Life insurance seems simple on the surface, but is probably the most complicated financial product available on the retail market. Since licensing standards are not rigorous and do not require prior education or apprenticeship, and since training typically covers only the introductory topics necessary to make a sale, most life insurance professionals do not know the intricate details of how life insurance products work.

However, some sophisticated life insurance professionals have mastered the industry and know how to construct high-level strategies. Among the other contributors to advanced life insurance techniques include tax professionals such as accountants and attorneys who are constantly trying to devise methods to take advantage of the unique tax benefits of life insurance policies. These include tax-free death benefits under IRC § 101 and tax-free internal buildup of cash value under IRC § 72.

Here is an unvarnished look at some of the techniques past and present, simple and sophisticated, that have been and continue to be marketed by professionals in the life insurance industry. We have separated these techniques into the following categories:

• The Ugly – Those techniques that have either become IRS listed transactions or have backfired on clients at an unacceptably high rate.
• The Bad – Those techniques that have entered the IRS crosshairs due to widespread abuse and are likely to result in continued scrutiny.
• The Good – Those techniques that either have (1) the explicit approval of the IRS and/or the courts; or (2) strong enough tax law behind them to write a Circular 230-compliant opinion letter.

The Ugly: Abusive Welfare Benefit Plans

Congress has always incentivized employers providing “welfare benefits” to their employees. These welfare benefits may include medical insurance, disability insurance, severance pay, or life insurance. The vehicles used to provide these welfare benefits are known as “welfare benefit plans.”

The incentives came in the form of tax treatment. The employer’s funding of welfare benefits came with a tax deduction. The employees did not have to include any part of the welfare benefit plan’s reserves in gross income. Welfare benefit plans were also not rendered subject to the same complicated requirements and oversight as qualified plans. When Congress originally passed tax laws governing welfare benefit plans under IRC § 419 and 419A, they contained subtle ambiguities that tax and life insurance professionals attempted to exploit.

Congress wanted to curb abuses of welfare benefit plans, so deductions were limited based on three factors:

1. The “qualified direct cost” of the benefits provided (IRC § 419(c)(3))
   
   
2. Whether the benefits would otherwise be deductible to the employer if they were provided outside the welfare benefit plan (IRC § 419(a)(2))
   
   
3. How much money is reasonably necessary to pay benefit claims and administrative expenses (IRC §419(b) – references IRC § 419(c)(1)(B), which in turn references IRC § 419A(b), which in turn references IRC § 419A(c))

However, since Congress didn’t want to decrease the tax benefits of legitimate welfare benefit plans, it carved out exceptions for plans that were (1) “collectively bargained,” (2) “employee pay-all plans” with at least 50 employees, or (3) “ten or more employer” (TOME) plans. IRC § 419A(f)(5)-(6). These plans were not subject to the limitations under IRC § 419 or IRC § 419A.

Promoters would approach small business owners with the idea of including them in a type of welfare benefit plan known as a voluntary employees’ beneficiary association (VEBA) that purportedly qualified under IRC § 419A(f)(6) as a “ten or more employer” (TOME) plan. These plans were really just an amalgam of at least ten separate plans under the guise of one plan. The abusive plans would provide separate accounting for each participating employer, yet if the plan were truly a common pool for ten or more employers, the accounting would be on an aggregate basis.

Not only did the promoters purport that these abusive plans would qualify for the TOME exception, they also claimed that the entire contribution to the plan was a “qualified direct cost” under IRC § 419(c)(3). Contributions would be used to fund life insurance policies with significant cash value beneficially owned by the business owners (and, perhaps, key employees). The IRS raised the alarm about abusive welfare benefit plans in Notice 95-34. Among the concerns detailed in Notice 95-34 are the following:

• The plans do not qualify under the plain language of IRC § 419A(f)(6) because the separate accounting for each participating employer means that the plans are not truly TOMEs;
• Assuming, arguendo, that the plans do qualify under IRC § 419A(f)(6), the “qualified direct cost” of the life insurance benefit is limited to the cost of term insurance, so the deduction is limited accordingly. Therefore, the entire contribution to the plan cannot be deducted if the contribution is used to fund a life insurance policy with cash value.
• The life insurance benefit would not otherwise give rise to a deduction, therefore subjecting them to the prohibition on deductibility in IRC § 419(a).
• The plans are disguised methods of providing deferred compensation, which is not deductible outside of a qualified plan as a matter of policy.

The IRS caught wind of these promoted plans and challenged them twice. On both occasions, the IRS won, and at least some of its concerns in Notice 95-34 were blessed as correct by the U.S. Tax Court. See Neonatology Associates, P.A. v. Commissioner, 115 T.C. No. 5 (2000); see also Booth v. Commissioner, 108 T.C. 524 (1997).

Some promoters had the audacity to continue promoting these welfare benefit plans under other pretenses, so the IRS issued Notice 2007-83 and Notice 2007-84, which “listed” abusive welfare benefit plans for purposes of IRC §§ 6700, 6701, 6707, and 6707A. These notices were intended to be broad in order to cover every potential abuse of a welfare benefit plan.

Two important takeaways from the abusive welfare benefit plan saga:

• Promoters will often claim that certain tax authority supports a technique, but the technique does not actually comply with the authority cited. Therefore, “IRC § 419 Plan” is a misnomer for these abusive welfare benefit plans, because they do not actually comply with IRC § 419 or IRC § 419A. When a plan does not comply with either of those statutes, the plan will instead be considered under either IRC § 404(a)(5) or IRC § 409A.
• Before entering any tax-motivated transaction, a taxpayer should obtain a Circular 230-compliant tax opinion from an attorney with no vested interest in the result of the opinion. In other words, the taxpayer should seek its own tax counsel and not counsel recommended by the promoter.

The Ugly: Misapplied Premium Financing

Premium financing is typically marketed to clients as a way to obtain life insurance with paying little or nothing out-of-pocket. The typical structure of a premium financing arrangement is as follows:

1. The client applies for a life insurance policy with a significant death benefit (typically greater than $10 million). The policy is either a Guaranteed Universal Life (GUL) policy or an Index Universal Life (IUL) policy. GUL policies will pay a guaranteed minimum dividend with the possibility of a higher dividend based on the issuer’s investment returns. IUL policies will have cash value pegged to an underlying financial product or products, usually a fund mirroring the activity of an established financial index (e.g. the S&P 500). These policies will be “paid up” after a certain period of time (e.g., ten years) if all goes according to plan. Sometimes, the policy is owned by an irrevocable life insurance trust (ILIT).
   
   
2. The client approaches a bank to provide a loan to pay the annual premiums. The loan’s interest rate will either be fixed or variable. Variable interest rates are typically determined by reference to the U.S. prime rate or a standard variable rate equivalent to LIBOR. The loan is secured by the policy.
   
   
3. The loan’s total amount outstanding (unpaid principal + accrued but unpaid interest) will be in excess of the policy’s surrender value before the policy is “paid up.” Therefore, the bank typically requires additional cash collateral, which will be held in escrow, reflecting the difference between the amount outstanding and the surrender value. As the difference wanes, the escrow agent returns the cash collateral to the client.
   
   
4. By the time the policy is “paid up,” the client has a life insurance policy, the client’s collateral is fully returned, and the client has effectively never paid any out-of-pocket costs for the policy.

 The typical response to a premium financing pitch from an uneducated client:

“WOW!  That sounds great!”

What the life insurance professional typically does not tell the client, however, is that the transaction comes with significant and multifaceted risk. Among the potential pitfalls:

• Interest rate risk: In order for premium financing to work, the rate of return for the policy’s dividends or other crediting method must substantially exceed the interest rate on the bank loan. If the bank loan has a variable interest rate, both rates will vary with market conditions, therefore making the interest rate risk even more complex and difficult to measure.
• Bank commitment risk: The client must be careful to ensure the bank is committed to loan all of the policy’s annual premiums. If the policy is a ten-pay policy, but the bank is only committed to loan premium payments for five years, the bank can simply walk away from the transaction without consequence after five years if the financial ramifications turn negative. This would leave the client on the hook for at least the other five premium payments and her cash collateral.
• Counter-party risk: If the policy is an IUL policy, the issuer typically has the right to adjust the “collars” restricting the upside and downside of the investment returns. Shifting the collars significantly affects the likelihood that the arrangement will be successful.
• Market risk: With both GUL and IUL policies, there is at least some dependency on the returns generated by a variety of markets, such as the securities market, commercial real estate market, and commodities market.
• BEWARE OF ORIGINAL ILLUSTRATIONS: “The only thing a non-guaranteed illustration proves is that ink sticks to paper.” These illustrations are speculative at best and deceptive at worst. The outcome of a premium financing arrangement can vary wildly depending on a number of factors. One of the variances an insurance company or agent can easily project is the change in the outcome when the policy’s dividend performance does not meet expectations. Typically, the arrangement will have an adverse result for a client when dividend performance is less than projected.
• Never be afraid to ask questions about the risks inherent in a premium financing arrangement. The life insurance professional should be able to fully inform the client about what the adverse consequences will be if any of the risks manifest over the duration of the arrangement.

The Bad: Abusive Marketing of Captive Insurance Companies

Captive insurance is the concept of an operating business self-insuring through a subsidiary or related entity. These insurance companies are often created for legitimate reasons. For instance, Allstate began its existence as the captive insurance company for Sears Roebuck. Among the completely acceptable reasons for forming a captive insurance company are:

• The operating business has an adverse claims history and feels the open market is pricing its commercially reasonable insurance unfairly
• The operating business needs to insure a rare, unique, or obscure risk not properly insured on the open market
• The operating business can achieve substantially lower insurance costs either by self-insuring or by supplementing its third-party insurance with its own

The Code allows a deduction for up to $2.2 million worth of premiums paid to a captive insurance company under IRC § 831(b). For this reason, many captive insurance promoters have been marketing the technique as a tax shelter. In order to justify the tax benefits of a captive insurance company, all of the following conditions must exist:

1. The captive must be an actual insurance company regulated under the insurance laws of its home jurisdiction. Frequently used jurisdictions include Delaware, Vermont, Bermuda, Nevis, and St. Kitts.
   
   
2. The captive must insure risks that are germane and reasonably connected to the actual operations of the business. This can be shown through a legitimate claims history not unlike those found in third-party insurance policies.
   
   
3. The captive must issue policies with commercially reasonable features, including actuarially determined pricing, a contract with similar terms to traditional insurance policies of the same type, and benefits proportional to the price paid.

Many promoters make the mistake of trying to structure the captive in a way that effectively makes the captive a completely discriminatory deferred compensation plan. Promoters accomplish this by insuring very remote risks (at worst, terrorism risk in a flyover state or tsunami risk on the East Coast) and pricing policies without any reference to actuarial analysis.

The tax law does not permit this kind of structure. If a captive insurance company issues policies that would never be found on the open market, the IRS will disallow the IRC § 831(b) deductions because they are not justified by the actual economics of the arrangement. The IRS issued Notice 2016-66 to mark these types of captive insurance arrangements as a “transaction of interest,” which subjects the technique to many of the same requirements (and penalties) as a listed transaction.

Furthermore, the promoter may encourage a business owner to gift interests in the captive to trusts in order to avoid gift, estate, and generation-skipping transfer taxes on the corresponding ownership interests and profit distributions—but note that IRC 831(b)(2)(B)(i)(II) forbids ownership by any trust that is not also a proportionate equity holder in the insured entity. Finally, the promoter may also include key man life insurance as one of the risks a captive can permissibly insure, but the tax law generally does not allow a tax deduction for the payment of life insurance premiums, and the conflict between IRC §§ 264 and 831 is unlikely to resolve in the taxpayer’s favor.

