Life insurance is fundamentally a wager between the purchaser and the insurance company about whether a person will die within a given year. The most basic life insurance is term insurance whereby the purchaser pays a premium each and every year for the life insurance. As the person gets old, the risk of their dying goes up, and so the premiums increase each year. Eventually, as a person gets along in years, the cost of the life insurance becomes exorbitantly expensive, and at that point the life insurance will be allowed to lapse. It is in fact the lapse rates which makes life insurance highly profitable to insurance companies, since if the policy lapses then the insurance company will have taken in a great deal of premiums without ever having to pay on that policy.
Good for the insurance company, but not so good for the purchaser who may need the life insurance to take care of the needs of survivors. Thus, cash value life insurance was developed so that a purchaser could pay a great deal of money up front, that money would have an investment return, and the life insurance premiums (premiums for the so-called death benefit) would be paid from the accumulated moneys in the policy until the person died, whenever that was (or the policy endowed and paid out at some very advanced age, such as at 105 years).
Congress liked the idea of cash value insurance and so from very early on the cash value of life insurance was deemed to be free of taxes while it remained within the cash value policy. This brings us to the seed of today’s problem, since anything that is free of taxes will invariably lead to abuses, whether it is misused charitable organizations, misused IRAs and pension accounts, and pretty much everything else that has a tax-free feature — including cash value life insurance.
But here we must digress before we talk about the tax abuses of cash value life insurance, for there is another abuse of life insurance to be considered. That abuse has nothing to do with taxes, but rather goes to the commissions paid to agents. The commissions paid to life insurance agents for cash value life insurance can be as high as 40% of the first year’s premiums for so-called universal insurance, which allows for a variable schedule of premium payments by the purchaser, to 80% of the first year’s premiums in the case of whole life insurance, which has a fixed schedule of premium payments. Thus, a life insurance agent who sells a whole life policy that is funded by five equal $100,000 payments will generate a commission in the neighborhood of $80,000 for just a few hours’ actual work.
It doesn’t take a Ph.D. in economics to realize that the purchaser would be better off having the high commission amount instead applied to the policy’s cash value. The retort of the agents would be that the commission is not paid from the cash value, so long as the policy is not terminated during the surrender period, but rather from the insurance company, which is true as far as that goes. The insurance company still has to get the money from somewhere, however, and ultimately does so by internally charging a higher cost for the death benefit to cover such commissions.
Which brings us now to variable universal life insurance, commonly known as “VUL”. This product invests in tradeable securities and thus creates the opportunity for greater returns (and, of course, greater losses). While VUL does not pay the high up-front commissions for traditional cash value products, the financial advisor involved can charge an annual fee to “manage” the VUL’s portfolio and these fees can add up over time. Perhaps this isn’t that big of a deal, since presumably the same financial manager would charge the same fees outside the policy, but there is also another restriction: The investments within a VUL policy are typically restricted to a controlled group of investments, similar to the most common mutual funds, and thus do not offer the flexibility for the policy owner to invest in more exotic things such as hedge funds.
The bottom line of all this is that life insurance does offer the Holy Grail of tax-free investments, but with the costs of insurance agent commissions or the financial advisors fees, and investors are handcuffed into either cash investments (universal or whole life policies) or a limited menu of investment funds (in the case of VULs).
Enter private-placement life insurance, commonly known as “PPLI”. These are insurance policies which are designed in a bespoke fashion for each purchaser, and they originally became popular in the mid-1990s as a way for wealthy people (accredited investors are the only folks who can buy them) to avoid the large life insurance agent commissions or dubious financial advisor fees, by way of direct negotiations with the insurance company where the commissions and fees are dialed-down to some minimal figure or even nothing.
PPLI policies act like VUL policies in the sense that they can invest the cash value in securities, but PPLI policies, being specifically-tailored for each purchaser, have the ability to invest in a much wider range of things, and still, of course, do so completely tax-free.
Very early on, it was realized that PPLI products were ideal for hedge fund investments. The reason for this is that hedge funds often generate a great deal of tax liability to the investor, but by putting a hedge fund investment inside the cash value of a life insurance policy through PPLI, those taxes can be avoided. While the IRS has issued various rules and regulations to try to clamp down on this, those efforts have largely been hit-and-miss and PPLI is still used even today to basically soak up the taxes that an investor normally would pay on their hedge fund investments.
And now we finally get to the most abusive part of PPLI. Remember that a PPLI policy has a cash value account, and that account is used to make investments. Usually, that means some form of investment funds, but what if somebody has an investment that throws off a lot of cash and with it taxable income? The idea thus came up to look for ways to move revenue streams into PPLI products, such as an interest in the owner’s operating business, or maybe a licensing right from a patent or trademark. A few tax attorneys have made considerable fortunes structing their clients’ affairs so that they went from earning a lot of money and paying a lot in taxes to instead avoiding those taxes altogether and instead growing their PPLI policy’s cash value ― which can then be borrowed against tax-free.
Is that even legal? No. As I wrote in my article Swiss Life Companies Enter Into Deferred Prosecution Arrangement For Abusive Private Placement Life Insurance Policies (May 28, 2021), the U.S. Attorney’s Office for the Southern District of New York entered into a deferred prosecution agreement with Switzerland’s largest insurance company which were facilitating abusive PPLI deals. As part of that agreement, Swiss Life was to pay $77.3 million to the U.S. Treasury as restitution, forfeiture of all gross proceeds, and penalties. This came about after Swiss Life was alleged to have concealed more than $1.452 billion in assets and income from the IRS through the use of their PPLI policies.
