Maximizing Tax Efficiency of PPLI in Hedge Fund Investments

Private placement life insurance (PPLI) policies are custom-written life insurance or annuity contracts. Initially, customized PPLI products were arranged offshore using small insurance carriers that were willing to put policy assets in vehicles such as hedge funds. More recently, however, large domestic insurance carriers have begun to offer the product as well.

PPLI policies are priced institutionally and comply fully with U.S. tax rules. Therefore, they receive the preferential tax treatment afforded by life insurance. The income earned by the assets in the policy is tax-deferred as long as the assets remain in the policy.

In addition, the policy owner may make tax-free loans against a PPLI policy’s cash value, and at the end of the insured’s life, the death benefit is tax-free.

PPLI Products As Investment Vehicles

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Unlike traditional life insurance, an investor does not buy a PPLI policy for its life insurance component. Instead, it’s purchased as a tax-free investment vehicle. This tax-free status, as well as the owner’s ability to designate an investment manager, has made PPLIs very attractive vehicles through which to invest in traditionally tax-inefficient assets, including hedge funds.

The Role of Hedge Funds

Hedge funds are unregistered investment vehicles that employ a variety of techniques to enhance returns. These techniques, such as shorting securities, are either unavailable to or severely limited for registered investment companies.

Growth of Hedge Funds

Over the past decade, hedge funds have become more and more popular. Assets under management by hedge funds have grown from around $40 billion in 1990 to an estimated $600 billion in 2002.

Tax Inefficiency of Hedge Funds

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Insufficient tax planning makes hedge funds tax-inefficient because, unlike mutual funds, hedge funds can pass through both long and short-term capital gains, the dividends they earn are generally not eligible for the special 15% reduced tax rate, and because onshore hedge funds are typically structured as partnerships, their earnings are taxed immediately, regardless of cash flow. 80%-90% of hedge fund gains come in the form of interest, dividends, and short-term capital gains, which are taxed at top marginal income tax rates.

Additional Tax Strategies

In addition to PPLIs, several strategies can be employed to reduce or eliminate the tax burden of hedge fund ownership. These strategies include the use of swaps, active loss harvesting to offset short-term gains with realized losses from other investment products, and the use of grantor-type trusts where the grantor has retained one or several attributes of control over trust assets that cause the grantor of the trust to be treated as the owner of the trust for income tax purposes.

Critical Life Insurance Component of PPLI

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When an investment is made in a hedge fund through a Private Placement Life Insurance (PPLI) contract, however, the life insurance component of the PPLI policy is critical. All of the tax benefits of these products are lost if the product fails to qualify as life insurance under tax rules.

Life Insurance Contract Standards

To be a life insurance contract, the contract must meet the standards for a life insurance contract under applicable law and either meet the cash value accumulation test of IRC section 7702(b) or both meet the guideline premium requirements under IRC section 7702(c) and fall within the cash value corridor of section 7702(d).

IRC Section 7702 Compliance

A contract meets the cash value accumulation test of section 7702(b) if, by the terms of the contract, the cash surrender value of the contract does not at any time exceed the net single premium that would have to be paid at that time to fund future benefits under the contract.

The guideline premium requirements of section 7702(c) provide that, in general, a contract meets the guideline premium requirements of the section if the sum of the premiums paid under the contract does not, at any time, exceed the “guideline premium limitation” as of that time.

The “guideline premium limitation” as of any date is the greater of 1) the guideline single premium, which is the premium at issue with respect to future benefits under the contract, and 2) the sum of the “guideline level premiums” to such date. The “guideline level premiums” are the level annual amount, payable over a period that does not end before the insured attains age 95, computed on the same basis as the guideline single premium, with limited exceptions.

A contract falls within the cash value corridor of section 7702(d) if the death benefit under the contract at any time is not less than the applicable percentage of the cash surrender value set forth in section 7702(d)(2). Per IRC section 7702(f )(9), in the case of a variable contract, the test to determine whether the contract meets these requirements must be performed at least once every 12 months.

Avoiding Modified Endowment Contract Status

In addition, a policy owner must avoid funding a policy so heavily that it is defined as a modified endowment contract (MEC) under IRC section 7702A. If a policy is defined as an MEC, the owner will pay tax at ordinary income tax rates on policy value gains that are accessed during the insured’s lifetime. Per IRC section 7702A, an MEC is defined as a contract entered into on or after June 21, 1988, that meets the requirements of section 7702 but fails to meet the 7-pay test of subsection 7702A(b).

A contract fails to meet the 7-pay test if the accumulated amount paid under the contract at any time during the first seven contract years exceeds the sum of the net level premiums that would have been paid on or before such time if the contract provided for paid-up future benefits after the payment of the seven-level annual premiums.

