kuchner | November 15, 2016
A powerful tool for wealth accumulation, asset protection and estate planning.
Contrary to popular belief ― and probably in keeping with your own professional experience ― high net worth individuals (HNWI) rarely regard tax reduction and improving cash flow as chief among their concerns. In fact, according to one reliable source1, the top five financial interests of HNWIs are, in order of importance:
- Maintaining their lifestyle in retirement;
- college education funding;
- protecting their current levels of wealth;
- growing their wealth; and,
- leaving an estate for heirs.
Of course, there are many means to achieving these ends. However, again contrary to popular belief, hedge funds, mutual funds, stocks, bonds, and T- notes, et al, may not be the most efficient or tax-effective ways to protect and preserve a client’s assets.
In fact, life insurance, be it ever so humble, can actually be a really powerful tool for wealth accumulation, asset protection, and estate planning. The beauty of insurance products is that the tax treatment of your clients’ investments are either tax exempt or tax deferred. Life insurance itself is tax free to the beneficiary.
For affluent investors it's really about what they can walk away with, not necessarily how much they earn. And let’s face it, a great performing investment can become a very mediocre one once taxes kick in.
Private Placement Life Insurance
One of the most flexible, and efficient insurance ‘tools’ available is probably Private PlacementLife Insurance (PPLI). PPLI is a variable universal life insurance policy that provides cash value appreciation based on a segregated investment account and a life insurance benefit; it’s designed to maximize savings and minimize the death benefit. In other words, less insurance more investment.
The investment account can use hedge fund strategies using in tax-inefficient investments because the tax effect is completely eliminated ― from the investor standpoint. So, a hedge fund or other investment that produces above average returns, may actually be very tax-inefficient resulting in less than stellar returns for the investor.
But here’s the point: Ultimately, PPLI allows the investor a highly effective way to mitigate the tax bite and capture returns income tax-free.
PPLI also provides its owner with tax-free access to the policy cash values. The policy owner can access the account value in one of two ways, both of which are income-tax free. They may:
- Withdraw the cost basis of the policy, which is equal to the cumulative premium amount deposited in the PPVUL Investment Account; or,
- Take a low-cost loan from the account. When the insured passes away, all the deferred investment gains are paid to the beneficiaries of the policy as an income tax-free insurance benefit. The loan balance is offset against the proceeds of the policy.
The Control Doctrine: The biggest stumbling block for private equity
Predictably, there are downsides to acquiring PPLIs, chief among them the fact that the owner of the policy must give up control. Jurisdiction is assumed by an investment manager, who determines the investment strategy for the available accounts. Plus, in a PPLI, the insured cannot directly or indirectly communicate with the advisor who runs the account.
Once your client purchases the policy, they cannot discuss ― or suggest ― investment strategies to either party. However, private placement life insurance can be customized to meet your client’s particular needs.
As such, there is nothing to prevent your client from suggesting which advisor they would like to run their sub-accounts. Still, the client absolutely cannot demand that a particular advisor run the fund. That decision ultimately rests with the insurance company.
Of course, your client is permitted to transfer funds between any of the sub-accounts made available to them. The catch, however, is that they cannot have an agreement with the Insurer that a particular sub-account ― or even a particular type of sub account― will actually be available.
It is very important that the requirements of the control doctrine are always met, since that’s what creates the major income tax advantage: By entering into a contract where they do not direct the investment of the funds, your client is not treated as an owner of investments within the fund.This means that, for tax purposes, they are not legally regarded as the owner of an asset and cannot, therefore, be taxed on the income derived from that asset.
Diversification requirements: IRC section 817
It’s worth pointing out that, in order for an investment vehicle to qualify as a life insurance contract, it must comply with certain diversification requirements. Each sub-account must be “adequately diversified,” meaning that it must contain at least five different investments. In addition, the investments must be weighted so that no particular investment dominates the performance of the account.
If a sub-account fails to meet this requirement, then the policy-holder will be taxed on the gains under section 7702(g) of the Internal Revenue Code.
The bottom line is that if you are setting up a PPLI for your client it is important for you to pick both an insurance company and an advisor that can be trusted to employ the correct strategies.
In order for a product to qualify as “Life Insurance,” the holder must have an insurable interest in the person who is insured. That means if your client is planning on placing a PPLI policy on their own life into a trust, all of the trust beneficiaries must have an insurable interest in your client’s life. Immediate family members, including spouses and children have such an interest.
