President Biden and Congressional Democrats have recently proposed a $3.5 trillion infrastructure bill that contains nearly all of Biden’s American Families Plan proposed in April 2021, plus expanded Medicare coverage for hearing, vision and dental care.1 To pay for these programs, the President wants to raise federal income, capital gains and estate taxes in either 2021 or 2022.2 Additionally, many states and localities are increasing income taxes due to high debts and deficits. For example, California and New York City have proposals to increase their highest rates to 16.8% and 14.8%, respectively.3 Many other states are also looking to increase income and capital gains taxes.4 Private placement life insurance (PPLI) is a great vehicle to lessen the burden of the proposed higher federal and state income and capital gains taxes.
How PPLI Works
PPLI acts differently from a typical whole life insurance policy. PPLI is a specifically designed variable universal life insurance policy to maximize savings and minimize the death benefit.5 PPLI cash values may be directed by a client’s chosen investment advisor and accumulate income and capital gains tax free.6 Cash values are also available federal and state tax free using withdrawals of cost basis (total premium paid) and very low cost loans. Additionally, at the insured’s death, the death benefit is payable tax free. Therefore, all investment gains, dividends and interest are compounded without income tax.7
PPLI policies can now be structured very cost effectively. The cost of these PPLI insurance wrappers generally average 100 basis points (bps) or 1% annually. This is a low price to payto alleviate federal and state income and capital gains taxes.8 These modern PPLI policies also allow for a wide variety of investment opportunities. They can frequently be designed around investments of the client’s choice.9 A PPLI policy owned by a trust provides a wrapper around trust investments resulting in a zero tax trust.10 Generally, if a trust owns a PPLI policy, it will be sitused in one of the modern trust states with low state premium taxes and other favorable insurance laws. The premium tax savings can average 200 bps (that is, 2%) or more in one of these low premium tax states.11
PPLI must be sold to an accredited investor who’s a qualified purchaser. This would generally include a trust with assets in excess of $5 million and an individual with a net worth of $1 million (excluding residence) and investable assets of $5 million. Unlike a trust, a limited liability company (LLC) doesn’t generally need assets of $5 million because there’s a look-through to the equity owners to see if there’s an accredited investor/qualified purchaser.12
Zero Tax Dynasty Trusts
The dynasty trust has been one of the more popular trusts for many clients to use their $11.7 million gift, estate and generation-skipping transfer (GST) tax exemptions.13 The Biden and Democratic proposals have called for a reduction of the exemption to $5 million or even to $3.5 million.14 Generally, tax increases aren’t retroactive. However, many advisors have been planning to provide ways to unwind $11.7 million gifts, if need be, by using disclaimers, formula clauses or family loans.15
PPLI is frequently purchased by a dynasty trust. This minimizes the federal and state income and capital gains taxes on dynasty trust assets. Additionally, trust distributions made from dynasty trusts as PPLI loans to beneficiaries in high income tax states can be both federal and state tax free, thus, creating a zero tax dynasty trust:
- No federal income taxes (trust income/capital gains and distributions);
- No state income taxes (trust income/capital gains and distributions);
- No federal death taxes; and
- No state death taxes.
PPLI can generally be purchased by the dynasty trust on the life of the grantor/settlor, grantor’s/settlor’s spouse and/or on the beneficiaries’ lives at each generational level. This provides powerful leverage so that the dynasty trust becomes a well-funded family bank for several generations either long term or in perpetuity.16
However, it’s important to note that the recent Biden Green Book has a proposal to tax dynasty trusts every 90 years but leaves the long-term and unlimited dynasty trust durations in place. The Obama administration’s Green Book also proposed this tax, but it never passed.17 However, if it now passes, PPLI could also be used to pay for the tax every 90 years. Also, some advisors believe that decanting a trust might be a way to get around the 90-year tax. Advisors may not want to rely on this strategy because extending the duration of a trust is generally problematic. On the other hand, decanting to change the term of a trust generally isn’t a problem.18
In addition, dynasty trusts are often established as grantor trusts. A grantor trust is one in which the trust is excluded from the estate, but trust income is attributable to the grantor instead of the trust. Thus, the grantor pays the trust income tax instead of the trust. This results in a tax-free gift to the trust, achieved by the grantor retaining certain powers under the trust that trigger the grantor trust status.19 In combination with the purchase of PPLI owned by the trust, federal and state income tax owed by the grantor can be minimized, because PPLI is a zero tax asset.