Of course, this provision deals with the taxability of gains that the policy owner accesses during the insured’s lifetime. Therefore, if the purpose of buying PPLI is to pass wealth on from one generation to the next without requiring access to the policy’s cash value, then MEC status is irrelevant. 

IRS Perspective On PPLI Products 

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As one might expect, the IRS does not like variable annuities and life insurance contracts to be used primarily as investment vehicles. Therefore, it attacks such arrangements on two fronts. The first attack is on the diversification front and the correlated “look-through” provisions that allow contracts to achieve diversification through investments in investment partnerships, mutual funds, and other vehicles.

IRC section 817(h)(1) says that in order to meet the definition of a life insurance contract, a variable contract based on a segregated asset account must make investments that are adequately diversified in accordance with regulations prescribed by the secretary.

Further, section 817(h)(4) provides that if all of the beneficial interests in a regulated investment company or trust are held by one or more:

  1. Insurance companies in their general account or segregated asset accounts.
  2. Fund managers in connection with the creation or management of the regulated investment company or trust.

Then the diversification requirements of section 817 shall be applied by taking into account the assets held by the regulated investment company or trust. 

Second, the IRS attacks them based on the well-established federal income tax principle that a person is treated as the owner of an asset if he possesses “significant control” and ownership over the asset, regardless of who holds legal title to it. This substance-over-form argument is broadly known as the investor control doctrine.

Investor Control Doctrine and IRS Responses

The investor control doctrine was developed beginning in a series of revenue rulings in 1977. The rulings were the IRS’s response to the development of variable life insurance and annuity products that allowed the contract owner to retain so much control over the investment assets underlying the contract that they were inconsistent with the insurer being the owner of the contract. 

Between 1977 and 1982, the IRS issued revenue rulings 77-85, 80-274, 81-225 and 82-54. These rules ascribe the investor control doctrine to various life insurance arrangements. They describe circumstances in which owners of variable life insurance contracts would be treated and taxed as owners of the underlying assets because of their control of the investments, even though they did not hold legal title to these assets.

Revenue ruling 77-85 considered a situation in which the individual purchaser of a variable annuity contract retained the right to direct the custodian of the account supporting that variable annuity to sell, purchase, and exchange securities of other assets held in the custodial account. The purchaser was also able to exercise an owner’s right to vote on account securities either through the custodian or individually.

The IRS concluded that the purchaser possessed “significant incidents of ownership” over the assets in the custodial account. Therefore, any interest, dividends, and other income derived from the investment assets were included in the purchaser’s gross income. 

Similarly, in revenue ruling 80-274, the IRS, applying revenue ruling 77-85, concluded that if a purchaser of an annuity contract may select and control the certificates of deposit supporting the contract, then the purchaser is considered the owner of the certificates of deposit for federal income tax purposes.

Revenue ruling 81-225 concluded that investments in mutual fund shares to fund annuity contracts are considered to be owned by the purchaser of the annuity if the mutual fund shares are available for purchase by the general public.

Further, it concluded that if the mutual fund shares are available only through the purchase of an annuity contract, then the sole function of the fund is to provide an investment vehicle that allows the issuing insurance company to meet its obligations under its annuity contracts and the mutual fund shares are considered to be owned by the insurance company. 

In revenue ruling 82-54, the purchaser of certain annuity contracts could allocate premium payments among three funds and had an unlimited right to reallocate contract value among the funds prior to the maturity date of the annuity contract. Interests in the funds were not available for purchase by the general public but were instead available only through the purchase of an annuity contract.

The IRS concluded that the purchaser’s ability to choose among general investment strategies either at the time of the initial purchase or subsequently did not constitute control sufficient to cause the contract holders to be treated as the owners of the mutual fund shares. 

The Court’s Perspective On PPLI Products

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In 1984, the United States Court of Appeals for the Eighth Circuit weighed in and upheld the investor control theory espoused in revenue ruling 81-225 in Christoffersen v. United States. Recall that revenue ruling 81-225 concluded that investments in mutual fund shares to fund annuity contracts are considered to be owned by the purchaser of the annuity if the mutual fund shares are available for purchase by the general public.

Further, it concluded that if the mutual fund shares are available only through the purchase of an annuity contract, then the sole function of the fund is to provide an investment vehicle that allows the issuing insurance company to meet its obligations under its annuity contracts and the mutual fund shares are considered to be owned by the insurance company. 

In Christoffersen v. United States, the taxpayers purchased a variable annuity contract that reflected the investment return and market value of assets held in an account that was segregated from the general asset account of the issuing insurance company. The taxpayers had the right to direct that their premium payments be invested in any one of six publicly traded mutual funds. The taxpayers could reallocate their investment among the funds at any time.

