Insure This: Getting Your Hedge Fund Tax-Free
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If you are like most financial advisors, you probably don’t know a thing about private placement life insurance. But maybe you should. A growing number of ultra-wealthy investors are using it as a legal means to avoid paying income taxes on their gains in hedge funds—and other alternative investments.
It's a clever way to accumulate assets for heirs: gains on hedge funds held inside the policy are tax-free, and heirs can also collect their share of the death benefit free of taxes. Some policyholders may even be able to withdraw , or borrow, funds, tax-free, depending on how the product is structured.
Sure, the hedge fund industry has suffered quite a few blows in recent months—this week alone brings us headlines about the fake suicide of one convicted hedge fund manager as well as footage of two Bear Stearns hedge fund managers being perp-walked to court. Still, hedge funds aren’t going away any time soon, and for the ultra-wealthy, they are an increasingly popular place to invest. The problem is, they can be a real taxation nightmare. Because they trade frequently, they are prone to generate a lot of short-term gains, which carry a federal tax rate of up to 35 percent.
“Private placement insurance appeals to the client who is primarily invested in hedge funds, and given the high tax costs associated with most hedge funds that are making money, this is an opportunity to scale back on those taxes,” says David Neufeld, a partner with Markuson & Nefueld, Princeton, NJ, which advises accountants and tax attorneys on the private placement insurance deals.
The vehicles—essentially insurance wrappers for alternative investments—were first rolled out in the late 1990s but only began to catch on a few years ago as hedge funds became more mainstream, and after the IRS issued guidance in 2003 about how the insurance vehicles could be used, say industry executives. Now a small group of insurance companies offers the products, including The Phoenix Companies, SunLife Financial, Massachusetts Mutual, American International Group and New York Life Insurance. Industry executives and experts estimate that the onshore market for individual private placement life insurance and annuities had doubled since 2006 to around $10 to $12 billion.
“Private placement has been around long enough now,” that investors’ comfort levels are rising, says John T. Fischer, executive vice president at The Philadelphia Group, a subsidiary of the Phoenix Companies. The Philadelphia Group, which offers private placement annuities, private placement variable universal life and private placement survivorship life, has recorded 40 percent annual growth in premiums in the past four years, he adds.
“We do hundreds of transactions a year, as opposed to hundreds of thousands. The premium dollars are bigger, because they have to be,” he says. “The nature of the business is individualized and customized.” The Philadelphia Group works directly with high-net-worth and ultra-high-net-worth investors, as well as with wealth managers and financial advisors and select insurance agents. Investors must pay a minimum of $1 million a year in premiums, but the average investor purchases annual premium of $5 million, says Fischer. Advisors who recommend the product must be have a license to sell insurance. “Some clients also vet it with tax professionals or attorneys, and we encourage that,” he says. “But the rules are fairly clear, and if somebody wants to do something that isn’t within the rules we wont’ work with them anyway.”
Private placement insurance can hold any number of alternative investments, including commodities, management accounts and private equity offerings. But the tax advantages are particularly attractive for hedge funds. The payout upon death is also shielded from taxes.
Meanwhile, the costs associated with private placement insurance are typically lower than for other insurance vehicles, at around 3 percent, Neufeld. “What private placement life insurance has going for it are a few elements,” says Neufeld. “They’re low-cost, tax-free and [unlike other insurance vehicles] you can invest in alternatives,” he says.
The only real downside to the product is that wealthy investors don’t have any control over the way the money is invested. “The client has to yield control of the investment,” says Neufeld.” The IRS requires that the insurance company have full control of the investments within these policies, rather than the policy owner.”
