Overview
Perhaps you are tired of reading that I grew up in the Panama Canal Zone, but it is one of the last bastions of American colonialism. Personally, I do not like the word “colonialism” because it inevitably conjures up negative images associated with capitalism gone wrong. It is a word that left leaning Latin Americans with a distant memory of Che Guevara, have in mind when they of American imperialist “pigs.” All of this being said while Latin American turns hard-left again.
When the Panama Canal Treaty was being negotiated, our favorite “roving” reporter Geraldo Rivera was on the scene to investigate. His reporting on the Canal Zone and the Zonian lifestyle did not help the cause. Limousine liberals and the NY Times wanted to portray the Americans in Canal Zone as the operators of a federal plantation where people with dark skinned lived-in segregated communities and where the U.S. trained Latin American military leaders at the School of the Americas to support dictators who supported the United States. Where was Dan Bongino when you needed him?
Unlike most Americans, TV watching was limited. The only English TV was on Channel 8 on the military AFRTS channel. The channel came on the air at 4:30 in the afternoon and went off the air at midnight as I recall. College football games were shown two weeks after the fact. Most of the shows that the rest of you take for granted like Leave It to Beaver, Green Acres, et al, we did not have. We were able to watch The Adams Family, Three Stooges and Scooby Doo, in Spanish. The one show that we were able to watch was All in The Family. As an American who never lived in the United States, the show provided me with a window of what was going on in the United States.
Most of you that have read my articles know that I write frequently on the topic of private placement life insurance (“PPLI”) and tax planning using the product. I have worked as a home office employee, consultant, broker, and attorney in PPLI for the last twenty-two years. I have previously written that aside from my article series Nowotny Knows Squat, I do know PPLI.
This article introduces Family Owned Life Insurance™ or (FOLI) which are trademarked names for the specialty use of a private placement life insurance policy for family offices. The policy is issued on a guaranteed basis. FOLI is a powerful product that will allow family offices to accumulate and pass family investment capital on an income and estate tax-free basis for multiple generations. The concept is related to the historical use of Corporate owned life insurance (COLI), Bank Owned Life Insurance (BOLI) and Insurance Only Life Insurance (IOLI).
Background on COLI, BOLI, and IOLI
It is estimated the amount of COLI, BOLI and IOLI life insurance assets exceeds $500 billion. From any perspective, this amount is a very meaningful number. On a macro level, it suggests that if large corporations, national banks, savings and loan associations, life insurance and property and casualty companies recognize the special tax status of permanent life insurance, why shouldn’t ultra-high net worth individuals. In some cases, the families are the founders or largest individual shareholders in these companies. Show me a left-leaning high net worth family that supports paying higher corporate or individual taxes, and we can jointly call him “Mentiroso,” the Spanish word for liar.
Large Fortune 500 companies have used COLI to finance non-qualified deferred compensation or Supplemental Executive Retirement Plans (SERP) for senior executives. These policies usually insured participants on a guaranteed issue basis or with simplified underwriting. The corporation is the applicant, owner, and beneficiary of a COLI policy. Based on the tax treatment of life insurance, the policy cash value accrues on a tax-free basis, and the corporation has the option to tax tax-free loans or alternatively pays corporate benefits out of cashflow and recovers the after-tax cost of the program through the policy’s tax-free death benefit.
An expanded and liberal use of COLI allowed large Fortune 500 companies to invest corporate treasury funds on a tax-free basis by insuring all or most of the employees in the corporation. Known as “Janitor Insurance,” this was the proverbial straw that broke the camel’s back. Politicians cried “foul” when large corporations received tax-free death benefits on employees’ lives, while Pedro the Janitor’s family died penniless.
Politicians on the State and federal level made it harder to implement COLI programs by adding more restrictive consent to be insured rules at the State level while the federal government added IRC Sec 101(j) to cause adverse taxation.
BOLI is a variation on the same theme. First, permanent life insurance is very tax advantaged. Second, national banks and savings and loans associations have Tier I capital that can be invested more tax efficiently inside of a life insurance policy than outside. Third, banks have employee benefits costs in retirement for healthcare and retirement that can and should be funded for currently. BOLI provides a combination of tax and financial and efficiency for meeting these planning needs.
IOLI is the insurance company version of the same product. First, permanent life insurance is tax advantaged. Second, State insurance regulation and the National Association of Insurance Commissioners have investment regulations in place dictating the type of investments that insurance companies can make in their general accounts. Certain variable insurance products issued by well rate life insurers provide a mechanism that allows a life insurance company as an investor to make a larger investment in a riskier investment or asset class without adversely impacting their Risk Based Capital ratio.
All these niche programs operate from the same premise, e.g., permanent life insurance is very tax advantaged. The biggest limitation preventing large corporations, banks, and insurance companies from putting all their money into these programs is the number of available insured lives, the tax law definition of life insurance, the consent to be insured rules and IRC Sec 101(j).
A family office is a private wealth management firm offering a range of personalized services that go way beyond investment management or financial planning. A family office differs from a typical financial advisory relationship in its breadth as it often provides a range of concierge services that eclipses any single stand-alone service required by ultra-high-net-worth (UHNW) families. The original family offices managed the financial affairs of a single, extremely wealthy family such as the Rockefellers, Vanderbilts or du Ponts. Such single-family offices still exist but the wealth management industry has evolved so that multi-family offices can bring a higher level of expertise than most single families can attract.
Family Owned Life Insurance™ (FOLI)
Based on size and reach of the COLI, BOLI, and IOLI marketplaces, family offices need to come to terms with the idea that life insurance is the most tax-advantaged on Planet Earth. The biggest limitations to overcome are the reinsurance limits of an individual policy and the tax law definition of life insurance found in IRC Sec 7702. These two factors determine the premium limits of a life insurance policy. The reinsurance limits on a single insured life are $125-150 million. The other consideration is the fact that most taxpayers would prefer to fund a policy as a non-modified endowment contract (non-MEC) preserving the policyholder’s ability to take tax-free loans from the policy. The bottom line is that a family office cannot allocate all the premium that they would allocate to PPLI based upon the reinsurance limits, IRC Sec 7702 and the MEC limits in IRC Sec 7702A.
The reality of the situation is that most ultra-high net worth families do not require any additional life insurance for estate liquidity planning purposes. Instead, most family offices would rather have a “magic box” where they can invest money and grow it on an income and estate tax-free basis for multiple generations. FOLI is a variable universal life policy that may be issued with full underwriting, simplified underwriting and guaranteed issue underwriting. The mortality risk is reinsured by investment grade reinsurers. The policy is issued on a non-MEC basis. Unlike COLI, BOLI, and IOLI, IRC Sec 101(j) is not applicable. Nevertheless, the life insurer has obtained consent to be insured agreements on all the insured lives. Like any other PPLI policy, the investment options within the Policy are customized.
Example
Facts
Wile E Coyote sold his interests in Acme, Inc., for $250 million. He would like to coordinate his income and estate planning to maximize wealth accumulation on a multi-generational basis. He proposes to invest $100 million in a PPLI policy. The problem is that all the “wear and tear” of growing and managing his company came at a high price, his personal wealth.
Solution
Wile E and his wife both create Spousal Lifetime Access Trusts (SLAT) with Pico De Gallo Trust Company in Nevada. The SLATs are designed so that they are not reciprocal trusts for tax purposes. The two SLATs form an LLC (PPLI LLC) that will be taxed as a partnership. Each SLAT will have a fifty percent LLC interest. PPLI LLC will be the applicant, owner, and beneficiary of PPLI contract issued by Great Atlantic Life. The policy is U.S. tax qualified and features a customized investment fund managed by Roadrunner Investment Advisory, Ltd.
Wile E and his wife enter into a Restricted Collateral Assignment Private Split Dollar Agreement using the loan method of split dollar. Wile and his wife will each contribute $100 million to PPLI LLC. The premium contribution will not be treated as a gift to the SLATs but as a loan based on the long term applicable federal rate (AFR) of two percent. The arrangement is expected to be in place for the next seventy years at least. The loan rate will be frozen at two percent for the duration of the arrangement. PPLI LLC will pay the interest annually.
Assuming a net investment return of eight percent per annum over the next seventy years, the policy projects the following wealth accumulation on an income tax-free, estate tax-free and GST tax-free basis. The chart assumes a premium payment of $100 million and an investment return of eight percent in all years.
The split dollar agreement will be terminated on a heavily discounted basis which will be a topic for a future article. When it is all said and done, the partnership of SLATs will own a PPLI policy that will accumulate to ten billion over the next seventy years income and estate tax free.
Estimate of Policy Values (in Millions)
YEAR | ACCOUNT VALUE | DEATH BENEFIT |
1 | 103 | 555 |
10 | 183 | 223 |
20 | 356 | 223 |
30 | 694 | 153 |
40 | 1,354 | 95 |
50 | 2,644 | 132 |
60 | 5,023 | - |
70 | 10,110 | - |
Net amount at risk assumes the mortality risk in excess of the account value and total death benefit per insured life.
Summary
FOLI is a new innovative planning tool for family offices which allows a family to deploy investment capital on an income and estate tax-free basis. Magically, FOLI does not depend upon the size of the taxpayer’s family, health status or the longevity of the Patriarch and Matriarch. Furthermore, there is not a transaction size that will break the bank. The policy can be issued quickly because there is no medical underwriting. Additionally, it is not constrained by IRC Sec 101(j).
Large corporations and banks have known the “secret for a long time and benefited handsomely. From the skeptic’s perspective, the strategy may not seem long-lasting. The American Council of Life Insurers is the professional and legislative lobby of life insurance companies. Large corporations and banks have implemented these strategies for at least fifty years. While it is conceivable to change the favorable taxation of life insurance, it seems to me that there is lower hanging fruit. Congress would be stepping on some big toes considering the amount of COLI and BOLI assets that large life insurers have on the books. FOLI is the logical planning step to implement what large corporations and banks have known and implemented for over half a century. What are you waiting for? Ultra-high net worth investors are looking in the sky for manna while it is already on the ground to be enjoyed.