The taxpayers also had the right upon seven days’ notice to withdraw funds, surrender the contract, or apply the accumulated value under the contract to provide annuity payments. The Eighth Circuit held that the taxpayer, not the issuing insurance company, owned the mutual fund shares.

The court said, “the payment of annuity premiums, management fees and limitations of withdrawals to cash [did] not reflect a lack of ownership or control as the same requirements could be placed on traditional brokerage or management accounts.” Thus, the taxpayers were required to include in gross income any gains, dividends, or other remuneration derived from the mutual fund shares.

Christoffersen v. United States

After the IRS issued these four revenue rulings and the Eight Circuit decided Christoffersen, Congress enacted, as part of the Deficit Reduction Act of 1984, Internal Revenue Code section 817 to discourage the use of variable annuities and life insurance primarily as investment vehicles.

Per IRC section 817(h)(1), for purposes of section 7702(a), a variable contract based on a segregated asset account shall not be treated as a life insurance contract unless the investments made by the account are adequately diversified in accordance with regulations prescribed by the secretary. For purposes of testing diversification, section 817(h)(4) and regulation 1.817-5(f ) provide a look-through rule for assets held through certain investment companies, partnerships, or trusts.

Section 1.817-5(f)(2)(i) provides that look-through treatment is available with respect to any investment company, partnership, or trust only if all of the beneficial interests in the investment company, partnership, or trust are held by one or more segregated asset accounts of one or more insurance companies and public access to such investment company, partnership, or trust is available exclusively through the purchase of a variable contract, except as otherwise permitted under regulation 1.817-5(f )(3).

Under 1.817-5(f )(2)(ii), the look-through rule applies to a partnership interest that is not registered under a federal or state law regulating the offering or sale of securities. Unlike 1.817-5(f )(2)(i), satisfaction of the non-registered partnership look-through rule of 1.817-5(f )(2)(ii) is not explicitly conditioned on limiting the ownership of interests in the partnership to certain specified holders. 

On July 23, 2003, the IRS issued Revenue Rulings 2003-91 and 2003-92. Revenue Ruling 2003-91 presented a “safe harbor” from which taxpayers could navigate the investor control doctrine. The IRS described two factual situations to demonstrate whether owners of variable contracts will be deemed to own a variable contract’s underlying assets. In both cases, the IRS ruled that the contract owner would not be treated as the owner of the underlying assets. 

The significant facts of the situation were that the owner could not select or direct a particular investment to be made by the separate account. Either the insurance company or an investment adviser made all investment decisions.

The insurance company, at its sole and absolute discretion, made all decisions concerning both the choice of any of its investment officers who would be involved in the investment of the owner’s separate account and the choice of any independent financial adviser. The owner was not allowed to communicate directly or indirectly with any independent investment adviser or any of the insurance company’s investment officers regarding the investment made by the owner’s separate account.

There was no arrangement, plan, contract, or other agreement between the owner and either the insurance company or the adviser regarding the investment activities of the owner’s segregated account. 

Revenue Ruling 2003-92 holds that a variable contract holder is the owner of interests in a non-registered partnership where interests in the non-registered partnership are not available exclusively through the purchase of a life insurance or annuity contract. 

On July 30, 2003, the Treasury Department and the IRS published a notice of proposed rulemaking (REG-163974-02, 2003-2 C.B. 595) under section 817 in the Federal Register (68 FR 44689). The proposed regulations would remove the rule that applies specifically to non-registered partnerships for purposes of testing diversification. On March 21, 2005, the law became final.

Frequently Asked Questions

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What is Private Placement Life Insurance (PPLI) and how has it evolved over time?

PPLI refers to custom-written life insurance or annuity contracts, initially offered offshore by small insurance carriers. These early PPLIs were distinctive as they allowed policy assets to be invested in vehicles like hedge funds. However, the landscape of PPLI has significantly evolved. Now, large domestic insurance carriers have started offering these products, reflecting their growing acceptance and mainstream appeal. These modern PPLIs are institutionally priced and adhere strictly to U.S. tax regulations, garnering them favorable tax treatment akin to traditional life insurance policies. The evolution of PPLI represents a broader shift in the insurance industry towards more sophisticated, investment-oriented products.

How do PPLI policies benefit from U.S. tax rules?

PPLI policies are intricately designed to fully comply with U.S. tax regulations, which affords them several tax benefits. Firstly, the income generated by assets within the policy is tax-deferred as long as it remains in the policy, enhancing the growth potential of the investments.