The Good: Private Placement Variable Life Insurance (PPVLI)

In a variable life insurance policy, assets are kept in a separate account, from which mortality costs and certain expenses are deducted yearly. The income generated by assets in the separate account is exempt from current taxation under IRC § 72 and is not taxed until the policy is surrendered or the policy lapses. This incentivized taxpayers to use life insurance policies as investment vehicles. Congress curbed some of this activity by passing IRC §IRC § 7702 and 7702A, which laid forth certain scenarios in which a life insurance policy would not be taxed as a life insurance policy.

• Under IRC § 7702, a “cash value buildup test” applies to determine whether the policy should be taxed as a life insurance policy. If the policy fails this test, all income from both the inside buildup and the death benefit will be rendered currently taxable.
• Under IRC § 7702A, a “seven-pay test” applies to determine whether the policy is a “modified endowment contract” (or “MEC”). If the policy is a MEC, only the tax-deferred nature of the inside buildup is lost. The death benefit is still tax-free.

However, so long as a policy passed the tests under IRC §§ 7702 and 7702A, the inside buildup and death benefit would both remain free of current income taxation. This meant policies with an investment component would still be viable products.

In a retail variable life insurance policy, the only investments available in the separate account are those investments preselected by the issuing insurance company. Therefore, the policy owner is restricted by a “menu” of available investments. For some clients, this makes variable life insurance considerably less attractive.

Life insurance professionals eventually asked: “Why can’t we create a product that would allow access to a broader selection of investments for the separate account of a variable life insurance policy?” The answer to the question came in the form of Private Placement Variable Life Insurance (PPVLI). Rather than purchasing a policy from a traditional issuer, the client can purchase a custom-designed policy unrestricted by a “preselected” investment menu. Besides meeting the tests in IRC §§ 7702 and 7702A, the policy must also meet the following requirements:

• Diversification in accordance with the RIC rules under IRC § 851(b)(3) to meet the safe harbor in IRC § 817(h)(2); and
• No investor control, a doctrine developed by the IRS in Rev. Rul. 77-85, 1977-1 C.B. 12 and refined over several other Revenue Rulings. The Tax Court afforded the investor control doctrine Skidmore deference in Webber v. Commissioner, 144 T.C. No. 17 (2015).

Investor control can typically be avoided through the following measures:

• Formation of a custom insurance-dedicated fund (IDF). Under Rev. Rul. 82-54, 1982-1 C.B. 11, and Rev. Rul. 2003-91, 2003-2 C.B. 347, an IDF will not trigger investor control, provided the IDF itself is diversified. An IDF must only allow for the cash value of annuities and life insurance policies to invest; participation cannot be open to the general public. See Rev. Rul. 81-225, 1981-2 C.B. 12.

• The IDF manager, who selects the individual investments, must meet the following criteria:
  
  

  1. Must be a third party unrelated to the policyholder.

  2. Must not accept anything more than broad general input from policyholder regarding how to invest and manage the assets.

  3. Must perform its own due diligence regarding each individual investment.

  4. Avoidance of all indicia of ownership. The policyholder cannot manage, directly access, or exercise any powers conferred by the policy’s assets. Access can only be achieved through policy loans.

PPVLI has the following uses:

For high-net-worth individuals who enjoy owning alternative assets giving rise to ordinary income, PPVLI avoids the current income taxation on these tax-inefficient assets. Such assets might include long-short equity hedge funds, international bond funds, REITs, MLPs, and investments requiring mark-to-market treatment under IRC § 1256.

For nonresident aliens who wish to invest in U.S. assets, PPVLI avoids nonresident alien withholding, ECI issues, FIRPTA, difficulty of enacting a IRC § 1031 exchange, and other adverse consequences of nonresident alien ownership. This is because the PPVLI can simply make an IRC § 953(d) election to be treated as a United States taxpayer, even if the policy is located offshore.

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Matthew E. Rappaport, Esq., LLM. is the vice managing partner and chair of the taxation group at Falcon Rappaport & Berkman PLLC, a law firm with offices in New York and Rockville Centre providing services to real estate professionals, private equity funds, closely held business owners, international investors, and discerning families.

Edward W. Gordon is managing partner of Preservation Capital Partners LLC, with offices in Garden City and Chicago providing tax, financial, and estate planning strategies for select clientele.