General Taxation Effects and Benefits of Private Placement Life Insurance
Definition of Life Insurance
The tax law definition of life insurance is found in Code Section 7702. Two different definitions of life insurance are provided and the policyholder must select the definition to be used at the time of the policy's issuance and maintain that definition throughout the policy's life.
The cash value accumulation test tends to be used more in COLI transactions. This actuarial test provides for a lower initial death benefit relative to the initial premium, but has a larger net amount at risk in older ages near actuarial life expectancy (age 82). The net amount at risk is the difference between the policy's total death benefit and cash value. The net result is that the higher mortality cost in the older ages does not produce cash value accumulation as high as the second test-guideline premium test/cash value corridor.
Most high net worth Private Placement Variable Annuity accounts use the guideline premium test, which also utilizes the cash value corridor requirement found in Section 7702.22. The guideline premium test using the cash value corridor provides
the policy with better long-term cash accumulation. The cash value corridor reduces the amount of net amount at risk over the life of the policy.
For example, at age 90, the policy no longer requires any risk transfer in excess of the policy cash value, i.e., the policy death benefit and cash value can remain equal.
Modified Endowment Contract Rule. (MEC)
Section 7702A provides that a modified endowment contract (MEC) is a life insurance policy that is overfunded in the initial years of its existence based upon the timing and amount of premiums paid in relation to its death benefit. The Modified Endowment Contract rules are essentially designed to discourage policy premium front-loading in the manner in which Congress believes too closely resembles the way an investor would make his or her investment in an annuity product.
The determination of whether a life insurance policy is a Modified Endowment Contract Rule is based on complex actuarial calculations and what is known as the "seven-pay" test.
Generally, a policy is an MEC where, for example, the cumulative premiums paid at any time during the first seven years of the contract exceed the sum of the maximum net level premiums that could have been paid on or before such time, if the contract provided for paid-up future benefits after the payment of seven level annual premiums.
Effectively, this test requires that the premiums paid into the policy be made over several years, as opposed to a single up-front payment. The seven-pay test, through complex actuarial assumptions and calculations, can be passed for a premium payment period of only four years.
The following repercussions arise following characterization of a life insurance policy as an MEC:
• Loans taken from or secured by the policy are generally deemed to be distributions of earnings from the policy.23
• All distributions, including payments upon the lapse or surrender of an MEC policy, are generally taxable as ordinary income up to the amount by which the cash surrender value of the policy exceeds the cumulative amount of premiums paid into the policy."
• A 10 percent additional income tax is imposed on all distributions made prior to the insured attaining age 59 1\2- provided, however, that this penalty shall not apply where the insured is disabled, or where such distributions are part of a series of substantially equal periodic payments extending over the life of the taxpayer."
Where an insurance policy is not characterized as an MEC, loans can generally be made from the policy on a "tax-free" basis. This result will ordinarily still be achieved in cases where the cumulative loans are in excess of the cumulative premiums paid into the policy
The policy's cost basis is its cumulative premiums. Loans and partial surrender of the cash value are the primary mechanism whereby the policy owner is permitted to have access to a portion of the investment account during the insured's lifetime. As such, non-MEC status is of critical importance in order to obtain the full benefits of this planning.
Tax Advantaged Wealth Accumulation: Using Private Placement Variable Annuity Basics
Private Placement Variable Annuity policies have no surrender charges and the investment options may include sophisticated investment options such as Hedge Funds. Retail variable annuity contracts typically provide the policyholder with a wide range of mutual fund subaccounts. Private Placement Variable Annuity contracts have customized and negotiated sales loads that generally are equal to 1 percent to 2 percent of each premium deposited into the contract. These sales loads are much lower than those for retail variable annuity contracts.
The taxation of annuity contracts is governed by Section 72. Private Placement Variable Annuity contracts are also subject to the same investment diversification and investor control considerations as under Section 817(h) and Treasury Regulations Section 1.817-5. Private Placement Variable Annuity provides for tax deferral.
The retail variable insurance market offers immediate variable annuities, which provide for annuity payments to the annuitant within a year of the premium payment. Rather than provide a "fixed" payment, variable immediate annuities provide for payments that increase or decrease based upon the investment performance of the underlying investment(s) within the contract. The policyholder is able to make an election to determine fund selection.
These contracts are not yet available with the high net worth Private Placement Variable Annuity marketplace. Generally, wealthy individuals have other sources of income and use insurance products for tax-advantaged accumulation rather than income planning.
The retail variable marketplace has evolved with a number of interesting product developments and features. Other features found in retail variable insurance products that are not found in Private Placement Variable Annuity products include the Guaranteed Minimum Death Benefit Rider and the Guaranteed Minimum Income Benefit Rider. These riders provide a guaranteed income at age 65 regardless of the underlying investment performance of separate account investments.
Similarly, the policy also provides for a guaranteed accumulation payable at the death of the policyholder. These contracts come at a price. It is not uncommon for a life insurer in the current market to offer a 5 percent guaranteed return while charging 4 percent (including the policy 's mortality and charge expense).
Private placement variable annuity contracts are unique investment vehicles that are grossly under-utilized by professional advisors. These institutionally priced variable insurance contracts allow for investment customization and provide for the possibility of stronger and more consistent investment performance. The tax advantages of life insurance and deferred annuities are well known, but not on this institutional platform. The cost of the insurance contract presents very little "drag" on investment performance. Ultimately, it is strength and consistentency that are the biggest catalysts in investment performance. Life insurance agents have not been and will not be the catalyst of the sector's growth due to a fundamental conflict of interest-their large commissions. Thus, it is up to professional advisors-lawyers, accountants, trust officers, and private bankers-to bring the planning possibilities to the attention of their clients.
The long-term results can be stunning, providing families with generations of tax-advantaged wealth accumulation. The thought of what lies ahead from a tax perspective for high net worth investors is daunting, to say the least. There is a very high likelihood we will see combined marginal federal and state income tax rates in excess of 50 percent, along with the return of higher federal estate tax rates and a reduction of available income tax deductions. High net worth investors will need to rely on their advisors to steer them to viable tax structures with an underpinning of strong statutory authority. The life insurance industry has managed to preserve the favorable taxation of life insurance and annuities.
-Tax professionals should not let their clients miss out on a tremendous planning opportunity.