In addition, the grantor defective dynasty trust can be combined with the promissory note sale strategy to the trust. The promissory note sale strategy is a very powerful leveraging strategy that allows for very large insurance purchases (that is, PPLI). The leveraging is based on an arbitrage between the note interest (that is, the Internal Revenue Code Section 1274 rates) and the investment return on the underlying trust assets.20 Additionally, the life insurance cash value can generally serve as a down payment for future promissory note sales to the trust. The promissory note sale strategy can add significant amounts of life insurance to the trust without any gift, estate or GST tax consequences.21
Note, however, that the Biden Green Book did propose a fundamental shift in the transfer realization rules, specifically by deeming transfers to trusts except for wholly owned revocable grantor trusts as recognition events.22 At this time, it’s unclear whether the recent $3.5 trillion Biden and Congressional Democrat Infrastructure Bill proposal will include such changes. If it does, however, such proposals could heavily impact or even potentially eliminate the use of the promissory note sale strategy by having the grantor’s sale or exchange with the trust subject to estate and gift taxes.
Self-Settled DAPTs
Domestic asset protection trusts (DAPTs) are generally self-settled trusts that allow for the grantor to be a permissible discretionary beneficiary of the trust. These trusts are either established as irrevocable trusts excluded from the estate (that is, as a dynasty trust) or as an incomplete gift included in the estate.23 PPLI is also a popular investment for DAPTs due to the federal and state income tax savings on both the trust growth/income and distributions. Single individuals are establishing self-settled DAPTs prior to marriage and naming themselves and a floating spouse as beneficiaries. A “floating spouse” is defined as a spouse the grantor is living with and married to, so at the time of the marriage, the spouse can automatically be added as a trust beneficiary on a “floating” basis.24 In the unfortunate event that the grantor and the floating spouse get separated and/or divorced, the floating spouse is automatically removed as a trust beneficiary.25 Additionally, the grantor can name unborn children as beneficiaries, as well as a charity directly or indirectly through a donor-advised fund and/or private foundation. Alternatively, the grantor may desire to name only unborn children and a charity as beneficiaries instead of naming a floating spouse.26 Consequently, single clients can contribute to the self-settled trust to pay premiums of PPLI policies purchased and owned by the trusts. Moreover, the grantor has the ability to receive future PPLI distributions (that is, loans) during their lifetime (for example, retirement) both federal and state tax free from these self-settled DAPT trusts. Additionally, because these trusts are established before marriage, they’re generally protected from divorce depending on the DAPT situs. These DAPTs may also be established post-marriage and purchase PPLI to provide the federal and state income tax savings benefits from both the income and the distributions from the trust.
State Income Tax Planning
PPLI can also be very beneficial to clients in high income tax states such as California, Connecticut, Hawaii, Massachusetts, New Jersey and New York.27 If investments within trusts in these high income tax states are wrapped within a PPLI policy, the income and capital gains they generate aren’t generally subject to state and/or federal income and/or capital gains taxes. Additionally, if a beneficiary with residence in a high income tax state receives a PPLI loan distribution from a trust, the distribution generally won’t be subject to federal or state income taxes.28 Despite the availability of PPLI, these clients will usually choose to situs their trusts in boutique trust states with no state income tax to garner the many non-tax benefits such as asset protection, privacy, as well as flexibility and control regarding investments and distributions.29 Also, if these trusts are located in states with no state income tax on trusts, when the death benefit pays out and is invested within the trust, there will be no state income or capital gains taxes on the investment income.
State Insurance Premium Taxes
Another important reason for choosing a boutique trust state may be state premium tax savings.30 Generally, state premium taxes are imposed on all life insurance premiums paid and are generally based on where the applicant for the insurance policy is a resident, domiciled or sitused. Consequently, an insured’s resident state generally doesn’t levy a premium tax on premiums paid for a life insurance policy purchased by a trust or an LLC sitused in another state. The trust or LLC situs state premium tax would generally apply.31 The four states with the lowest premium taxes for trusts are Alaska, Delaware, South Dakota and Wyoming. Alaska, South Dakota and Wyoming also have the lowest premium taxes for LLCs. If there are existing trusts in high income and premium tax states and a client wants to purchase PPLI in these trusts to take advantage of lower premium taxes, an LLC may be used. The client can form an LLC in the states with a low premium tax. A co-manager is then appointed in the low premium tax states to purchase insurance within the LLC and allocate the units to the out-of-state high income and premium tax trusts. This strategy can result in powerful tax savings to a trust in a non-favorable income and premium tax state.32
Asset Protection
In addition to the federal and state tax savings, PPLI policies are also protected from creditors of an insurance company because they’re segregated into separate accounts.33 Clients may also desire that their PPLI policies be protected from their own creditors. Many states (for example, Florida, New York and Texas) have statutes for residents that protect both the cash value and death benefit of PPLI policies, whether or not owned by a trust or an LLC.34 The premium taxes in these insurance asset protection exemption states are all high. Consequently, whether or not clients are residents of one of these states, they may want to use a self-settled and/or third-party trust and/or LLC wrapper in a state with a low premium tax. The trust and/or LLC wrapper provides a low premium tax as well as a layer of asset protection for the PPLI policies. These low premium tax states also provide many other key benefits, such as in-kind lifetime cash value and death benefit distributions, thus preventing any possible issues associated with any underlying alternative investment lock-up periods as well as very favorable insurable interest definitions.35
Growing Popularity
With both higher federal and state income taxes on the horizon, PPLI could provide a very important solution for many clients. Advisors need to be cognizant of the opportunity that PPLI insurance provides to maximize their clients’ federal and state tax savings. They need also to be aware of the many additional advantages that a trust sitused in a boutique trust state can provide, as the owner of the PPLI. The popularity of PPLI insurance is only going to grow as federal and state taxes, debts and deficits continue to grow.
Endnotes
1. Christina Wilkie, “Democrats’ $3.5 trillion budget package funds family programs, clean energy and Medicare expansion,” CNBC (July 14, 2021), www.cnbc.com/2021/07/14/democrats-3point5-trillion-budget-package-funds-family-programs-clean-energy-medicare-expansion.html.
2. Greg Iacurci, “Biden’s top tax rate on capital gains, dividends would be among highest in developed world,” CNBC (June 21, 2021), www.cnbc.com/2021/06/21/biden-tax-plan-raises-top-capital-gains-dividend-tax-rate-to-among-highest-in-world.html.
3. See Robert Wood, “California Proposes 16.8% Tax Rate & Wealth Tax . . . . Again, Time To Move?” Forbes (May 1, 2021); Carmen Reinicke, “New York is raising taxes for millionaires. Will other states follow?” CNBC, www.cnbc.com/2021/04/08/new-york-is-raising-taxes-for-millionaires-will-other-states-follow.html.
4. Karen Langley, “Tax Hikes for High Earners Are on the Table in Some States,” Wall Street Journal (Feb. 24, 2021).
5. Internal Revenue Code Section 7702; See Kirk Loury, ed., The PPLI Solution: Delivering Wealth Accumulation, Tax Efficiency, and Asset Protection Through Private Placement Life Insurance (2005); See also Lynnley Browning, “Tax-Free Life Insurance: An Untapped Investment for the Affluent,” The New York Times (Feb. 9, 2011).
6. Al W. King III and Pierce H. McDowell III, “Powerful Private Placement Life Insurance Strategies With Trusts,” Trusts & Estates (April 2016).
7. Ibid.
8. Al W. King III, “Important Trust Trends,” Trusts & Estates (June 2021).
9. Aaron Abrahms and Eric Naison-Phillips, “The Popularization of the Separately Managed Account,” Wealthmanagement.com (July 26, 2021).
10. See supra note 8.
11. Ibid.; seefor example, Alaska, Delaware, South Dakota and Wyoming.
12. See supra note 6.
13. Aaron Abrahms and Matthew Wosk, “The Power of PPLI Planning,” Wealthmanagement.com (Oct. 16, 2020).
14. See supra note 8.
15. Martin M. Shenkman, “Checklist 2020 Planning Follow Through: You Have More Work To Do,” Forbes (Dec. 27, 2020).
16. Al W. King III and Pierce H. McDowell III, “State Premium Tax Planning?” Trusts & Estates (June 2011).
17. Martin M. Shenkman, “President Biden’s Budget Includes Big Tax Increases That Will Rock Your Tax World,” Forbes.com (May 28, 2021).
18. Al W. King III, “Decanting is a Popular Strategy, But Don’t Ignore Several Key Considerations,” Trusts & Estates (August 2018).
19. The tax rules that govern grantor trusts are set forth in IRC Sections 671-676 and the supporting regulations. See Al W. King III, “Maintaining Control in an Uncertain Environment,” Trusts & Estates (June 2020).
20. See supra note 6.
21. Ibid.
22. See supra note 17.
23. Al W. King III, “Attacking, Defending & Fortifying Domestic Asset Protection Trusts: A Trustee’s Perspective,” Desert Estate Planning Council (April 2016); Mark Merric, Daniel G. Worthington, Paul MacArthur and John E. Sullivan III, “Find the Best Situs for Domestic Asset Protection Trusts,” Trusts & Estates (January 2021).
24. See Al W. King III, “Anticipating the Unanticipated With Trust Planning,” Trusts & Estates (October 2018).
25. Ibid.
26. Ibid.
27. See supra note 6.
28. Ibid.
29. For example, Alaska, Delaware, Nevada, New Hampshire, South Dakota, Tennessee and Wyoming.
30. For example, Alaska, Delaware, South Dakota and Wyoming.
31. See supra note 6.
32. Al W. King III and Pierce H. McDowell III, “Selecting Modern Trust Structures Based On a Family’s Assets,” Trusts & Estates (August 2017).
33. See supra note 6.
34. For example, Florida, Kentucky, Hawaii, Michigan, New Mexico, New York, Oklahoma, Texas and Wyoming. See Duggan & Bertsch, “Creditor Protection Laws for LI and Annuities” chart, Asset Protection Society, https://assetprotectionsociety.org/creditor-protection-laws-for-li-and-annuities.
35. Al W. King III, “Defend Against Attacks on DAPTs?” Trusts & Estates (October 2014).