Paradise Found! – The Use of PPLI Planning in Income Realization Planning in the Sale of a Capital Asset
I was at the PPLI conference in Boston a week and a half ago. Usually it is the same group of people saying the same things. However, this year was a little different. I have lived through several cycles of evolution of the PPLI industry since I got involved with PPLI in 1999. The PPLI market segment may have finally turned the corner! Even though the industry has consolidated, the entry of the world’s largest investment management firm as an owner of the two leading global PPLI carrier lends a large degree of credibility to the PPLI industry, and also has the effect of opening some new doors that were heretofore closed.
The industry has become standardized in many respects. The degree of difference between onshore and offshore carriers has largely disappeared. One difference that has also disappeared are the types of transactions that offshore life insurers were willing to consider versus their domestic counterparts. In particular, offshore life insurers in the past were willing to consider the transfer of capital assets as a form of in kind premium. Additionally, offshore life insurers were willing to invest in small private companies that bordered or crossed the line of investor control. Those days are gone!
The transactions being done by offshore and domestic life insurers involve cash premiums exclusively with the majority of investment options being structured as insurance dedicated funds (IDF). One of the planning considerations in the past was the use of PPLI in conjunction or anticipation of an income realization event through the sale of a capital asset such as the sale of a business or the sale of appreciated stock or real estate.
Advisors considered the transfer of the asset at its lowest value to the life insurer as an in kind premium, or sold the asset on an arms-length to the investment advisor within the policy. The capital gain realized upon the sale of the asset would be realized within the policy and receive the tax treatment of life insurance, i.e. the policyholder would not be taxed and the life insurer would receive a reserves deduction equal to the amount of investment income. Today most life insurers and advisors would concede that this type of transaction probably violates the investor control doctrine. The question the reader might ask is if you can no longer execute the former technique, what might an advisor tell his client to do instead?
This article outlines the combination of a technique using an installment sale with the purchase of private placement life insurance (PPLI). The combination of techniques allows the Seller of a highly appreciated capital asset to defer capital gains taxation for up to thirty years while separately obtaining a loan monetizing 93-95 percent of the sales price in the installment agreement on a tax-free basis. The Seller is then free to use those tax-free proceeds from the monetization loan in order to purchase PPLI and further maximize the tax benefits of life insurance. The purchase of the policy may be structured so that it obtains not only income tax benefits, but estate and generation skipping transfer tax benefits. The combination of techniques allows the taxpayer to proceed in a more certain direction without significant planning results.
Variable Insurance Products
In case you did not know, the assets of variable life insurance and annuities in the U.S. life insurance industry exceed two and a half trillion dollars. The majority of the assets are part of variable annuity arrangements. The marketplace for private placement life insurance and annuities easily exceeds $100 billion. High net worth assets account for approximately $15 billion while corporate and bank owned life insurance programs account for $100 plus million.
What is private placement life insurance (aka PPLI)?
PPLI is a form of variable universal life insurance. The policy is strictly available for accredited investors and qualified purchasers as defined under federal securities law. The policy is institutionally priced and is virtually a “no load” product. The insurer provides the policyholder with the ability policyholder to customize the investment options within the policy. The range of investment options can include a customized fund managed by the client’s existing investment advisor as well as a range of asset classes including hedge funds, real estate and private equity.
How do private placement insurance products differ from retail insurance products in regard to sales loads?
In order to appreciate the cost perspective of PPLI, you need to understand the cost structure of retail insurance products. Variable life insurance products have a commission structure that pays the agent 55 -95 percent of the target (commissionable) premium in the first policy year.
Commissions in subsequent years on premiums vary by carrier from 2-5 percent of the premium. Additionally, the agent receives 25-35 basis points (.25-.35 percent) of the policy’s account value each year. The policies usually have declining surrender charges of 10-12 years. These charges allow the insurer to amortize and recoup these sales
Private placement life insurance and annuities have no surrender charges and compensate the distributor (agent) with premium based commissions equal to 1-3 percent and asset based commissions based on the account value of 25-35 basis points. The impact of these charges creates a “drag” on the investment performance of approximately one percent per year over the life of the policy.
