private placement - markuson law group

A Special Advertising Supplement To Trusts & Estates

PRIVATE PLACEMENTLIFE INSURANCE:

By: Grant R. Markuson, Markuson & Neufeld, LLC, Oakbrook Terrace, Illinois

New Insights for an Enduring Technique

PPLI is more flexible from aninvestment side in that the insur-ance companies can hire individ-ual managers to invest in stockportfolios, hedge funds, privateequity, and REITs. This is in con-trast to the limited number of tradi-

tional mutual funds offered in retailproducts. Just as individuals with $10million portfolios rarely invest a major-ity of their assets in mutual funds withthe associated fees and restrictions,instead being more likely to have a cus-tomized portfolio with non-traditionalinvestments, so too would you expectthis same preference with an insurancepolicy with a $10 million cash value. Itis only through PPLI that these types ofinvestments can be incorporated intoan insurance product.

It is important to note that private place-ment annuity contracts, as opposed tolife insurance, do exist. Since mostannuities are used for pure income taxdeferral, the corresponding ordinaryincome tax treatment associated withannuities (to be discussed later) makestheir use somewhat limited when con-templating multi-million dollar premi-ums. The potential unwinding of theentire account at ordinary income taxrates and the restrictive ownershipissues under the Internal Revenue Code(Code) Section 72(u) present significanthurdles to be addressed.

Nonetheless, there will be situationswhere annuity contracts might be used,such as in deferred compensation, andother transactions where the incometax treatment will not necessarilychange. The general tax deferred nature

Planning techniques arenormally developed tosolve one specific prob-

lem, while remaining neutralin respect to another area.Periodically, a technique is foundthat can address many aspects atone time, which makes that tech-nique particularly useful in a varietyof planning environments. Privateplacement life insurance (PPLI) is oneof those tools that is truly a cross spec-trum technique. Having elements oflife insurance, investment, estate andincome tax planning, PPLI canaccomplish many goals at one time.

Unfortunately, implementation of theappropriately structured PPLI pro-gram takes the input from invest-ment, insurance and tax professionalsin order to work appropriately with-in a specific client fact pattern.Although many other techniquesrequire planning professionals tohave only limited knowledge of theircounterpart’s area of expertise, PPLIrequires each participant to havemuch more of a broad based knowl-edge platform. This is especially trueof tax advisors who will most likelyspearhead the planning elements ofPPLI, but may not be fully conver-sant in the various insurance rulesthat will apply. This “white paper” isdesigned to help bridge these gaps.

What is PPLI?PPLI is a life insurance contract thathas substantially reduced costs andmuch greater investment choices thanin traditional retail contracts.Furthermore, PPLI products normallyhave minimum annual premiums of at

December 2002 1

A Special Advertising Supplement To Trusts & Estates Private Placement Life Insurance

Private Placement Life Insurance: NewInsights for an Enduring TechniqueBy: Grant R. Markuson, Markuson & Neufeld, LLC, Oakbrook Terrace, Illinois

PRIVATE PLACEMENT LIFE INSURANCE has become

an increasingly popular planning technique withinthe estate planning community.Unfortunately, a great deal ofconfusion has arisen as to itspractical applications due to thelack of guidance for the taxpractitioner.

least $1 million, and thus it is a tool foronly wealthier individuals. For manypeople, PPLI is simply the product ofchoice for buying death benefit at thecheapest cost. For others, placing sub-stantial sums of money into a vehiclewhereby they can choose a managerwho will customize the portfolio andlet the assets grow income tax free. Inthese situations, the death benefit pro-vided by the insurance is secondary tothe tax benefits. Finally, for others it isutilizing PPLI as one componentamong many in a myriad of tax plan-ning scenarios but doing so with a con-tract that is cheaper and more flexiblethan might otherwise be available.

PPLI is often cheaper since it does notcarry the traditional 40-80% commis-sion that retail products carry. In mostsituations, commissions and/or plan-ning fees related to PPLI are individ-ually negotiated with the client. Thesefees are much more likely to be asset-based fees (in line with traditionalmoney management fees), rather thanlarge premium-based fees. Unlike thetraditional distribution of insuranceproducts through insurance agents,most PPLI products are utilized as aplanning tool by tax and investmentprofessionals, and thus in many situa-tions the middleman/agent has beenremoved. This is especially true inthe institutional use of PPLI.

of life insurance and annuities and thespecial rules regarding variable con-tracts are the same. However, manyplanners feel there is more certainty inthe laws and regulations addressing thetreatment of life insurance contracts.

In general, individuals utilize PPLIbecause of the increased investmentflexibility, the dramatic decrease inoverall costs, and the ability to cus-tomize many elements of the contractover time. Although the due diligenceon the actual tax aspects of PPLI isquite straight forward, to be discussedshortly, there are clearly some psycho-logical elements of PPLI that often cre-ate the proverbial paralysis by analysis.Sometimes the most common questionis “If this is so great, how come Ihaven’t heard of it before?” This is avalid and poignant question thatdeserves a straightforward answer.

HistoryAlthough the permutations havechanged somewhat over time, the corestructure of PPLI has remained rela-tively unchanged for some twentyyears. A quick historical overview isnecessary so that practitioners canunderstand that PPLI is not a new, andthus untested, cutting edge planningtechnique. It is only by understandingthe history of a technique that one candetermine its applicability for today’splanning scenarios.

PPLI really began as a way of cus-tomizing specific types of insuranceproducts as part of corporate benefitplanning for senior executives. Al-though the rank and file employeesmay have been happy with the benefitsof more typical insurance offerings,senior executives often desired greaterinvestment options, lower fees, andgreater overall customization. This, inconjunction with the growing use ofvariable contracts, led to the birth ofindividualized PPLI products.

The Internal Revenue Service (Service)initially ruled on these types of cus-tomized variable products in a series of

Revenue Rulings from 1977-1982.1

With inflationary pressures at that timemany states increased their state premi-um taxes2 on life insurance and annuitycontracts. As the regulatory costs rose,coupled with changes in 1984 regard-ing taxation of insurance and annuitycontracts, and an overall reduction intax rates in 1986, the need for PPLI justfaded away. Domestically there was lit-tle activity in the personal PPLI marketother than Corporate Owned LifeInsurance (COLI) and Bank OwnedLife Insurance (BOLI) transactions dur-ing the late 1980s.

In the early 1990s, PPLI products forwealthy individuals surfaced again outof the Channel Islands. Soon after that,Cayman Island and Bermuda basedproducts started to surface. As thehedge fund industry started to pick upsteam during this period, many of theproducts were being specifically devel-oped for these investments.

In the mid 1990s, many of the majorU.S. and European carriers entered theinternational PPLI market, whichbrought this type of planning back intothe mainstream. As of today, there are afew dozen international carriers (most-ly small private carriers) who allege tohave U.S. qualified contracts. Althoughmany of the carriers have excellent cre-

dentials and administrative capabili-ties, there are certain carriers who havequestionable programs, as is so oftentrue with certain aspects of “offshore”business.3 However, due to the volumeof quality carriers both internationallyand domestically, there is little reasonwhy an informed client would choosethese questionable carriers.

In the last few years of the last decade,many of the carriers started to offerdomestic products. As of this writing,there are about twenty U.S. carrierswho either have, or will shortly have,U.S. registered products.

In many ways, the business cycle ofPPLI has come full circle, although ithas taken twenty years. Perhaps thebiggest problem with such a longbusiness cycle is the lack of knowl-edge retained by many of the institu-tions and advisors who representwealthy individuals. There has beenfor all practical purposes a generationgap of advisors who may have workedon PPLI years ago, but are nowretired. While at the same time manyof today’s senior tax advisors mayhave only been junior associates atthat time, or were involved in a differ-ent practice area. For many reasons,there is a substantial information voidamong today’s tax advisors as to thetrue uses and applicability of PPLI.

