Initially looked at as an estate planning strategy, private placement life insurance (otherwise known as PPLI) is really an income tax planning opportunity. Still, PPLI policies can integrate estate planning strategies.

Even though a taxpayer may not be interested in life insurance, the special income tax rules for life insurance embedded in the Internal Revenue Code allows for income tax-free growth of the cash surrender value (i.e., investment portion) of a permanent (not term) life insurance policy. Further, distributions up to tax bases or loans from the cast surrender value will not be subject to income tax. If properly structured, the life insurance policy’s death benefit payment to the beneficiary will avoid any income tax.

Investment rules

The investments of a life insurance policy are subject to two basic rules.

• Number one, there will be a certain level of diversification requirements, starting generally with at least five investments and none for more than 55% of the insurance policy’s investment portfolio.

• Second, there cannot be investor control. In other words, the client will need an independent investment manager. The investment manager can choose from various public or more private investment opportunities.

The financial goal is a positive arbitrage to (1) increase the value of the cash run to value compared to the life insurance policy costs. At a higher marginal income tax rate, ordinary income is particularly ideal for investment within a PPLI policy. If a taxpayer expects large capital gains, it can make sense for a PPLI policy to own those assets.

Cost and other considerations

Generally, but subject to negotiation, the life insurance policies costs include an upfront fee of maybe 40-60 basis points and then an annual trailer of from 35-100 basis points. For many, the policy charges will be significantly less than the potential income taxes on the growth of the policy. The cost structure includes the life insurance company’s costs of annual term insurance, administrative expenses, and their negotiated profits.

Often these PPLI policies, especially with the choice of more private assets to be held in the policy, will be set up in a foreign jurisdiction. Monetary controls at these foreign countries are generally similar to those provided by United States’ Securities and Exchange Commission (SEC). If there are more traditional investments, like marketable securities, it may make sense to establish a PPLI policy with a domestic life insurance company.

PPLI may provide a significant income tax planning opportunity. With proper structuring, PPLI policies can provide tax-deferred growth, tax-free distributions, and a range of investment options, all while potentially reducing overall tax liability.