Caution regarding Private Placement Life Insurance policies funded with business interests

Income & Capital Gains Taxes

Private Annuities are sometimes used in conjunction with PPLI policies, to transfer income-producing assets into the PPLI separate account. There are typically two phases to this transaction:

Phase 1 -- The income-producing asset is transferred to an LLC owned by a trust formed for the benefit of the PPLI purchaser's children, as part of a Private Annuity transaction. This gets the income-producing asset into the LLC. The LLC is obligated to the PPLI purchaser for the annuity, through the PPLI purchaser's life.

Phase 2 -- The manager of the PPLI purchaser's separate account purchases the LLC interest from the children's trust for "notional" value, i.e., very little, because while the LLC has the income-producing assets it also has a corresponding liability in the annuity obligation. Once the LLC is owned by the separate account, the income produced by the asset is "upstreamed" to the separate account, thus increasing the cash value of the separate account. The PPLI purchaser can now borrow -- tax-free -- against the cash value (which presumably beats the heck out of paying income tax on the income generated by the income-producing asset).

This is a transaction that is heavily marketed by many U.S. planners. But other planners (read: those whom we work with) have expressed concern about this transaction, as we will next discuss below.

Potential Problems

The problem under U.S. tax law is that this transaction may or may not work, primarily because of a 1941 case decided by the U.S. Supreme Court, in Helvering vs. LeGierse, 312 U.S. 531, 61 S.Ct. 646 (1941) ("LaGierse"). The LaGierse case basically says that there is no true "shifting of risk" because the annuity ends up in the life insurance policy.

Indeed, at the Florida Bar Annual International Tax Conference, held in January, 2002, the Internal Revenue Service stated that the use of an annuity contract with respect to the sale of property to an entity underneath an offshore variable life insurance policy/structure is now on the list of transactions for audit. The Internal Revenue Service at the conference made several general comments, followed by the specific position of the Internal Revenue Service with respect to this particular matter. The general comments were:

• The use of a domestic irrevocable trust that then funds a foreign irrevocable trust that acquires a variable policy and includes as one of the investments an entity underneath the policy that enters into a private annuity arrangement with a U.S. person is used to decontrol the entity as a controlled foreign corporation;

• The marketing and sale of these transfers of property to the entity underneath the policy is heavily marketed, and the Internal Revenue Service is receiving complaints from practitioners regarding this transaction;

• This transaction is a step-transaction that is collapsible into a direct sale from the U.S. person to the foreign entity; and

• I.R.C. § 367(f) applies if the transaction occurs after August 5, 1997, and I.R.C. § 1491 applies if the transaction occurred prior to that date.

The specific positions and alternative positions taken by the Internal Revenue Service are as follows:

• The economic substance of the transaction is a sham, and the transaction is a direct sale by the U.S. person under a private annuity agreement to a controlled foreign corporation or other foreign entity.

• The policy of insurance is not a life insurance contract because the insurer offsets its risk by acquiring a valuable property in exchange through an annuity contract with the debt of the policy extinguished at death under the case of Helvering v. Le Gierse, 312 U.S. 531 (1941). The Le Gierse case stated that where the insurer simultaneously issued a single-premium life insurance contract and a single-premium annuity contract, the risks offset each other. Thus, if the insured died prematurely, the insurer was compensated by a profitable annuity premium; and if the insured lived beyond his life expectancy, the insurer was compensated by profitable insurance premiums. Thus, no shifting of risk to the insurer occurred, and the court held that there was no life insurance contract. See also, Rev. Rul. 89-61, 1989-1 C.B. 75.

• The transaction is a step-transaction. The U.S. person negotiated the entire deal.

• I.R.C. § 367(f) applies to the transaction. The U.S. person is treated as transferring property to a foreign corporation as paid-in surplus or as a contribution to capital, and the transfer is treated as a sale or exchange for an amount equal to the fair-market value of the property transferred. The transfer results in recognition of gain in the amount of the fair-market value over the basis. The presenter for the Internal Revenue Service stated that no Treas. Regs. are issued with respect to I.R.C. § 367(f) but that the U.S. Treasury has agreed to make this a project.

• The transfers to the foreign trust are required to be reported under one or more of the provisions of I.R.C. §§ 6038, 6038A, 6038B, 6046, 6046A, or 6048. As a result, under the provisions of I.R.C. 6501(c)(8), the time for assessment of any tax imposed shall not expire before the date which is three years after the date in which the required tax return is filed with the Internal Revenue Service. In addition, the filings with respect to Schedule B, Part III, of Forms 1040 or 1120, may be: (i) suspended by petition to quash summons; (ii) open due to fraud; or (iii) extended by filing an amended return; (iv) extended by failure to correctly file certain information returns.

• The Treas. Regs. under I.R.C. § 684 apply with respect to the transfer of appreciated property.

For Non-U.S. Taxpayers

Those who are not U.S. taxpayers can usually take advantage of the Private Annuity/PPLI structure without these or similar concerns.