Technical OverviewPPLI in its purest sense is quite easy tounderstand, although applying it in aplanning situation is a bit more compli-cated. It is critical to view PPLI as aplanning tool, rather than as a productto be sold. PPLI is a variable universallife contract that has stripped out all ofthe retail pricing and markups, while atthe same time allowing policy ownersto choose and/or suggest the use of spe-cific investment managers, subject tonormal due diligence and investor con-trol issues (to be discussed later). It isimportant to note that some PPLI pro-grams, most often built for insuranceagents, are heavily laden with commis-sions, which make them as inapplicable

December 2002 2


In general, individualsutilize PPLI because of

the increased investmentflexibility, the dramaticdecrease in overall costs,and the ability to cus-tomize many elements ofthe contract over time.

as traditional retail contracts.

There are three primary uses for PPLIin today’s planning environment.First, individuals who need a substan-tial amount of death benefit are usingPPLI to purchase insurance at a great-ly reduced price due to its institution-al pricing format. Second, individualswho need this coverage and/or arelooking for a long-term repository oftheir funds are attracted to the favor-able tax treatment of life insurance inreducing the overall income tax onthese investments. Finally, advancedplanners are utilizing PPLI as an inte-grated planning tool for employeebenefit, estate tax, and cross-borderplanning. With those primary plan-ning objectives in mind, it is appropri-ate to set out some preliminary issuesfor the reader who has not had exten-sive experience in the tax aspects oflife insurance and annuity contracts.

The term “life insurance contract” refersto any contract which is a life insurancecontract under applicable law (withoutthe benefit of what the term “applicablelaw” means), but only if the contractmeets one of two separate require-ments.4 The first alternative is meetingthe so-called “cash value accumulationtest”.5 The second alternative is meetinga two pronged test: the so-called “guide-line premium requirements”6 and the“cash value corridor” test.7

Although PPLI products can be struc-tured under either test, it is most com-mon to see the Guideline Premium /Cash Value Corridor test used. This testusually dictates that a certain flat faceamount8 on the policy will dominate forthe earlier years until the cash value ofthe account grows enough to have thecash value corridor test “kick-in”. Forthe life expectancy of most insureds, itis likely that the corridor test will be thedominating test for most of the policy’sterm. An example of this is addressed inthe underwriting section to follow.

PPLI contracts are considered universalvariable life contracts. The term “vari-able contract” is defined in Code § 817.9

The term includes annuity contracts andlife insurance contracts whose benefitsare tied to the investment performanceof accounts which are segregated fromthe general accounts of the issuing com-pany. In the case of an annuity, the annu-ity amounts paid in or out are tied to theinvestment performance and marketvalue of the account as opposed to afixed or guaranteed rate. Similarly, for avariable life insurance product, theamount of the cash value and death ben-efit fluctuates or varies with the per-formance of the underlying assets.

Life insurance death benefits. As ageneral rule, life insurance death bene-fits are not includible as gross incometo beneficiaries.10 There are exceptions,

the most notable being transfers forvalue11 and an interest element if pay-ment of the death benefit is payable ininstallments or otherwise delayed.12

Estate taxes and insurance.If theinsured retains any incidents of owner-ship in the policy, the insurance pro-ceeds will be included in the insured’sestate for estate tax purposes.13 Further-more, transfers of the policy accompa-nied by the transfer or relinquishmentof all incidents of ownership will notremove the proceeds from the estate ofthe decedent if such a transfer occurswithin three years of the death of thedecedent.14 Suffice it to say that withproper planning, life insurance pro-ceeds can be excluded from the estate.It should always be remembered thatPPLI is a standard life insurance chas-sis, and all the traditional gift and estatetax rules apply.

Inside buildup. The buildup withinboth life insurance and annuity policiesis generally free from current inclusionin gross income.15 In the past this led tothe use of insurance policies solely forthe purposes of investment planning.To curb those abuses, Congress rede-fined “life insurance policy” by enact-ing Code § 7702. Furthermore, Con-gress wanted to limit access to the pol-icy values during the term of the poli-cy, resulting in the enactment of themodified endowment contract (MEC)rules (to be discussed shortly).16

Distributions. If distributions are madeout of the policy, such distributions willbe specifically included in grossincome. Annuitized distributions can beconsidered partially a return of premiumand earnings. A critical issue in deter-mining inclusion within gross income isfound in Code § 72, which distinguish-es between “amounts received as anannuity” and “amounts not received asan annuity”. “Amounts received as anannuity” are amounts which are payableat regular intervals over a period ofmore than one full year, provided thatthe total amounts payable or the periodfor which they are paid is determinable.

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Any other amounts not considered as“amounts received as an annuity” willbe considered to be “amounts notreceived as an annuity”. This applies toboth life and annuity contracts, regard-less of the term “annuity”.

“Amounts received as an annuity” aretreated partially as a return of premi-um and partially a return of theappreciation of the premium. Thereturn of premium is tax free, the returnon principal is subject to income tax.Employee annuities under Code § 72(d)are treated somewhat differently and willnot be further discussed in this article.

“Amounts not received as an annuity”are generally includible in gross incometo the extent the amounts exceed thepremiums or other consideration paid.This LIFO (last-in-first-out) treatmentlimits the tax deferral treatment ofinsurance contracts by always causing adistribution to be considered fullyincludible in gross income unless it is areturn of premium.

Income taxation changes under Code§ 72 depending on whether the pay-ments are received by the annuitant ora beneficiary.17 Proper distributionplanning is critical in any insuranceor annuity transaction.

Modified Endowment Contracts.The MEC rules of Code § 7702 wereenacted under the Technical andMiscellaneous Revenue Act of 1988(TAMRA) and were primarily target-ed at single premium life insurancepolicies. In order to discourage thepurchase of these products for taxplanning purposes, Code § 7702Amakes an exception to the general ruleapplicable to non-annuity amounts,i.e., non-periodical distributions, fromlife insurance contracts.

For purposes of Code § 72, the term“modified endowment contract”means a contract (entered into on orafter June 21, 1988) otherwise consid-ered a “life insurance contract” (i.e.meeting the requirements of Code §

7702 as outlined below) which fails tomeet the so-called “7-pay test”18 orwhich is received in exchange for sucha contract. The alternative is referred toas a Non-Modified EndowmentContract (Non-MEC).

Under a MEC, loans are treated as dis-tributions (non-annuity amounts). If aloan is made under a MEC, or if divi-dends are used to pay back a loan orinterest on a loan, those amounts will beconsidered a taxable distribution. Anadditional 10% penalty tax on distribu-tions made prior to the date the taxpay-er reaches the age of 59 fi is alsoimposed on a MEC policy distribu-tion.19 This is to effectively prohibit tax-payers from using a MEC as an alterna-tive retirement planning vehicle. Thereare certain exceptions, very similar tothe ERISA rules, for early withdrawalsfrom the policy. Loans from Non-MECs are not taxable.

One needs to be cautious when dealingwith reducing the face amount of aNon-MEC during the early years sothat it will not be converted to a MEC.This rule, as well as the general schemeof Code § 7702A, is not unique to PPLIcontracts, but it is absolutely criticalthat the planner have a detailed workingknowledge of these rules before imple-menting any insurance based plan.20

SpecialConsiderations ForVariable Contracts

Diversification requirements of vari-

able contracts. Each of the segregatedaccounts underlying a variable contractmust satisfy strict diversification require-ments. The diversification requirementswere provided to discourage the use oftax deferred variable life insurance orannuity products strictly as investmentvehicles.21 These rules apply to retailcontracts alike, but since all retail con-tracts are structured in a mutual fund set-ting, diversification does not need to bemonitored as much as in PPLI. In termsof the details of diversification, they canbe found in Treas. Reg. § 1.817-5. Thegeneral requirements are that the invest-ments of a segregated asset account shallbe considered adequately diversified forpurposes of Code § 817(h) only if—

(a) No more than 55% of the value ofthe total assets of the account is rep-resented by any one investment;

(b) No more than 70% of the value ofthe total assets of the account is rep-resented by any two investments;

(c) No more than 80% of the value ofthe total assets of the account is repre-sented by any three investments; and

(d) No more than 90% of the value ofthe total assets of the account is rep-resented by any four investments.

In addition, there are special rules for“safe harbor” investments in UnitedStates obligations, and so called“look through” rules to assets whichare under certain umbrellas such asregulated investment companies ortrusts.22 In most situations the diversi-fication test must be met on the lastday of each quarter starting after aninitial 12 month diversification freeperiod.23 Finally, for portfolios thathave a large percentage of real estateassets, there is a more complex 60month diversification requirement.24

Consequences of a failure to diversi-fy. The consequences of a failure tosatisfy these requirements are severeindeed.25 Failure to satisfy the re-quirements results in the contract not

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Each of the segregatedaccounts underlying a

variable contract must sat-isfy strict diversificationrequirements. The diversi-fication requirements wereprovided to discourage theuse of tax deferred vari-able life insurance orannuity products strictly asinvestment vehicles.

being treated as an annuity, endow-ment, or life insurance contract for anycalendar quarter period for which theinvestments of any such account arenot adequately diversified. What isworse, the disqualification continuesfor any subsequent period, even if theinvestments are adequately diversifiedfor such subsequent period. The resultis that any income on the contract mustbe included by the policyholder asordinary income received or accruedby the policyholder during such year. 26

Investment management and control.The IRS has made it clear through letterrulings and the like that the policyhold-er cannot select, manage or control theinvestments of the segregated account.This has come to be called the InvestorControl Doctrine. It is by far the mosthotly debated issue in the PPLI industrydue to some of the vagueness of thedirection the Service has provided.27

Revenue Ruling 82-54 provides a sum-mary and discussion of the applicableletter rulings on this matter.28 To sum-marize, the investor may designate aninvestment strategy or even a particularsegregated account offered by the insur-ance company. However, the policy-holder cannot and should not be pos-sessed of sufficient “incidents of owner-ship” of the segregated assets to bedeemed the owner of the assets forincome tax purposes. If this occurs, thetax advantages of the policy would belost. The letter rulings advise that thepolicyholder may choose among gener-al investment strategies, either at thetime of purchase or subsequent thereto,without being deemed the owner. Thepolicyholder should not be permitted tovote shares or otherwise control the seg-regated assets. The segregated assetsmay be managed by an independentinvestment advisor. However, suchadvisor must be retained by the insur-ance company, not the policyholder.The segregated assets may not be com-posed of registered investment fundsgenerally available to the public; accessto funds must be restricted to annuity orinsurance contracts.

Until recently, there was still some ques-tion as to the Service’s position when itcame to unregistered private partner-ships like hedge funds. On November 1,2002 the Service released Private LetterRuling 200244001.29 This ruling hasalready started a substantial debateregarding the Service’s position on thismatter for two reasons. First, many cur-rent PPLI offerings directly invest innon-registered investment partnerships.Second, the Service has made a conclu-sion not adequately supported by thecurrent Regulations, and some mighteven argue that the ruling is directlycontrary to the Regulations.

As of this writing, there has been noother published guidance indicatingwhether the exclusivity rule governsthese partnerships, although the regula-tions seem to clearly indicate that itdoes not. For this purpose the exclusiv-ity rule means that such non-registeredpartnerships cannot have both insur-ance related investors and non-insur-ance related investors, or there is abreach of the investor control doctrine.Furthermore, although it would seemmoot at this point, there is no look-through for diversification purposes.

The debate will center around the incon-sistency of the Regulations, ConferenceCommittee Reports, Revenue Rulings,and finally the actual Private LetterRuling. Specifically, the Service is tak-ing an extremely strict reading of theCommittee Reports, while effectivelyignoring the actual wording of theRegulations themselves. Without anyexplanation, they find that theRegulations and the Revenue Rulingsare consistent with their opinion.

Clearly, for new cases, regardless ofone’s opinion of the Ruling, a restruc-turing of planning must be consideredwith these types of investments. Theeasiest way to resolve this is to simplyclone the investment into a partner-ship that will only accept insurance-based investors. This will no doubtcause some additional legal fees, butthis should be a minimal cost if sever-al investors plan on utilizing the newinvestment option within the policy.The second key way would be to havean allocation or fund-of-fund structuredesigned within the policy that theninvests in these partnerships. This fol-lows the guidance set out in PLR985104430 in which the Service statedthat a fund that satisfies the investorcontrol requirements will not failmerely because the fund invests in apublicly available fund.

For most practitioners in this area, theconcern is not so much the end result ofthe ruling, but rather the methodologyby which the Service reached that rul-ing. The general consensus at this pointis that the Service, in this situation,wanted to take a certain position regard-less of the actual issues outlined in theRegulations. Perhaps this is some typeof foreshadowing of a new Notice orRevenue Ruling addressing this matter.

Offshore vs.Onshore Carriers

As was previously mentioned, theoffshore carriers really dominated themarket during the 1990’s. However,the recent trend has been decidedlydomestic, especially for financialservices companies worried aboutforeign issued products from a regu-latory standpoint. Nonetheless, in thepast there were, and continue to be tosome extent, three primary reasons toimplement an offshore policy over adomestic one beyond the fact thatvery few domestic alternatives exist-ed in the past.

Offshore carriers take the position thatforeign issued contracts are not subjectto state premium taxes. This is based

December 2002 5


The IRS has made itclear through letter

rulings and the like thatthe policy holder cannotselect, manage or controlthe investments of thesegregated account.

upon the solicitation, application, andin some instances the underwriting allbeing completed internationally.

In the last few years, two states,Alaska and South Dakota,31 haveimplemented reduced state premiumtaxes that have dramatically cut thiscost to a policyholder and havereduced the impetus toward offshoreinsurers. In both of these states, thepremium tax on a $10 million premi-um would result in a savings of atleast a hundred thousand dollars overmost other states. The tax is a gradu-ated tax, but on a $10 million premi-um it would be approximately tenbasis points (one tenth of a percent).However, in order to take advantageof this premium tax, one must have acontractual nexus to these states.This is often done by having the pol-icy owner be either a trust, partner-ship or corporation domiciled in suchstates. In addition, the applicationand perhaps even the solicitationmust be done in the states as well.The burden of determining whichstate will receive the state premiumtax lies with the insurance company,and thus the determination of how toallocate premium taxes differs fromcompany to company.

The next benefit foreign issued con-tracts have over their domestic coun-terparts is that the securities regulatoryenvironment is slightly more liberalinternationally. Although this shouldbe a concern for most clients, wealthyindividuals usually have proper repre-sentation to avoid the ever changingworld of securities scams in the “off-shore” world. The major benefit isthat foreign issued contracts can investin foreign registered securities thatcannot be sold to U.S. persons. Sincemost U.S. individuals do not activelyseek these types of funds, and due tothe fact that many of these managersdo have U.S. registered products, thisbenefit is much more illusory, not like-ly creating any substantial benefitsother than for only the most sophisti-cated investors.

The final benefit is the fact that for-eign issued contracts are not “bur-dened” by many of the state con-sumer laws on policy contractualissues. The consumer laws of allinsurance policies in the U.S. general-ly follow the model rules of theNational Association of InsuranceCommissioners (NAIC). Like mostconsumer laws, the rules were estab-lished to protect the less sophisticatedconsumer, and these laws work wellfor the traditional policies issued inevery day life. However, for thewealthy client who wishes to placeseveral millions of dollars into a pol-icy, many of those rules can actuallylimit the policy design options. Thesepolicy design options center aroundthe contractual definitions themselvesof a life insurance contract.

Although one must still follow thegeneral qualification rules of Code§ 7702 in order to maintain the policyas qualified as life insurance for fed-eral income tax purposes, many of theconsumer laws have an indirect effecton the tax laws. As an example, itemslike net cash surrender values andhow they are calculated are often dic-tated by the policy contract, and varyfrom company to company. Itemslike surrender fees, crediting rates,commissions, mortality rates, etc. allhave an effect on this value. None ofthese items are dictated by the

Service (other than the general mor-tality rates), but these consumer lawitems can have a profound effect onthe net cash surrender value of thecontract that is used for gift andincome tax purposes.

In many situations, foreign policiesare drafted to be either more or lessrestrictive, so that the policy will bemore efficient on a design basis. Thiscan be done internationally withoutthe undue effect of some of the con-sumer law limitations. This opens ahost of planning options internation-ally for everything from split-dollarto employee benefit planning, not tomention domestic and cross borderestate planning.

