Author by Leslie C. Giordani, Michael H. Ripp, Jr. and Amy P. Jetel A. Introduction: "Big Picture" Estate and Tax Planning This article will examine two strategies that fall outside the bounds of a traditional estate planning framework, although they are well within the "big picture" that clients wish their estate planners to address; and in many ways, these two strategies go hand-in-hand. The first is private placement variable universal life insurance ("PPVUL"), an investment-oriented strategy that can dramatically improve the tax efficiency of a client's investment portfolio. The second is hedge fund investing, an investment strategy that has rapidly gained popularity among taxable investors in today's equity market environment due to its ability to deliver superior risk-adjusted returns in both bull and bear markets.
Private Placement Variable Universal Life Insurance 1. Introduction As the investment power of high-net-worth individuals continues to grow, legal and financial advisors are frequently asked about tax-advantaged structures for passive investments. A life insurance policy that is U.S.-tax compliant, especially one offered by an established carrier, presents a conservative and cost-effective investment opportunity. By virtue of the substantial lobbying influence of powerful interest groups, including the U.S. life insurance industry, life insurance as a financial product has had a long history in the United States as a tax-advantaged investment vehicle with minimal legislative risk. Certain carriers with well-established operations both inside and outside of the U.S. offer "private placement" (or, more appropriately, "customized") policies that are fully compliant with U.S. tax rules and are, therefore, fully entitled to the preferential tax treatment that life insurance enjoys. With proper policy design, an investor can place wealth in a tax-free investment environment at a low cost, achieve protection against future creditor risk and local economic risk, gain financial privacy, and enjoy superior flexibility with regard to the policy's underlying investments.
Despite the long-standing availability of variable universal life insurance products in the retail market, the PPVUL market is still in its growth and development phase, and there are significant traps for the unwary. Accordingly, it is important for the advisor who counsels high-net-worth clients for whom private placement life insurance planning is advantageous to understand the tax, investment, and pricing aspects of life insurance generally, and to be able to weigh the advantages and disadvantages of an offshore private placement policy against a domestic private placement policy or a domestic retail policy. It is equally important for the advisor to be attuned to jurisdictional issues when planning the life insurance ownership structure and for the advisor to engage the services of a knowledgeable intermediary, such as an experienced insurance broker that dedicates itself to the private placement marketplace, to be involved in the design of the product, the selection of the carrier (and the attention to related due diligence issues), and the ongoing service and compliance matters related to the policy itself.
What PPVUL is Not There are currently two insurance structures other than PPVUL on the market that have recently come under a significant amount of scrutiny by the Internal Revenue Service (the "Service" or "IRS"). These structures are Internal Revenue Code ("IRC") § 501(c)(15) insurance companies and equity acquisitions of offshore insurance company stock. It is essential to understand that these structures are unrelated to the PPVUL structure discussed in this article.
The first structure mentioned, an IRC § 501(c)(15) insurance company, is statutorily defined in the Internal Revenue Code. IRC § 501(c)(15) was originally passed as a way to assist farmers who lacked easy access to the insurance market. The goal of IRC § 501(c)(15) was to allow these farmers to set up small insurance companies that would be considered tax-exempt, provided that they collected less than $350,000 in premiums a year and did not underwrite life insurance. Recently, however, ultra-high-net-worth investors, seeking to shelter assets from income taxation, have availed themselves of the tax benefits available to IRC § 501(c)(15) insurance companies. That is, as long as such an insurance company does not collect more than the $350,000 premium limit per year, it is allowed under IRC § 501(c)(15) to accumulate earnings on its investments income tax-free. Moreover, appreciated assets may be transferred to the corporation in exchange for stock when the company is initially capitalized. These insurance companies are legal under the letter of the law, and several of them have accumulated millions of dollars of tax-free earnings for their investors. However, the IRS apparently now perceives the use of IRC § 501(c)(15) insurance companies to be investor abuse in some cases. Accordingly, the IRS issued Notice 2003-35 in May 2004 to remind the public that an IRC § 501(c)(15) insurance company's primary purpose is to provide insurance, not investment opportunities.1 Notice 2003-35 also advises that the IRS will begin active investigation of these entities in the near future.
The other insurance structure attracting the IRS's attention has as its purpose the conversion of hedge fund earnings from ordinary income and short-term capital gain income into long-term capital gain income. As mentioned above, hedge funds have become increasingly popular over the last several years due to their consistent outperformance of other investment strategies. This performance has driven investors to seek ways to avoid paying the high level of income tax typically attributed to hedge fund returns. The strategy involving the acquisition of offshore insurance company stock, sometimes referred to as the "equity transaction," involves a hedge fund manager or other investment service provider setting up an offshore insurance company. The organizer then seeks equity investors for the insurance company (i.e., investors interested in hedge funds), promising to allocate the investor's equity to a specified investment account, typically the investor's preferred hedge fund(s). The primary argument made by the IRS in...