The tax advantages of Life Insurance
The net cost of the loan which does not have to be repaid is approximately 25-50 basis points (.25%-.50%) per year. The death benefit is income tax-free and can also be arranged so that it is estate tax-free. Not bad, right! However, the premiums are not tax deductible.
In plain English, the policyholder’s account value grows tax-free, can be withdrawn tax-free, and is received tax-free by beneficiaries.
Who can purchase a private placement insurance contract?
The purchase of private placement insurance products is limited to accredited investors and qualified purchasers as defined under federal securities law. Private placement insurance products are a non-registered security for federal and state securities law purposes. The product is available to accredited investors and qualified purchasers as defined in federal securities law. The Securities Act of 1933 provides an exemption under Section 4(2) from securities registration for accredited investors as defined in Rule 501(a) of Regulation D under the Securities Act. An accredited investor is defined as an investor with a net worth of at least $1 million and joint income of at least $300,000 in each of the last two years, with the likelihood of continuation in the current year.
PPLI offerings are exempt from the Investment Company Act of 1940 under Section 3(c)(1) and 3(c)(7) offerings. Under Section 3(c)(1) the number of beneficial owners is limited to 99 investors.[1] Investors must be accredited investors or qualified purchasers. A qualified purchaser has investable assets of at least $5 million. Under Section 3(c)(7) the number of beneficial owners is limited to 499 investors.[2] The investors must be qualified purchasers. New SEC proposals would exclude the value of an investor’s principal residence from investable assets.
PPLI – The Bottom Line?
I have outlined a hypothetical purchase of a PPLI contract. A high net worth investor, age 50, invests a single premium of $10 million into a contact issued by a domestic life insurer. The policy is a modified endowment contract. The initial death benefit is $35 million. The cash value is invested into a customized hedge fund managed account managed by the client’s multi-family office.
The policy is invested at an assumed rate of 15 percent per year (I know- wishful thinking!). The comparison demonstrates the difference between a taxable account (far left column in red) and a tax-advantaged column (second and third columns in green). The taxable account is taxed at a combined rate of 47 percent.
The long-term results in favor of PPLI are staggering.
| $10 Million Deposit | ||||||
|
Year |
Net Taxable
Investment Value ($) |
End of Year
Policy Cash Value ($) |
Death
Benefit ($) |
Net Taxable
Investment IRR (%) |
Policy Cash
Value IRR (%) |
Death
Benefit IRR (%) |
| 1 | 10,795,000 | 11,362,510 | 35,943,930 | 7.95 | 13.62 | 259.44% |
| 2 | 11,653,203 | 12,912,620 | 35,943,930 | 7.95 | 13.62 | 89.60 |
| 3 | 12,579,632 | 14,684,290 | 35,943,930 | 7.95 | 13.65 | 53.18 |
| 4 | 13,579,713 | 16,710,230 | 35,943,930 | 7.95 | 13.69 | 37.68 |
| 5 | 14,659,300 | 19,019,330 | 35,943,930 | 7.95 | 13.75 | 29.15 |
| 10 | 21,489,508 | 36,525,140 | 48,943,680 | 7.95 | 13.84 | 17.24 |
| 15 | 31,502,114 | 70,617,360 | 86,153,180 | 7.95 | 13.91 | 15.44 |
| 20 | 46,179,894 | 136,575,200 | 158,427,200 | 7.95 | 13.95 | 14.82 |
| 30 | 99,238,319 | 525,828,200 | 552,119,600 | 7.95 | 14.13 | 14.32%
|
| 40 | 213,258,263 | 2,004,725,000 | 2,104,961,000 | 7.95 | 14.17 | 14.31% |
Installment Sales
IRC Sec 453(c) defines an installment sale as method under which the income recognized in any taxable year from a disposition is the proportion of the payments received in a year which the gross profit (realized or to be realized when a payment is completed) bears to the total contract price. Essentially, the taxpayer is required to pay the tax proportionately as the principal payments are received.
A specialty dealer may facilitate and structure collateralized installment sales. As a dealer in capital assets, the company can purchase assets from a Seller. The assets can be virtually any capital asset, whether it’s a business, investment or personal asset, on an installment basis. The installment note calls for payments of interest only from the Dealer to the Seller for a specified number of years, followed by payment of the entire purchase price at the end of the term.