Regardless of the perceived and/orreal benefits of an internationallyissued contract, many clients will stillfeel uncomfortable with the foreign“taint” of conducting any element ofinternational planning. For those indi-viduals who are normal investors, arewilling to pay a slightly higher imple-mentation fee (state premium tax) andare not looking for advanced policydesign options, the domestic con-tracts will more than adequately meettheir requirements. Due to the regula-tory issues of implementing and sell-ing a foreign issued life insurancecontract, it is not surprising thatfinancial institutions heavily favorthe domestic versions simply from aregulatory view. Although these insti-tutions will still utilize foreign basedcontracts, it is done more on an adhoc basis rather than as a matter ofnormal planning for U.S. taxpayers.

A Detailed View Of APPLI Contract

PPLI contracts are not dissimilarfrom their retail counterparts. As pre-viously mentioned, most variablePPLI contracts look much like anyother variable universal life contract,but with a few notable exceptions.For the tax advisor who has dealt withlife insurance in the past, they likelyhad little or no ability to negotiate the

December 2002 6


terms of the contract, and thus theseretail policies were literally on an as-is-where-is basis. Retail contracts areoften filed with fairly restrictiveterms, and changing these terms canbe very burdensome in some states.Such changes are not as burdensomewith the PPLI formats.

PricingPerhaps the most complex issue fortoday’s advisors and non-insurancebased institutions to resolve are thesomewhat complex pricing modelsthat vary from carrier to carrier.More problematic is that most advi-sors (including many insurance pro-fessionals) don’t really understandthe pricing models of the carriers.This is simply due to the fact thatadvisors have been accustomed to thetake-it-as-it-is retail mentality ofinsurance. It is safe to say that mostadvisors have not had to conduct anin-depth analysis of the inherent pric-ing models of an insurance policy. Inthe past, the driving force was whichcompany could deliver the lowestamount of premium for the rightamount of death benefit. With PPLI,since the death benefit is not the onlymotivation, but rather the long-termbuildup of the cash value, smallinherent cost differences have a sub-stantial effect on the benefit of onecarrier over another.

What follows is a brief overview of thebasic costs of PPLI and how an advisorcan intelligently compare one productto another for the benefit of the client.Focusing on one cost alone is a dra-matic mistake, in that carriers canmove prices around quite easily, and itis not unusual for the product that actu-ally looks cheap to be one of the moreexpensive options in the market. Costsfall into three major categories: regula-tory, annual insurance charges, andinvestment related charges.

Although sales and distribution feesare an additional cost, one must beable to look at the core policy in orderto compare contracts on an equal

footing. Since sales commissions areoften individually negotiated, theinformed advisor will first knowwhich product is best suited for theclient, and then individually negotiatethe sales fee. This can often be diffi-cult in that the vast majority of insur-ance products today have built insales commissions that are not explic-itly disclosed to the buying public.Although one normally does not seethis in PPLI, there are certain carriersand products that “bury” the salescommission within the product.

Regulatory FeesThe regulatory fees differ dependingon whether the policy is foreign ordomestically issued. If a policy isissued by a foreign company whichhas not made a Code § 953(d)32 elec-tion, then the policy owner will incura 1% federal excise tax under Code§ 4371.33 It is assumed that a foreignissued contract will not incur statepremium taxes, and this is the onlyregulatory fee normally associatedwith these policies. Please note, thisassumes the policy is issued in a lowtax jurisdiction that does not have itsown regulatory costs. For domesticissued contracts there is the appropri-ate state premium tax for the policy.Currently, the average state premiumtax is around 2-2.5% of the premiumas it is paid into the policy.

A U.S. issued policy or a foreignissued policy by a company that hasmade a Code § 953(d) election will notincur the excise tax, but the companywill charge a Deferred AcquisitionCost (DAC) charge.34 This is some-times erroneously called the DAC tax.

In fact it is not even a regulatory fee,but it is easiest to discuss it in this sec-tion. The DAC varies from companyto company, and usually is in the rangeof 50-150 basis points.

Together, on a domestic basis, a poli-cy owner should expect to see a totaldeduction from their premium of any-where from 1% to 4%, depending onthe state and carrier used. The excisetax, state premium taxes, and theDAC are incurred only at the timepremiums are paid into a policy.They are not annual fees.

Many of the larger carriers can amor-tize these costs within the policy.That is, instead of taking 3% of thepremium off the top, the carrier cansimply pay these fees, and then chargethe policy owner an increased annualfee that amortizes these costs over acertain period of time. One shouldamortize these costs if they believethat the growth on their investmentaccount will be greater than the amor-tization rate the insurance companyuses. Since an upfront fee is nowbeing spread over time, most carrierswho accommodate this will require asurrender fee equal to the presentvalue of the unpaid amortized costs.

M&E And COIThe annual insurance costs fall intotwo major categories: Mortality &Expenses (M&E), and the Cost ofInsurance (COI). These are perhapsthe most important, but also the mostconfusing costs to understand. Theprimary reason for this is thatalthough separately charged and cal-culated, the carriers view the totalityof both charges to calculate theirprofitability. The M&E is in the totalcontrol of the carrier since it is a feethat they keep. The COI floor is whatreinsurance companies will charge ona purely wholesale basis for reinsur-ing part or all of the true insurancecoverage of the policy.

It is not unusual to see one carrier with ahigh M&E have a low COI rate, while

December 2002 7


Although sales anddistribution fees are

an additional cost, onemust be able to look atthe core policy in order tocompare contracts on anequal footing.

another carrier may have just the oppo-site. In the end, they could actually becomparably priced. However, sincesome policies have an emphasis ondeath benefit, while others mightemphasize cash build up, the appropriatecarrier must be used that properlymatches a client’s primary needs.Choosing the wrong carrier can cost apolicy owner literally millions of dollars.

The M&E in PPLI is really the fee acarrier charges for issuing and admin-istering the policy. It is usually an assetbased fee that is calculated based uponthe cash value of the contract, ratherthan the death benefit. It is unrelated tothe amount of insurance needed, theunderwriting status of the insured, orany other variable other than the cashvalue. It is this fee that generates mostof the revenue for the carriers, and thusthe fee structures vary dramaticallyfrom one carrier to another, and inmany situations vary dramaticallywithin different offerings of the samecarriers, as will be explained later.

For the non-insurance professional,and really for most practitioners otherthan the actuaries, the concept andpricing of a company’s COIs can bemind boggling. The primary reasonfor this is that few practitioners evereven look at COI tables, and moreimportantly, even fewer conduct aside-by-side comparison. However,many “games” can be played withCOIs for marketing purposes.

For instance, one carrier was asked byits distribution source to reduce theCOI charges in the first year of theillustration to below its true COI costs.Why? Because many practitioners andclients only look at the first year COIcharges to compare one company overanother. If one illustration shows thefirst year hard cost of mortality to be$10,000 and all the other carriers arecharging around $25,000 for that year,it is a normal response to think that thefirst carrier must have overall cheaperexpenses. However, carriers are notdoing this for free, and will makeup

for this in subsequent years by increas-ing their COIs in less visible years, andoften times quite dramatically.

Another carrier advertised a greatreduction in their costs hoping to spurbusiness. They dropped their M&E asubstantial amount, but an almost dol-lar for dollar increase was made to theCOI. In the long run, the end price tothe client was almost exactly the same.It was simply a sales and marketingissue, but with little savings to theclient. Unfortunately, many advisorsthought that there were dramatic sav-ings, but never bothered to look further.

It is not unusual to see a carrier withseveral products with completely dif-ferent COIs. Sometimes state premi-um taxes, DAC, and even commis-sions will be amortized into the COI.This in many situations can doubleand even triple the values. If a com-pany builds in surrender fees coupledwith escalating increases in the COIs,this markup will be almost impercep-tible to the client and their adviser.

