A co-owner of a beverage company, “Olivia,” recently sought my help in finding a way to reduce her taxes. In the past two years, her company had become very profitable and she wanted to make sure she would be able to live a very comfortable retirement … very soon! After we explored the benefits of an assortment of tools and techniques to defer or even eliminate taxes, Olivia decided to set up a “Private Placement Variable Life Insurance” contract to reduce her taxes.
Using a life insurance contract – to reduce your taxes?
What the heck is a “Private Placement Variable Life Insurance Contract … and why should I care”?
A Private Placement Variable Life Insurance (PPVLI) contract sure is a mouthful. “What is it?” you ask. It is a strategy often used by high income/high net worth individuals for years … but more often on the East Coast of the U.S. than us here on the “Left Coast.” Like any life insurance contract, it is made up of two components: a survivor benefit and accumulation value. Normally, life insurance is purchased to provide a survivor benefit, but not a PPVLI. It is primarily utilized as a tax-exempt “wrapper” to hold individual stocks, bonds, mutual funds, and even real estate! (No, this is not your grand-parents’ or parents’ life insurance contract for sure.) It is typically structured to provide the least amount of survivor benefit required by the IRS to just barely qualify as a life insurance contract. By doing this, it reduces the “friction” of mortality charges and thus allows the bulk of the investment account to grow without tax.
What are the Advantages of a Private Placement Variable Insurance Contract?
Here are the main benefits of purchasing a PPVLI:
- Lower costs, commissions and fees—since this is a private contract, institutional pricing is available and results in significantly lower premiums than the public would pay for similar coverage. The biggest savings, however, is that these contracts typically do not pay commissions, and are instead placed with an up-front consulting fee to the advisor. When millions of dollars are concerned, these savings can be significant
- Flexible premium contributions—premium contributions are far more flexible than garden-variety life insurance contracts. You can of course contribute cash, but as said above, other options include stocks, bonds, mutual funds, hedge funds and even real estate
- No Federal or State premium taxes for international jurisdictions—which saves paying the 3-4% Federal and State premium taxes per new contribution when the insurance is purchased inside the U.S. (Note: a U.S. federal excise tax of 1% is imposed on policy premiums on U.S. lives that are paid to foreign life insurance companies if those companies are not taxed as U.S. corporations)
- Tax-free appreciation—the money inside the contract grows without incurring taxes, and can be repositioned without paying taxes on any gains
- Loans are non-taxable—you can borrow up to 90% of the values inside the PPVLI without paying any taxes on appreciation, and the special loan feature often has a net effective loan interest charge of 0% net (I know that is a head-scratcher, but we can “unpack” that more later)
- Great for appreciating assets—this is an ideal tool to purchase assets that will appreciate. There is no tax upon the sale, so there is no need for a 1031 exchange if you have a real estate transaction
- No surrender charges—in retail permanent life insurance contracts, there can be substantial surrender charges in the early years of the contract. This is to recover the commissions paid to the agent and other expenses incurred in setting up the life insurance contract. PPVLI contracts typically have no surrender charges
- Assets are inherited income-tax free—at death, the assets receive a stepped-up basis and become income-tax free to the beneficiary(ies) (although they may be subject to Federal estate taxes or State inheritance taxes – see below discussion for more information)
- If you follow the rules, international domiciles provide the best benefits—while domestic versions of this product exist, the most powerful form is using an international situs. Costs are lower, and asset protection is greater. If an international location is selected, however, it is imperative that required disclosure forms be filed annually. The IRS will be your friend as long as you follow the rules of disclosure, which require all U.S. based taxpayers to report their world-wide income, even if there are no taxes to be paid. Penalties for non-disclosure – either through ignorance or carelessness – are not pretty, so make sure to inform your CPA
- Asset protection—assets inside the contract are beyond the reach of creditors (including the IRS) after 2 years + 1 day have passed. As important, the assets are not subject to the 10-year Federal bankruptcy “look-back” rule. If you choose an international situs, a U.S. court cannot force a PPVLI contract to release funds to a creditor. And, while the “wrapper” is domiciled outside the U.S., the assets remain in the U.S.
There are Some Drawbacks Which Should be Considered
Although there a host of benefits in purchasing a PPVLI, there are a few drawbacks that must be taken into account:
- “Accredited” investors need only apply—this is only for accredited investors as it requires a minimum of $1 million in contributions – which can either be a lump sum or over time. You must meet the Securities and Exchange Commission’s definition of “accredited investor” to qualify (see the SEC’s Bulletin on Accredited Investors for more specifics: https://www.sec.gov/files/ib_accreditedinvestors.pdf)
- Even though of minimal impact in many cases, insurance costs will reduce your returns—while not typically purchased for the survivor benefit, there is “friction” on returns to some degree. Mortality expenses are charged in the contract – since it is, after all, a life insurance contract! That said, the mortality expenses in a PPVLI are surprisingly low. Even for clients in their 70s, 80s and 90s, the friction is much less than what might be expected
- Federal estate or State inheritance taxes may apply upon death of the insured—depending on the amount of benefits paid upon death, the insured’s estate may owe Federal estate taxes; and beneficiaries may owe State inheritance taxes, depending upon their State of residence. The provisions in the Tax Cuts & Jobs Act of 2017 and the applicability of the so-called “spousal portability” rules influence this issue greatly. Each spouse is given a multi-million-dollar tax credit against federal estate taxes. This credit is indexed for inflation, and for 2018 the inflation adjusted amount is $11.18 million, or double that for a husband and wife
- You must comply with investment diversification rules—IRS rules provide detailed instructions on how to diversify investments: up to 55% of the total assets in the account can be in one investment; up to 70% in two investments; up to 80% in three investments; and up to 90% in four investments. As a result, you will need to have at least five investments to satisfy the investment diversification requirements. IRS regulations provide a one-year startup period that starts ticking the day a fund receives its initial contribution. Real estate accounts get more time to diversify—they have a five-year period
Contact us to learn more about the benefits of a PPVLI and whether it is something you should consider as a tax-efficient investment solution, or if a different solution might make more sense. Let’s brainstorm the unique circumstances of your situation and see what concepts might be most applicable to you. Setting up a PPVLI is clearly not something to “try at home.” The documents themselves are often not “traditional” and need to be properly customized, especially if you are interested in obtaining a PPVLI in another country.