Most often, the Seller has already found an ultimate buyer for the asset before the Dealer becomes involved. Frequently, the ultimate buyer is prepared to pay cash, or a considerable portion of the price in cash, while the Seller prefers to defer the tax on the cash proceeds.
With these circumstances in mind, the Seller brings the Dealer into the transaction as an intermediate purchaser from the seller. At the same time as the purchase, the Dealer resells the asset to the ultimate Buyer to whom the Seller had planned to sell directly. The Dealer receives and retains the sale proceeds which the final buyer pays. Both the installment sale to the Dealer and its resale to the final Buyer are closed simultaneously, pursuant to mutually agreed closing instructions provided to the closing agent.
Concurrent with the closing of the transaction, a third-party lender which is unrelated to the Dealer may be willing to lend to the Dealer’s Seller, an amount of cash that is equal to a specified high percentage (90=93.5% of the sales price) of the cash paid by the final Buyer. The Dealer’s monthly payments on the installment contract will equal or exceed the Seller’s loan-interest payments on the monetization loan. The final due dates on the installment contract and the monetization loan will typically be the same, while the principal amount paid on the installment contract at the end will equal or exceed the amount that the seller then owes on the loan.
The Seller may then use those loan proceed which are non-taxable for tax purposes for any business or personal; investment purpose which the Seller prefers, including to pay debt on the asset being sold or to pay other business debt. The lender does not receive a lien on the installment contract, or the asset that was sold including the installment payments made by the Dealer. The Dealer is not a party to the loan; it is a transaction solely between the Seller and the lender.
From an estate tax standpoint, installment contracts are typically valued at a value considerably discounted value from an estate tax perspective while the installment debt related to the monetized loan reduces the taxable estate by the full amount owed. The combination of a collateralized installment sale and the loan from the separate lender can materially reduce the seller’s future estate tax liability. At the same time, it provides the Seller with tax-free use of 90-95 percent of the sales price while deferring recognition of the gain related to the installment sale for up to thirty years.
Strategy Example
Instead of an outright sale, the sale of the assets are structured as installment sale with no money down and a non-amortizing installment contract with due in thirty years with interest payments due on a monthly basis. At the same time, a third party lender arranges a monetization loan equal to $18.7 million. The proceeds are made available to Sam individually outside of the corporation on a tax-free basis.
Sam is able to use these proceeds to purchase PPLI. The policy is structured within an Irrevocable Life Insurance Trust (ILIT). Sam intends to allocate $10 million of the proceeds as premium. The trustee is the applicant, owner, and beneficiary of a second-to-die life insurance policy insuring the lives of Sam’s son and daughter for $85 million and an annual premium of $2.5 million per year for four years.
Sam and his wife enter into a private split dollar arrangement with the trustee of the ILIT. Sam and his wife will retain an interest in the policy cash value and death benefit equal to the greater of the policy cash value or cumulative premiums. However, their access will be restricted until the death of the insured(s) or the termination of the split dollar agreement.
The projected cash value in thirty years assuming a seven percent net investment return is projected to be $76 million. The projected death benefit is $115 million. The projected $7.3 million deferred capital gains tax at the end of the thirty years has a present value of $3 million assuming a three percent discount rate. The tax-deferred growth of the policy plus its income, estate, and generation skipping transfer tax treatment at the death of the insured(s) demonstrate incredible leverage of the funds accessed through the loan monetization of the installment note on a tax-free basis. In the example, Sam is able to enjoy the other $10 million of the loan on a tax-free basis for reinvestment or personal expenditures.
Summary
The PPLI industry has finally reached prime time. In the past advisors explored aggressive techniques to combine tax planning and the purchase of PPLI. The technique outlined in this article summarizes a combination of techniques that will allow the taxpayer to enjoy considerable tax benefit and reinvestment on a tax-advantaged basis with minimal tax-risk. It is the best of all Worlds!
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Gerald Nowotny
Law Office of Gerald R. Nowotny
266 Lovely Street
Avon, CT 06001
United States
860-404-9401
TaxManDotCom.com
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