This process of moving fees and costsinto the COI is neither unethical norhighly deceptive, it is just the way thatmost insurance products have been builtover the years. It is simply the fact thatstate consumer laws do not require adetailed breakdown of these fees to the

client on a comparative basis. Althoughclients are concerned about the apparent“hiding” of fees, the more importantquestion is how to compare differentcompanies with different levels of dis-closure. It is only through an independ-ent analysis of looking behind the cur-tain that clients and their practitionerswill become enlightened on such issues.

Ask yourself, when was the last timeyou looked at and compared the COIrates for different companies, not justthe hard costs, of a life insurance con-tract in years 15-20? Is the contract atwenty-year level select, or is someother design standard being used? Thepoint is, actuarial designs can be as con-fusing and sometimes even moremanipulated than advanced tax plan-ning. Insurance agents for years havebeen able to go back to their carriersand request different premium quotesfor the same amount of coverage. Themotivating factor there was to reducethe premiums. However, the hard andhonest facts are that carriers knowexactly what their costs are and have anability to move them around by frontloading, back loading, changing surren-der fees, using different amortizationschedules, and moving fees betweenM&Es, COIs, investment fees, custodi-al fees, etc. It is up to the practitioner tounderstand this so that the client is mak-ing a truly informed decision.

December 2002 8


GRAPH 1Annual COI Charges

$0

$20

$40

$60

$80

$100

$120

$140

1 3 5 7 9 11 13 15 17 19 21 23 25Years

$/$1,000 of coverage

As an example, Graph 1 shows a com-parison of four different PPLI policiesand their COI charges on a particularcase. It is important to note the hugevariations in pricing, and the changesthat take place over time. Some carri-ers are cheaper in the earlier years, butby the tenth year are almost three timesthe cost of their competitors. Some car-riers’ charges increase at a somewhatproportionate rate tracking the 1980CSO table rates, others have substantialincreases or decreases at certainanniversary dates of the policy. Thedefinitive point here is that practitionersmust look at all aspects of charges, notsimply the static early year numbers.This graph shows that the most expen-sive carrier on a Standard rating isequivalent to the cheapest carriers Table3 or even a Table 4 rating. Does thismean that you never go with the highermortality costs? That question can onlybe answered by determining why PPLIis being used in the first place.

The most important element of pricing isto look at the totality of pricing compar-ison in line with the actual needs of theclient. Clients seeking a maximum deathbenefit amount for pure insurance pur-poses would be ill served to go to a car-rier with low M&Es but high COIs. Thesame is true for clients who may receivetable ratings due to health problems. Inthe same light, clients who want to max-imize the internal cash value will best beserved by a contract with lower M&Es.The reason here is that as the cash valuegrows the amount of insurance needed

as a percentage of cash value drops, andthus makes the COI charges less drain-ing on the overall account. It is impor-tant to test a certain policy at differentgrowth rates and underwriting classifica-tions to establish the range of applicabil-ity to the facts at hand.

Reinsurance AndUnderwriting

It is important for tax practitioners andthe other non-insurance professionalsto understand that PPLI is a life insur-ance product and thus has most of thetypical life insurance underwriting andqualification tests common to otherlife insurance products. However, dueto the specific design issues of PPLI,there are some notable differences.Perhaps the most striking differencearises from the actual amount of pureinsurance that the insurance companyand ultimately the reinsurers are liablefor over time.

As an example, for a MEC contract ona 50 year old male, the guideline pre-mium test requires that the contracthave an initial face amount of approx-imately $3.2 million for a single pre-mium of $1 million. In the first year,the Net Amount at Risk (the differencebetween the face amount ($3.2 mil-lion) and the cash value ($1 million))is $2.2 million. This is an initial ratioof 220% of the original premium.However, as the cash value of the con-tract grows, and the corridor require-ments of Code § 7702 go down, theNet Amount at Risk drops rather sig-nificantly. For instance, assuming a

10% growth rate on the internal assets,Chart 2 illustrates the changing rela-tionship between cash value, the faceamount, and the net amount at risk.

This chart illustrates that the actualamount of insurance coverage (netamount at risk) drops until age 75,rises again slowly until it peaks at age90. This is all due to the corridor testof Code § 7702. Compared to a nor-mal retail policy, the reinsurers oftentake a slightly lower risk with PPLIsince it is likely that their risk willactually decrease over time. For PPLIpolicies with substantial net amountsat risk above the corridor require-ments, one would expect the normalunderwriting standards to apply.

The process of underwriting, includingall of the appropriate medical tests isstill a critical element of PPLI.However, it is important to note thatsince the use of PPLI goes beyondstraight insurance needs, it is not criti-cal to insure the traditional insuredwho happens to be the oldest and usu-ally wealthiest family member. It isnot unusual to see life insurance con-tracts in Generation Skipping Trusts(GST) where the insured is the twenty-three year old grandchild. This was notdone for estate liquidity purposeswhen the grandmother and grandfatherdie, but more to simply shelter thegrowth of the assets within a policy fora longer period of time, at effectivelycheaper mortality costs.

There are, of course, as many differ-

December 2002 9


ent reasons to choose one insuredover another as there are families. Itis simply another element of the plan-ning design parameters of PPLI.

Planning OptionsAnd Examples

Traditional Insurance Needs. Al-though PPLI is quite flexible andserves various needs, one mustremember that it is still, at its core, alife insurance contract. Althoughmany wealthy individuals have anaversion to life insurance and thesales process that often accompaniesit, there is no doubt that life insuranceneeds exist and must be filled. Inmany ways, there is no better way tofulfill the order for a life insuranceneed than by using PPLI. Due to thereduced costs, and the fact that thepolicy-owner can have greater inputregarding the investment options,PPLI is well suited to serve tradition-al insurance planning needs, but withgreater efficiency. In addition, withthe reduced or non-existing commis-sions, the ability to separately negoti-ate costs can greatly affect the bot-tom-line pricing of a particularamount of insurance. Furthermore,there have even been instances inwhich a carrier has negotiated notonly the M&E, but also the COIs.

Large life insurance policies are oftenused for estate planning, buy-sell, andother corporate purposes. In situationswhere large life policies are needed (orin some situations where large privateplacement annuities are needed) PPLIcan be particularly cost efficient.

Investment Planning. Clearly, manyindividuals are utilizing PPLI not onlyas an insurance planning tool, but alsoas a tool to maximize the growth of theinternal cash value for investment andaccumulation purposes. This has beenespecially true where the underlyinginvestments are hedge funds wheremost, if not all of the returns are subjectto ordinary income tax rates. Due toPrivate Letter Ruling 200244001, aspreviously discussed, there will no

doubt be a chilling effect on someaspects of PPLI planning in the hedgefund community. The requirement thatcloning of hedge funds might berequired within the PPLI market willno doubt keep certain fund managersaway who do not wish to spend thetime or expense on cloning a fund.

It is important to note that the benefi-cial income tax planning elements ofPPLI still remain the same. The use ofindividual managers in a non-fundsetting remains a viable option, andmore importantly is most likelywhere most individuals will utilizePPLI. The mathematics of the taxbenefits of PPLI are dramatic, and arethe driving force for the use of PPLIas an integrated solution for long terminvestment management issues.

A quick example will illustrate thebenefits. Assume that a person inter-ested in investing in the equities mar-ket has a long term growth rate projec-tion of 11% after management fees.Clearly, few have seen that type ofgrowth, if any, in the last few years,but historically that has been the long-term projected growth rate of the S&P500. Many promoters of PPLI willassume that the growth is fully taxableeach year and will apply the maximumordinary income tax rates to show thesavings of PPLI. Unfortunately, this isan incorrect assumption.

Unless one is talking about hedgefunds, bond funds, or a few other typesof management styles, it is unusual fora traditional equities portfolio to have a100% yearly taxable recognition of the

gains. It is more likely that a 20-40%annual recognition of the gains is expe-rienced. In addition, it is unlikely thatall of the gains are taxed at short termor ordinary rates. In summary, a moretraditional equities portfolio may have30% of the gain each year recognized,and the blended tax rate (short and longterm capital gains) may be 30% aswell. Clearly, each manager has itsown tax efficiencies, and these num-bers vary dramatically, not only frommanager to manager, but also for eachmanager on an annual basis.