Now one would think that such a prosecution would put a damper on the abusive use of PPLI policies, but that hasn’t been the case. Tax attorneys are still creating these arrangements in conjunction with other PPLI life insurance companies that don’t seem to mind so long as the checks keep clearing.
That now brings us to present news, which is that Congress has finally gotten fed up with the abuses of PPLI policies, and Senator Wyden of Oregon, the Chair of the Senate Finance Committee announced on August 15, 2022, that an investigation would be made into PPLI schemes.
According to Senator Wyden’s press release, the investigation has started with a letter to Lombard International, which is a subsidiary of BlackstoneBX +1.3%. I won’t rehash the entire press release, which you can of course peruse for yourself. What is interesting is that after PPLI being abusively used for over 25 years now, Congress is finally gearing up to take some action against those allegedly involved with abusive PPLI products. Some might say that this is just closing the barn door after all the horses have escaped, but the truth is this particular barn is going to continue to lead to abusive tax schemes until Congress finally nails that door shut for good.
It is interesting to consider what Congress might do with PPLI, and it might very well be that Congress decides to exclude PPLI from the tax-free buildup of cash value. Since this would affect relatively few taxpayers in the bigger scheme of things, albeit for some very big dollar amounts, that would not be the worst idea in the world. The IRS has itself discovered it is very difficult to create an effective set of rules to deal with only some PPLI transactions and not others, without creating an opportunity for abuse.
What I have been surprised about for about 20 years now is that the IRS has not made certain PPLI deals a listed transaction (basically, a presumed tax shelter) which would require special reporting of such transactions to the IRS, and also expose the planners who profit from abusive PPLI transactions to promoter penalties. Perhaps the Senate Finance investigation will lead to an answer from the IRS as to why that hasn’t been done.
Frankly, I would like Senate Finance to make a broader examination of large life insurance policies generally, i.e., those with cash values in excess of $10 million, whether PPLI policies or not. The purpose of life insurance is to provide for the needs of survivors, not to be a tax shelter for the very wealthy. A some point, the buildup in cash value should hit a point at which investment returns become taxable, which would prevent such abuses.
Another component of PPLI — and large life insurance policies generally — that Senate Finance should explore is the ability of policy owners to take tax-free “loans” from the policies that are limited by only the amount of the cash value. Originally, these loans were meant to allow policy owners to have a safety valve in case something happened, such as a medical emergency, where they needed to access the cash on a temporary basis. But there are no limits to such borrowing up to the limits of the cash value, and that is one of the things that has lead to abuses.
For example, the policy owner is able to structure a transaction whereby some revenue streams makes its way into ownership by the policy. As mentioned, the policy owner no longer pays income tax on that revenue stream, and whatever taxes would have been paid are now soaked up by the tax-free treatment of the cash value. The policy owner could then borrow against that money, thus obtaining immediate access to what otherwise would have been taxable income.
The easiest and most obvious way to defeat these shenanigans is to create a cap on policy loans, say $1 million, so that they can be accessed in an emergency, but the policy owner cannot use them to circumvent large amounts of otherwise taxable income.
Thus, my suggestions for how Senate Finance should deal with abusive PPLI policies is as follows, and assuming of course that they do not decide to just get rid of them completely:
1. Set a limit on the amount of cash value that is not subject to taxation on its investment income, say $10 million. Once the cash value exceeds that amount, the investment income on the entire cash value becomes taxable.
2. Require the investments of the policies to be in U.S. publicly-traded securities only. This serves two purposes: (a) It will keep the policies from investing in closely-held LLCs and other assets that are used to divert income streams into the policy, and (b) It will keep the assets in the U.S. investment markets instead of U.S. taxpayers effectively subsidizing investments abroad.
3. Restrict the amount of cash value that may be borrowed tax-free from the policy to $1 million, which is ample to provide for things such as medical emergencies (considering that accredited investors should have other assets available anyway), but will keep the policies from being used as a way to launder otherwise taxable income into tax-free loans against the policies. The policies should also be subject to LIFO (“last in, first out”) accounting, so that any withdrawals in the form of loans against cash value in excess of $1 million will be taxable as investment income.
4. Designate PPLI transactions to be listed transactions, requiring the filing of tax shelter disclosure forms. This does not mean that all PPLI transactions will become per se illegal, but it will make prospective participants in these plans think twice before attempting to abuse them.
What will Senate Finance actually do? Who knows, particularly with a Congress that can’t seem to agree on anything, and lots of lobby money floating around. It might be that Senate Finance simply investigates and issues a report without new legislation, or it might be that Senate Finance is finally tired of this particular shelter and enacts legislation to get rid of it in whole or part. We’ll have to wait and see.
People who have PPLI products should take this opportunity to have them reviewed by an independent tax advisor, with “independent” meaning somebody who has no connection whatsoever to the folks who set up the arrangement. If nothing else, getting a second opinion may help later to avoid penalties (but only if the second opinion is truly “independent”), or it might reveal planning that should never have been done in the first place and now needs to be unwound as quickly as possible.