Additionally, policy owners have the privilege of making tax-free loans against the cash value of their PPLI policy. Furthermore, upon the demise of the insured, the death benefit is distributed tax-free. These tax advantages make PPLI policies an attractive option for investors seeking tax-efficient ways to manage their wealth.

Why are PPLI products considered attractive investment vehicles, especially for hedge funds?

PPLI products have gained popularity as investment vehicles, particularly for assets like hedge funds, which are traditionally tax-inefficient. Unlike conventional life insurance, PPLIs are purchased primarily for their investment benefits, offering tax-free status on earnings.

This makes them ideal for investing in hedge funds, known for their diverse, often aggressive investment strategies that can be tax-heavy. Hedge funds, by nature, yield a significant portion of their gains through interest, dividends, and short-term capital gains, which are taxed at higher rates. PPLIs mitigate this tax burden, making them a sought-after option for savvy investors.

What are the key tax compliance requirements for PPLI contracts to be considered as life insurance?

For a PPLI contract to qualify as life insurance for tax purposes, it must adhere to specific criteria. These include compliance with the cash value accumulation test under IRC section 7702(b) or meeting the guideline premium requirements and falling within the cash value corridor under sections 7702(c) and 7702(d). The contract must ensure that its cash surrender value does not exceed the net single premium required for future benefits.

Furthermore, the sum of premiums paid should not surpass the guideline premium limitation. The death benefit must also maintain a minimum percentage of the cash surrender value, as dictated by IRC section 7702(d)(2). Strict adherence to these requirements is critical to retain the tax benefits of a PPLI.

What are the implications of a PPLI policy being classified as a Modified Endowment Contract (MEC)?

If a PPLI policy is classified as a Modified Endowment Contract (MEC) under IRC section 7702A, it has significant tax implications. This classification arises when a policy is overfunded beyond the limits of the 7-pay test within its first seven years.

When a policy is deemed an MEC, the owner faces taxation at ordinary income rates on any gains accessed during the insured’s lifetime. While this impacts the tax treatment of withdrawals or loans, it’s important to note that if the primary purpose of the PPLI is to transfer wealth without accessing its cash value, the MEC status may be less relevant.

How does the IRS view and regulate PPLI products as investment vehicles?

The IRS maintains a critical stance on using life insurance contracts like PPLIs primarily as investment vehicles. To regulate this, it focuses on diversification requirements and the “investor control” doctrine. Diversification mandates, as per IRC section 817(h), ensure that investments in variable contracts are adequately varied.

Meanwhile, the investor control doctrine, established through various revenue rulings, posits that significant control over investment assets by the owner can lead to them being treated as the direct owner for tax purposes. This doctrine aims to prevent policy owners from using PPLIs as mere investment tools while bypassing traditional investment taxation.

The Bottom Line

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Hedge funds have a reputation for being tax inefficient. Therefore, tax-conscious investors who want to maintain exposure to hedge funds often look for innovative arrangements to preserve that exposure but mitigate the tax consequences. For many years, PPLIs provided such a mechanism. Recent legislation, however, raises the question of whether PPLIs are still a tax-efficient means to invest in hedge funds. The answer is yes, but now there is a caveat. 

Amongst the many provisions that govern the taxability of life insurance products, IRC section 817(h) requires that the assets of a segregated asset account be diversified in order to be treated as a life insurance contract. Basically, there used to be two provisions that allowed investors to “look through” investment partnerships and use them to achieve the required diversity. One provision pertained exclusively to unregistered partnerships, and the other to both registered and unregistered partnerships. In 2005, regulation 1.817-5(f )(5)(ii) was removed.

This was the provision that specifically allowed look-through treatment for unregistered partnerships. It made no mention of limiting the ownership of interests in the unregistered partnership to certain specified holders in order to allow the look-through treatment. With the removal of this regulation, we are forced to look to regulation 1.8175(f )(2)(i), the provision that pertains to both registered and unregistered partnerships, for guidance on hedge fund treatment.

Although this provision allows look-through treatment for all investment partnerships, registered and unregistered, it limits the beneficial interests in the partnerships to the segregated asset accounts of insurance companies where public access is available exclusively through the purchase of a variable contract. 

What does this mean? It means that PPLI products are still a viable, tax-efficient way for investors to gain hedge fund exposure. However, they are limited to hedge funds that offer their shares exclusively through the purchase of a life insurance or annuity contract.

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Edmond Grady
Edmond Grady

Edmond Grady isn't just some suit. For over 20 years, he's been in the trenches, leading some of the biggest financial operations on the globe. He's the brains behind "TalNiri", which is the go-to financial site in Israel. When it comes to finance and entrepreneurship, Edmond's experience is second to none.

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