For conservative purposes, the fol-lowing will be assumed: a $10 millionsingle investment growing at an 11%pre-tax rate, and with 30% of thegains each year taxed at a blended taxrate of 30%. Assuming a constant setof assumptions, the taxable accountunder these facts would grow to $112

million in thirty years. There wouldstill be a small amount of untaxedbuilt-in gain at that point, but recog-nizing this amount would still leave$105 million on a fully after-tax basis.

This should be compared to the sameinvestment in a PPLI program.Further, assume basic costs of a policy(Mortality & Expenses and Costs ofInsurance) which might average 75basis points per year, and assume a 2%state premium tax and a 1% DeferredAcquisition Cost charge in the firstyear. In thirty years, the cash value ofthe contract will be $181 million. Theactual death benefit would be somemultiple of this number based upon theage of the individual. For instance, a

December 2002 10


The mathematics ofthe tax benefits of

PPLI are dramatic, andare the driving force forthe use of PPLI as anintegrated solution forlong term investmentmanagement issues.

policy with a cash value of $181 mil-lion on an 80 year old would require adeath benefit equal to 105% of the cashvalue ($190 million) under the guide-line premium/ cash corridor test.

The account has increased dramatical-ly during this period simply because ofthe compounding tax free environmentof PPLI. No more money was made orlost since the same manager was used.The same amount of money was made,the only difference is how much waskept and reinvested. This tax deferredanalysis is exactly the same used toillustrate the benefits of retirementplans. However, the death benefit of alife insurance contract is tax free with-out any recognition of the deferral.

If the example was on hedge funds, pri-vate equity funds, or some other invest-ment that might have a larger growthrate, or a higher blended tax rate, thesavings would be even more substan-tial. Since the policy costs are fixed, thegreater the earnings the greater the pro-portionate savings as measured againstthe cost of the policy. Accompanyingthe costs is a defined amount of lifeinsurance that eventually will provide abenefit to the beneficiaries.

Estate Planning. Life insurance plan-ning is intractably linked with overallestate planning, and it is difficult toseparate the two. This is especially truewith the nature of the larger PPLI poli-cies. Second-to-die policies exist in thePPLI world and can be used to greatlyreduce the overall costs of traditionalsecond-to-die policies. Furthermore,life insurance policies themselves canbe used as an estate planning tool.Some retail contracts have beendesigned to minimize the overall valueof the policies (the net cash surrendervalue), as well as utilizing largeexpenses in the earlier years. Althoughcore PPLI contracts provide neither ofthese benefits, it is often times easier tomodify a PPLI contract than a normalregistered retail product.

PPLI is often used as an income tax

tool to complement the general“income tax neutral” aspects of estateplanning. For example, placing a sub-stantial amount of assets into aGeneration Skipping Trust obviouslyresults in dramatic savings in transfertaxes over a long period of time.However, since the GST is its’ own taxpaying entity at a compressed incometax rate, there is a great deal of incometax inefficiency. This arises in lettinginvestments simply sit in the trust,while reinvesting in a taxable accountfor decades to come. Simply havingthe trust place some or all of the assetsinto a policy with the beneficiary beingthe trust itself will allow the trustee tohave the assets in the trust compoundfor the benefit of the trust beneficiaries.

Even though the use of family limitedpartnerships coupled with the sale ofpartnership interests to a defective trusthas become quite popular in estateplanning, this combination still isincome tax neutral and a great deal ofincome tax inefficiency will occur overthe years. The simple addition of PPLIinside the partnership can dramaticallyresult in substantial long term savingsto the family members. International Planning. For cross bor-der planning, the use of internationallyissued PPLI contracts can have a sub-stantial benefit. PPLI has been used inpre-immigration and cross borderemployee benefit planning for years.Although the rules on life insurancediffer from one country to another, thecore tax aspects are still favorable inmost jurisdictions. Since the basic tax

treatment of policies is fairly consis-tent, many times the life insurance taxrules may be the only common threadfor planning in the world of complicat-ed tax treaties, as well as civil versuscommon law discrepancies.

A detailed discussion of the internation-al planning opportunities are beyond thescope of this paper. However, suffice itto say that for the international practi-tioner more options are being developedeach day. Many view the internationalmarket as providing a much greaterbusiness opportunity for the insurancecompanies and advisors simply due tothe more favorable laws as well as theincreased acceptance of insurance prod-ucts in foreign jurisdictions.

Split-Dollar Planning. Split-dollarplanning remains a viable planningoption, not only for employer-employeerelationships, but also for estate plan-ning purposes. We will not attempt todissect the new regulatory scheme withthe sort of detail and attention that isbest left to the many excellent commen-tators in this arena.35 It should suffice tosay at this point that PPLI can be usedwith split-dollar in many different ways.

Due to the inherent flexibility of con-tract terms, valuation, and pricing,PPLI is uniquely suited to make split-dollar planning a unique planning tool.Proposed Regulations were recentlyissued that addressed many of theuncertainties of split-dollar planning.Unfortunately, the vagueness of partsof the regulations have caused addi-tional uncertainty in this area.

One of the areas where PPLI can beespecially useful is in the valuation ofthe contract via special contract terms.Unfortunately, the Proposed Reg-ulations do not include guidanceregarding the precise method for valu-ing economic benefits received undercertain split-dollar arrangements.However, the Service moved quicklyto prevent the use of techniques that itfelt were designed to “understate” thevalue of current life insurance protec-

December 2002 11


Since the basic taxtreatment of policies

is fairly consistent, manytimes the life insurancetax rules may be the onlycommon thread for plan-ning in the world of com-plicated tax treaties, aswell as civil versus com-mon law discrepancies.

tion and other policy benefits. In whatsome commentators feel was aresponse to a popular newspaper arti-cle,36 the Service released Notice2002-59 on August 16, 2002 toaddress the technique often classifiedas “reverse” split-dollar.37

While the reach of this Notice is notlimited to “reverse” arrangements, theService essentially prohibits the use ofthe Table 2001 rates or an insurer’s pre-mium rates for valuing one party’s cur-rent life insurance protection when sucha valuation is taken in order to establishthe value of policy benefits to whichanother party is entitled. Although thesomewhat unclear wording of Notice2002-59 may cause additional confu-sion among the split-dollar planningcommunity, it is clear that the Service isserious about curtailing the use of tech-niques designed to understate policyvalues for tax planning purposes.

Does this mean that split-dollar plan-ning is dead? Certainly not. It simplymeans that practitioners will have tocustomize their approach even morethan ever. Unfortunately, much of thiscustomizing cannot be accomplishedwith traditional retail products. In thefuture, it is likely that the largest split-dollar plans will utilize PPLI formatsrather than the current retail products.

Employee Benefit Planning. In addi-tion to the use of split-dollar arrange-ments there is an increasing use ofdeferred compensation programs andSupplemental Executive RetirementPlans (SERPS) that need to utilizespecifically designed insurance prod-ucts. Although Corporate Owned LifeInsurance (COLI) products will con-tinue to be used for the masses, somerecent abuses of these transactions hasplaced a great deal of COLI businessin question.38

Tax Neutral Holding Vehicles. PPLIcan be utilized for all types of planningwhere a tax neutral holding vehicle isneeded. Corporations with excess cashcan “park” these assets into policies on

their executives to avoid the taxationof the earnings in the account. Uniqueplanning opportunities exist for part-nerships which must redeem partnerswho have a low outside basis in theirinterest. Under partnership laws, dis-tribution of a policy created within thepartnership and then distributed to thepartner will obtain this carryoverbasis. However, since active tradingof the investments can exist withoutrelation to the basis of the policy itself,many planning opportunities exist.39

Combined With Other Techniquesand Investment Products. PPLI israrely a stand-alone technique. As it iswith most techniques, PPLI is good atsome things but not at others. Forexample, PPLI does not have the abili-ty to customize the benefits as much asthe partnership rules might allow oneto customize an agreement in countlessways. However, partners still areplagued with the income tax conse-quences of the partnership. PPLI canbe used to “turn-off” the income tax“pass-through” to the partners. Thiscan further benefit any estate planningelements by simply increasing the sizeof the estate due to income tax savings.

The RegulatoryEnvironment Of

Private PlacementLife Insurance

When discussing PPLI planning, it isimportant to briefly review the feder-

al and state regulatory authorities thatsupervise such products. The natureof PPLI planning often touches near-ly every aspect of securities and lifeinsurance product regulation. Whilethis section will highlight some of theimportant regulatory considerationsof PPLI planning, we would encour-age a comprehensive review of regu-latory resources for practitioners con-fronting such issues.40

The Securities Act of 1933 andRegulation D. Most PPLI contracts arefiled as a “Reg D” offering. While a dis-cussion of each of the rules underRegulation D is beyond the scope of thisarticle, certainly there are some high-lights of which practitioners should beacutely aware. Rules 501 and 502 ofRegulation D define the applicable termsand general conditions that must be sat-isfied to ensure the exemption, whilerule 506 provides the actual ‘safe har-bor’ to ensure private offering status. Ofparticular importance to the PPLI plan-ner is the definition of accreditedinvestor provided in Rule 501(a) and thelimitation on manner of offering provi-sions contained in Rule 502(c). Thesetwo sections essentially dictate that PPLImay only be privately offered to individ-uals or entities of sufficient net worth.41

No general solicitation or advertising byissuers or those acting on their behalf ispermitted. Specifically, the rules prohib-it advertisements or articles published inthe general media such as newspapers ormagazines, and also seminars wherethere has been an invitation by generaladvertising. Steps should be taken toensure that all parties in a PPLI planningsystem are working in concert to guaran-tee that the appropriate Regulation Drequirements are met and documented.Finally, it is important to remember thatdespite the registration exemption, theanti-fraud provisions of the securitieslaws still apply to these products, andcertain state laws may impose additionalrequirements on private offerings.

State Insurance Regulation. Whilemost PPLI products are exempt fromfederal securities registration, the reg-

December 2002 12


The nature of PPLIplanning often touch-

es nearly every aspect ofsecurities and life insur-ance product regulation.

December 2002 13


ulation of the business of insurancehas traditionally been left to thestates.42 As a result, securities regis-tration exemption will not exempt aPPLI product or any accompanyingdistribution channels from state regis-tration and regulation.

State insurance regulation can affectmuch of the PPLI planning and imple-mentation process. Most states requirelicensure for agents soliciting, selling,or collecting premiums for insurance inthat state, so planners seeking insur-ance-based fees need to seek properlicensure. In addition, insurance carri-ers must seek approval of their pro-posed contracts from the proper regula-tory authorities. Indeed, everythingfrom a determination of applicableinsurance premium taxes and retaliato-ry tax provisions to what constitutes“solicitation” in a particular state mightneed to be considered depending on theindividual case.43

Solicitation Issues and OffshoreProducts. Offers and sales of securitiesmade outside the U.S. might qualify foran exemption from 1933 Act registrationrequirements under the rules ofRegulation S. Similar to Regulation D insome respects, Regulation S operates asa safe harbor from registration for offersand sales that occur outside of the U.S.Under Rule 903, offers or sales of secu-rities are considered to occur outside ofthe U.S. if they are made in an offshoretransaction and there are no directed sell-ing efforts made in the U.S. In general,

directed selling efforts include any activ-ity undertaken to condition the U.S. mar-ket for the sale of a security, such asadvertisements in general circulationpublications, while offshore transactionsare those involving an offer and order fora security that occurs outside the U.S.44

The antifraud provisions of the securitieslaws, as well as additional requirementsimposed by the 1934 Act, still apply tothese offerings. State insurance lawshould again be examined to ensure thatissues relating to the reach of a particularstates’ regulatory scheme have beenaddressed. It is the unwise practitionerwho assumes that offshore PPLI plan-ning can operate in a “bubble” com-pletely free from regulation.45

The Future Of PPLIAs the PPLI market develops, the mostobvious growth potential for sophisti-cated life insurance products is not inthe U.S. market at all, but rather in theforeign markets. Since the tax laws ofmost other jurisdictions are generallymuch more favorable to life insurance,common sense dictates that its usemay be much more important abroad.Although the practical uses of foreignqualifying contracts will have limiteduse for the domestic tax planner, thosewith a cross-border practice will findthese new versions highly attractivefor solving difficult multi-jurisdiction-al transfer problems.

For most U.S. practitioners, the largestarea of growth will be coming out ofthe institutional setting. As privatebankers and large investment manage-ment groups become more integratedwith PPLI, practitioners will face manymore questions from their clientsregarding this technique. In the past,many practitioners have simply dis-missed the idea when their client waspresented it via some questionable off-shore investment promoter. That samepractitioner will be unable to easily dis-miss it when it comes from a clientwho was presented the idea by a majortrust, bank or investment firm whomay very well already send more tradi-tional business to the practitioner.

As the market develops, carriers andproducts will go through several mar-ket adjustments. First, certain carrierswill simply get out of the businessbecause they never made a concertedeffort to meet the right marketdemands. Other carriers will be sounyielding in their approach, adminis-tration, or facilitation that they willloose all credibility in the market.Others will simply adjust to marketpressures to fulfill the needs of theplanning community. Certain carrierswill build unyielding products and trythe mass marketing approach.

The successful carriers will understandthat the market is really the planningcommunity and will build products thatare conducive to a planner’s perspectiverather than to a product salesperson. Themost difficult issue is the ability of carri-ers to provide adequate sales support totraditional non-insurance based profes-sionals. Unfortunately, most carriershave simply provided a “product” plat-form, while most practitioners have a“planning” platform, and there is quite abit lost in the translation. Today, mostsuccessful programs are being imple-mented when tax planners are brought into train the investment and tax profes-sionals in more of a mentoring fashion.

Integrating PPLI IntoOnes Practice Or

InstitutionPerhaps the biggest hurdle for clients toactually utilize the benefits of PPLI isthe substantial information gap thatexists in the planning communityregarding PPLI. Since the revitalizedinterest in PPLI is relatively new, manypractitioners are either totally unawareof PPLI, or have only a brief recollec-tion of reading an article or attending aprofessional seminar where some indi-vidual briefly discussed PPLI.

More importantly, since PPLI first cameback via the international versions, sev-eral less than reputable foreign carrierswere started that had neither the creden-tials nor the financial backing to make

any prudent practitioner comfortable.This has led to many practitioners sim-ply lumping the good with the bad, andthey have thus discounted PPLI as “oneof those international tax scams”. As itis inevitable that certain companies(mostly international) and some advi-sors will abuse the tax and regulatorylaws, the fact remains that the vastmajority of PPLI carriers and practition-ers are good quality players.

SummaryPerhaps the most important message ofthis paper has been to illustrate theinherent planning attributes of PrivatePlacement Life Insurance in a multitudeof settings. PPLI IS a planning tool NOTa product to be sold. It is only throughthe diligent application of specific facts,and the integration of investment, tax,and insurance attributes that PPLI willmake sense in any client’s overall plan.

As the market develops, and moreinvestment options are added to thefold, retail type versions will appear(and to a certain degree they alreadyhave) that are labeled as PPLI but real-ly offer none of the true benefits ofPPLI. It is up to the practitioner to siftthrough the sales pitches and verify thecredibility and applicability of a certainprogram. PPLI is not for everyone, justlike any other planning tool, and therewill be cases involving premiumsunder $1 million when the client willbest be served by a traditional retailcontract. No insurance company, insti-tution, or insurance distribution sourcehas all the answers. Therefore, it is upto the planning practitioner to lead theprocess, and implement only those pro-grams that are best suited for theclient’s long term objectives.

As the market develops new varia-tions will surface, and of course it isinevitable that the Internal RevenueService will be faced with newRulings requests and fact patterns thatwill force them to refine their ownpositions on PPLI. Assuming that thecore benefits of PPLI remain, it willclearly be a viable planning tool forthe years to come.

Endnotes1.See generally Rev. Rul. 77-85, 1977-1 C.B. 12, Rev. Rul. 80-274, 1980-2 C.B. 27, Rev. Rul. 81-225, 1981-2 C.B. 12, Rev.Rul. 82-54, 1982-1 C.B. 11, and Rev. Rul. 82-55, 1982-1 C.B.12.

