Are you a fan of hedge funds? We can assume that you’re not a fan of paying taxes on Short-Term Capital Gains (STCG). As you undoubtedly know, those STCG are taxed at the same rate as ordinary income, taking a nasty chunk out of whatever profits you may have made. While this effective rate of 35% has been in place for over a decade now, that top rate is going up to 39.6% . What that means for you is that every dollar of income that your hedge-fund investment earns for you in 2013 is going to be subject to at least 39.6% in federal taxes. That's rough. Also, in most cases, an additional ObamaCare/Medicare 3.8% surtax will be imposed.
You might call PPLI a “loophole,” but we prefer to call it a “tax-policy-driven exception”. It is a legitimate tax plan.
Chances are — if you've read up to this point — you have plenty of liquid assets and you want to reach for outsized returns. But you find yourself asking, "What about the tax consequences?" No one likes to see their investment gains cut in half by the taxman, but that’s exactly what you should expect if you invest in a traditional hedge fund directly. Enter private placement life insurance. PPLI is an investment vehicle for those with an appetite for hedge-fund-sized returns and a distaste for the taxes that come along with them.
An optimal PPLI contract will generally be structured as a variable universal life insurance policy. However, a PPLI is different than an off-the-shelf policy in that it allows you to invest is a broader range of non-publicly available investments. In fact, these investments must be available only to purchasers of variable life insurance or a variable annuity contract with the insurance company in order for this type of planning to work. For a PPLI to be advantageous to you tax-wise, several requirements must be met. These requirements can be broken down into three broad categories: 1) control 2) diversification and 3) insurable interest.
1. The Control Doctrine: The biggest stumbling block for private equity
We'll just go ahead and talk about the worst aspect of a PPLI — that is, the owner of the policy must give up control. This is how it works:
The investments available for a purchaser of a PPLI policy are called sub-accounts. An investment manager (an “Advisor”) determines the investment strategy for the available accounts. In a PPLI, the insured cannot directly or indirectly communicate with the Advisor who runs a particular account. Really. This rule is referred to as the “control doctrine”. The bottom line is that if you are setting up a PPLI it is important for you to pick both an Insurance Company and an Advisor that you trust will employ the correct strategies.
Once you purchase the policy, you cannot discuss or suggest investment strategies to either party. By its very nature private placement life insurance is a product that can be customized to your particular needs. So nothing stops you from suggesting an Advisor that you would like to run your sub-accounts. But, on the other side of the coin, you cannot demand that a particular Advisor run the fund, the decision ultimately rests with the insurance company.
One thing you can decide is which sub-accounts made available by Insurance Company you wish to invest your policy funds and premiums in. You can transfer funds between any of the sub-accounts made available to you. The catch, however, is that you 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 met. You see, that’s what creates the major income tax advantage here. By entering into a contract where you do not direct the investment of the funds, you won’t be treated as an owner of investments within the fund, and when you aren’t the owner of an asset (for tax purposes) you can’t be taxed on the income made from that Asset.
Let me try to underline that: You can't be taxed on the income made from that asset. So, as long as you are hip to giving up control, the rest of the requirements are a breeze.
2. Diversification Requirements: IRC section 817
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.
3. Insurable Interest
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 that if you plan on placing a PPLI policy on your own life into a trust, all of the trust beneficiaries must have an insurable interest in your life. Immediate family members, including spouses and children have such an interest. If you don't have an insurable interest, a nearly awesome product known as a Private Place Variable Annuity is available.
The potential benefits of utilizing a PPLI are the following:
- 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
- If the insured is not the policy holder, then the death benefits paid out by the policy will not be subject to Estate Tax. And it looks like the Estate Tax is going to rise.
It all depends on what you are after
Setting up a PPLI policy isn’t a simple matter. To be honest, that's an understatement as it is incredibly complicated and needs to be handled by sophisticated managers, PPLI agents, tax attorneys, and clients who all have a solid understanding of what's going on. Yet, if the policy is set up correctly, it can lead to mind-blowing lifetime tax savings.
The PPLI is a flexible approach to a myriad of issues, but if you want to utilize it, you need to make sure that you have the right team in play. You're going to want to hire people who are familiar with a product that most people don't know exists, but has been around for 40 years. If you would like to discuss this option further, contact us at 888-727-8796 or email email@example.com.
UPDATE 10-26-2015: How to avoid ordinary income gains and fund your PPLI: