USING PPLI TO AVOID THE 3.8% OBAMACARE NET INVESTMENT INCOME TAX

The 2010 Affordable Care Act, or as it is more popularly termed “Obamacare,” created a new 3.8% Net Investment Income Tax in order to absorb some of the health plan’s costs. Starting in 2013, the 3.8% tax generally applies to income such as interest, dividends, capital gains, rental income, royalty income, and annuity withdrawals, among others.

To hold true to the Obama administration’s attack on the top 1%, this new tax is only to be paid by high-income earners, which are defined as follows:

Single Filers:

AGI in excess of $200,000

Married filing Jointly:

AGI in excess of $250,000

Married filing Separately:

AGI in excess of $125,000

Trusts and Estates:

AGI in excess of $12,000

The tax generally only applies to what is otherwise taxable income. Therefore, the primary solution to avoiding the 3.8% surtax is structure one’s portfolio in a tax-free structure.

PPLI is the Preferred Tax-Free Wrapper

Given the contribution limitations, restrictions, and ultimate taxation of IRAs, 401(k) plans, and similar retirement planning devices, these will not likely offer a meaningful solution to the high net worth, high income client. A popular device for the accredited investors, and soon to become more popular as a result of the additional 3.8% surtax, is a select form of insurance known as Private Placement Life Insurance (“PPLI”). Properly structured, PPLI provides tax-free growth as well as tax-free access to earnings in a low-cost structure that is not restricted like the other options. Tax-free access to earnings in a stripped down cost environment is what sets PPLI apart from the other alternatives.

Private clients have long benefitted from the marriage of PPLI with their taxable investments, such as tax-inefficient hedge funds, to provide a tax-free “wrapper.” PPLI is not typical insurance. It is a direct-issue policy from the insurer that avoids the multi-layered insurance brokerage paradigm and its attendant up-front and ongoing commission expenses. Consequently, the cost structure of PPLI is greatly reduced when compared to conventional insurance.

For example, in most cash value life insurance policies, the costs are difficult to ascertain and there is a break-even point which is usually many years after inception (e.g., 8-10 years).  In contrast, a competitive PPLI policy will offer full transparency of costs, avoid virtually all, if not all commissions, and should break even and become net positive in its first year.

Costs of PPLI Should be Less than Anticipated Taxes

The ultimate assessment is rather simple: the costs of the PPLI should be less than the total taxes that are anticipated on the portfolio assets. If so, the PPLI solution is a prudent one to pursue. With the 3.8% surtax in effect, the equation will likely weigh more often in favor of using PPLI instead of paying the tax. With these features, and its pricing more akin to an “assets under management” fee structure, PPLI has been enlisted as a useful financial solution for family offices and private clients alike.

Not surprisingly, given the significant tax savings benefits of PPLI, there are some requirements that must also be satisfied in order for the solution to work as intended. First, the PPLI policy must be properly diversified. Second, there must not be any impermissible investor control.

The Diversification Rules of 817(h)

Proper diversification for life insurance and annuities is set forth in Section 817(h) of the Internal Revenue Code. When compared to conventional diversification approaches, the standard is quite easy to satisfy:

·         No 1 investment can comprise more than 55% of the cash value of the policy;

·         No 2 investments can comprise more than 70% of the cash value of the policy;

·         No 3 investments can comprise more than 80% of the cash value of the policy;

·         No 4 investments can comprise more than 90% of the cash value of the policy;

Thus, this standard can be met with a total of 5 investments satisfying the allocation requirements above. Moreover, if the policy invests in a fund that is only available to qualifying insurance investors, then the policy is actually allowed to “look through” the fund and count each of the underlying fund investments as its own for purposes of the diversification test. If the fund is not limited to qualifying insurance investors, then the interest in the fund is viewed simply as one investment, without the benefit of look-through.

Avoiding Investor Control, and Taxation

Taxation follows from taxpayer control. Insurance policies avoid current taxation to the insured because the insurance company, rather than the insured, has ultimate control over the assets of the policy. If the situation arises where the taxpayer exerts too much control over the policy, then the IRS will view the taxpayer as the proper party to incur taxes during the life of the policy. The result? The policy becomes taxable.

Therefore, to avoid taxation of policy earnings, the taxpayer must give up control of the management of the assets. For those who have portfolios with third party discretionary managers, this standard is easy to meet. For those that that manage their own investments or micro manage their investment advisors, this standard may present too difficult a hurdle. Unfortunately, the issue of investor control is not black and white, and the assessment is ultimately a facts-and-circumstances test.

Onshore versus Offshore PPLI

PPLI is available in the US as well as offshore. For products in the US, the taxpayer will be underwritten in the US and can speak to the underlying investments freely in the US. For international PPLI, the taxpayer generally needs to actually leave the US to be underwritten and to be “solicited.” The benefit to being offshore is the avoidance of state premium tax, and the avoidance or minimization of “DAC” tax. In addition, for those seeking jurisdiction diversification and enhanced asset protection, international PPLI may offer the most cost-effective and comprehensive wealth planning solution. For those who are a bit skittish on offshore planning, the US option is easier to implement but may come with a little extra up front cost.  

Companies like AIG have recognized the desirability among private clients of both domestic and international PPLI, and it has therefore formed “AIG Delaware” for US policies and “AIG Bermuda” for those seeking international PPLI. It is important to ensure that any non-US policy is compliant with US tax laws to gain the intended tax advantages. The optimal jurisdiction selection for any PPLI structure is unique to each client’s circumstances and objectives.

Integrated PPLI Planning

PPLI can be utilized to avoid not only the 3.8% Obamacare tax, but it will also avoid the higher federal income taxes, state income taxes, and can be structured to avoid the increased 40% estate tax as well. There are a variety of PPLI policy structures, ownership options, and tax planning aspects to be considered. Implementing PPLI can have tremendous benefits, but must be integrated thoughtfully into the rest of one’s structure only after careful consideration with competent tax and wealth planning counsel.

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