2. Each of the fifty states charges a premium tax on lifeinsurance and annuity premiums. It is effectively a salestax and is measured against the gross amount of premi-um paid. The carrier is then required to collect this taxand pay it to the appropriate state.

3. For a general overview of conducting due diligenceon foreign carriers, see Grant R. Markuson, TheSecrets of International Private Placement VariableInsurance Contracts, J. Practical Estate Planning,August-September 1999.

4. For a detailed discussion of the testing under I.R.C. §7702, see Howard M. Zaritsky & Stephan R. Leimberg,Tax Planning with Life Insurance: Analysis with Forms(Warren, Gorham & Lamont 2nd ed. 1998).

5. I.R.C. § 7702(b).6. I.R.C. § 7702(c).7. I.R.C. § 7702(d). A contract falls within the cash value

corridor of this subsection if the death benefit underthe contract at any time is not less than the applicablepercentage of the cash surrender value. See Chart 1.

8. The term "face amount" is the actual death benefit of apolicy. The "cash value" is the actual underlying valueof the investments within the policy.

9. A more detailed definition can be found at I.R.C. § 817(d)and in Tax Planning with Life Insurance: Analysis withForms, supra note 4.

10. See I.R.C. § 101(a)(1).11. See I.R.C. § 101(a)(2) and Treas. Reg. § 1.101-1.12. See I.R.C. § 101(c) and § 101(d).13. See I.R.C. § 2042.14. See I.R.C. § 2035.15. See generally I.R.C. § 7702(g) regarding taxability if

the contract fails to qualify as life insurance underapplicable law.

16. See I.R.C. § 7702A and I.R.C. § 72(e)(10).17. See generally I.R.C. § 72(b)(3).18. See I.R.C. § 7702A(b) “...a contract fails to meet the 7-pay

test of this subsection if the accumulated amount paidunder the contract at any time during the 1st 7 contractyears exceeds the sum of the net level premiums whichwould have been paid on or before such time if the con-tract provided for paid-up future benefits after the paymentof 7 level annual premiums.” It is important to note that the7-Pay test is based upon the mortality costs of the 1980CSO tables. Since the true costs of the policy are oftenmuch less, it is not unusual to see a Non-MEC with a termof four or five years, rather than the safe harbor of seven.For a discussion of the flexibility of the 7-pay test, see gen-erally, Tax Planning with Life Insurance: Analysis withForms, supra note 4 at 4-32-33.

19. See I.R.C. § 72(v).20. See I.R.C. § 7702A(c)(2) regarding the treatment of a

reduction in benefits during the 1st 7 years.21. See H.R. Conf. Rep. 98-861, 98th Cong., 2d Sess. at 1054-

55 (1984), reprinted in 1984 U.S.C.C.A.N. 1445, 1742-43.22. See I.R.C. § 817(h)(4).23. Treas. Reg. § 1.817-5(c)(2)(i).24 Treas. Reg. § 1.817-5(c)(2)(ii). The regulations pro-vide specific definitions and limitations for real prop-erty accounts that must be reviewed when such hold-ings are contemplated.25 See I.R.C. § 817(h).26. See Treas. Reg. § 1.817-5.27. For a detailed review of the rulings and regulations sur-

rounding investor control in variable annuity and lifeinsurance products see Wayne K. Johnson, An Overviewof the “Investor Control” Issue, Conference on LifeInsurance Company Products: Current Securities, Tax,ERISA, and State Regulatory Issues, ALI-ABA(November 12, 1993).

28. Rev. Rul. 82-54 1982-1 C.B. 11. 29. Priv. Ltr. Rul. 200244001 (May 2, 2002). Although

issued in May, due to the request of reconsideration bythe initial company requesting the ruling, it was notreleased until November 1, 2002.

30. Priv. Ltr. Rul. 9851044 (Sept. 22, 1998). See also Priv.Ltr. Rul. 9433030 (May 25, 1995).

31. See S.D. CODIFIED LAWS ANN. § 10-44-2. Anexample of premium tax changes and additionalchanges useful for PPLI planning implemented in SouthDakota in 2001 can be found in a review of Senate BillNo. 225, available at http://legis.state.sd.us/ses-sions/2001/bills/SB225enr. htm.

32. See I.R.C. § 953(d). Under this Code Section, certainforeign insurance companies might elect to be treatedas domestic corporations.

33. See I.R.C. § 4371.34. I.R.C. § 848. 35. See generally, Lawrence Brody, Michael D. Weinberg, and

Mary Ann Mancini, Using Split-Dollar Insurance inEstate Planning Under the Proposed Regulations, A.B.A.-C.L.E. & SEC. REAL PROP. PROB. & TR. L. (July 30,2002). To review some detailed commentary submitted onthe proposed regulations, see ACLI Comments onProposed Regs on Split-Dollar Life InsuranceArrangements, Public Comments on Regulations, Oct. 72002, available in TAXBASE, 2002 TNT 197-15. For abrief historical survey on the many recent developments insplit-dollar insurance planning, see Burgess J.W. Raby &William L.Raby, The Split-Dollar Life Insurance Regimes,The Insurance Tax Review, March 2002, p.499.

36. See David Cay Johnston, Death Still Certain, butTaxes May Be Subject to a Loophole, N.Y. Times,July 28, 2002, Section 1, Page 1.

37. See Notice 2002-59; 2002-36 IRB 1 (16 Aug 2002).38. For a discussion of the court battles in the COLI arena,

see David Lupi-Sher, Three Strikes, You’re Out – TheCOLI Wars, The Insurance Tax Review, April 2001,p.589.

39. For a review of the rules for transfers of interests in apartnership, see generally I.R.C. §§ 741 – 743.

40. For a general discussion on the regulatory issues con-fronted in private placement life insurance planning, seeSteven B. Boehm and Thomas E. Bisset, PrivatelyPlaced VLI Products: Charting The Regulatory Waters,Conference on Life Insurance Company ProductsCurrent Securities, Tax, ERISA, and State RegulatoryIssues, SF36 ALI-ABA 551 (2000).

41. See Rule 501 of Regulation D of the Securities Act of1933 where individual “accredited investors” must havea net worth exceeding $1,000,000 or annual income inexcess of $200,000 (individually) or $300,000 (jointly).

42. Unless Congress chooses to introduce specific federal legis-lation relating to the business of insurance, the power to reg-ulate insurance has been granted to the states. See theMcCarran-Ferguson Act codified at 15 U.S.C. §§1011-1015.

43. For example, the Florida Insurance Code defines transact-ing insurance in that state as: solicitation or inducement,preliminary negotiations, effectuation of a contract of insur-ance, or transaction of matters subsequent to effectuation ofa contract of insurance and arising out of it. See FLA. STAT.ch. 624.10. In South Dakota, insurance business is definedas the transaction of all matters pertaining to a contract ofinsurance, both before and after the effectuation of that con-tract, and all matters arising out of that contract of any claimthereunder. See S.D. CODIFIED LAWS ANN. § 58-1-2.

44. See Rule 902 of Regulation S of the Securities Act of 1933.45. Many states have adopted legislation similar to the

Unauthorized Insurers Process Act developed by theNational Association of Insurance Commissioners.This act provides a list of the activities of insurancecompanies that a state might use in an attempt to reacha foreign insurer within its regulatory scheme.

Acknowledgments:Many thanks to David Neufeld andPaul Bristow for their editing andinsightful comments.

December 2002 14


Grant R. Markuson, J.D., LL.M. (Taxation), is the managing member atMarkuson & Neufeld, LLC. With a background in advanced estate taxplanning, Mr. Markuson has concentrated his practice in the private place-ment insurance area for the last ten years. Because of his expertise inthis area, he is sought out by domestic and international law firms,accounting firms, banks and insurance companies to address all issuesregarding the use and marketing of private placement life insurance plan-ning. Comments on this paper, as well as suggestions for future articlesare welcome and can be submitted by calling the author at 630-261-1490.

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