Private Placement Variable Annuity ― PPVA
If yours doesn’t have an insurable interest, perhaps because they are not easily insurable, another product known as a Private Placement Variable Annuity (PPVA) is available to them.
Private Placement Variable Annuity Investment Accounts
A PPVA Investment Account permits investors to defer income tax on investment gains. Investors can make deposits and take distributions from these accounts with the same flexibility as they would from any investment account (however, there’s a 10 percent excise tax levied on any gains that are distributed from the account before the annuitant’s age 59½).
After age 59½, any gains from the PPVA Investment Account will be taxed as ordinary income on distribution. The owner of the PPVA Investment Account remains in full control of the assets within the account. Additionally, PPVA Investment Accounts allow individuals to invest in non-registered investment offerings, such as hedge funds.
It is very important that your client’s personal advisor prepares substantial analysis be as to the time horizon of the investment vs the benefits of the tax deferral to see if this all pays off.
PPVA Investment Accounts are often utilized by ultra-affluent individuals and families who intend to leave assets to a public charity or private foundation at their passing. If a charitable entity is named as the beneficiary of a PPVA Investment Account, all the deferred gains pass tax-free to the charity.
However, unlike other charitable strategies that are irrevocable in nature, PPVA Investment Accounts provide flexibility for the individual or family if there’s ever a desire to access the assets during the owner’s lifetime. The PPVA Investment Account owner also retains full control during its lifetime to change the beneficiary from one charitable entity to another.
Are there any disadvantages with these vehicles?
One of the more important concerns with PPVA Investment Accounts is that all the deferred gains are taxed as ordinary income on withdrawal. This means that even if an investment would normally qualify for some Long Term Capital Gain treatment, on withdrawal from a PPVA Investment Account all the gains are taxed as ordinary income tax rates.
Because of this status, PPVA Investment Accounts are generally utilized for the most tax- inefficient portion of a high-net-worth individual’s overall portfolio. For example, a municipal bond fund wouldn’t be a strong candidate for a PPVA Investment Account, and again you must consider time horizon.
PPVA and PPVUL Investment Accounts may be beneficial for tax-sensitive investors, especially those seeking to invest in hedge funds or funds of hedge funds.
The potential benefits of utilizing PPLI are the following:
PPLI uses specially structured, insurance-dedicated fund so your client’s investments grow without being subject to current taxation.
The holder can take tax-free distributions up to the premiums that he has paid. That’s because distributions from Life Insurance Products are handled on a first-in, first-out (FIFO) basis. So, initial withdrawals are treated as if they come from the first source of the funds, and a return of basis is not a taxable gain.
The holder of a PPLI policy can borrow against the policy without recognizing a taxable distribution. This provides access to fund without tax consequences.
They use insurance-dedicated fund, which is structured so your client’s investments grow without being subject to current taxation
The owner of the PPVA Investment Account remains in full control of the assets within the account. PPVA Investment Accounts allow individuals to invest in non-registered investment offerings, such as hedge funds deferring taxes, really helping to boost your client’s asset values. The other advisors here can really help structure opportunities for you or your clients to take advantage of this tax advantaged strategy!
This article was written by Robert G. Kuchner, CPA/PFS, a Partner at Marks Paneth LLP. “What's Old Is What's New”, will appear in the December issue of Global Business Opportunities.
About Robert G. Kuchner
Robert G. Kuchner, CPA/PFS, is a Partner at Marks Paneth LLP. Mr. Kuchner serves a diverse spectrum of privately owned companies and their owners as well as clients in the theater, media and entertainment industry. He also provides Business Management and Family Office services to a varied client base. Mr. Kuchner holds a Bachelor of Business Administration degree in Public Accounting from Hofstra University’s Frank G. Zarb School of Business, where he currently serves on its Dean’s Advisory Board. He is based in Marks Paneth’s midtown Manhattan headquarters.
For More Information
If you have questions, please contact Robert Kuchner, Partner, by phone at (212) 330-6060 or by email at email@example.com.
About Robert G. Kuchner
Robert G. Kuchner, CPA, PFS, is a Partner at Marks Paneth LLP. Mr. Kuchner serves a diverse spectrum of privately owned companies and their owners as well as clients in the theater, media and entertainment industry. He also provides Business Management and Family Office services to a varied client base. Further, his broad background also includes serving clients in the manufacturing, distribution, publishing, banking and finance, leasing and transportation industries, as well as professional services... READ MORE +