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HOW PRIVATELY PLACED TAX ADVANTAGED PRODUCTS CAN BENEFIT HEDGE FUND INVESTORS AND MANAGERS
 
Hedge fund managers and US individual investors should be more familiar with three types of privately negotiated, tax advantaged products: (i) the Private Variable Annuity (PVA); (ii) the Private Variable Life Insurance (VL); and (iii) the Private Single

By Roger D. Silk a principal of the Sherman Oaks, California based tax planning firm of Silk Lintott, Inc.

Hedge fund managers and US individual investors should be more familiar with three types of privately negotiated, tax advantaged products: (i) the Private Variable Annuity (PVA); (ii) the Private Variable Life Insurance (VL); and (iii) the Private Single Premium Variable Life Insurance (SPVL). Each of these products appeals to wealthy individuals and families. In addition, the variable life insurance products are attractive to closely held corporations with significant liquid investment portfolios. They need to be structured privately in order to provide for the appropriate investment choices and, given the set-up costs, are more particularly appropriate for those with at least $10 million available to invest in hedge funds. The table below summarizes the major tax benefits of each of these products.

Product

Tax Deferred Growth of Assets

Tax-Free Access to Cash Value During Life

Tax-Free to Beneficiary at Death of Insured

PVA

Yes

No

No

VL

Yes

Yes

Yes

SPVL

Yes

No

Yes

A private variable annuity is an annuity contract, issued on a private placement basis. What makes it variable is the fact that the cash value of the contract varies directly with the investment performance of the underlying investment.

A private variable life insurance policy is a cash value life insurance policy in which the cash value of the policy varies with the investment results of the separate account assets. To get the most favorable tax treatment available, the investments into a VL policy must be phased in over 4 to 5 years. If this is done properly, the owner of the policy may borrow, tax free, against the cash value of the policy.

Single premium variable life is very similar to private variable life, with two important differences. First, as the name suggests, the entire investment into the policy may be made immediately. Second, there is no ability to borrow tax free from the policy. Any withdrawals or borrowings are taxed as ordinary income.

How it works

Although these contracts are issued by an insurance company, the cash assets are held in a separate account. These separate account assets are not available to the general creditors of the insurance company. In fact, these assets are available only to pay the investor on his annuity or insurance contract. This protection for separate account assets is written into law. The benefit to the investor is that at no time is the cash value of his investment exposed to the credit risk of the insurance company. However, not all offshore jurisdictions have such a law. It could be unnecessarily risky to have a policy from a company in a jurisdiction which does not have a separate account law. Even in jurisdictions which do have a separate account law, it may in certain circumstances be both possible and advisable to make arrangements that give even greater assurances that the client's policy assets will remain in the proper place at all times. In the case of VL and SPVL, separate, special arrangements may be desirable for both the cash value portion of the policy, and the pure death benefit portion of the policy.

A custodian bank holds the assets of the variable separate account. Typically, an arrangement will be created in which the investor sends his investments directly to an account at the custodian bank. For example, a variable annuity might be written by a small (perhaps a Cayman Islands-based) insurance company, using a strong bank as the custodian. The investor would send his investment cash directly to the bank, for the separate account of the insurance company, and not to the Caymans. This gives the investor the confidence that his assets are at all times in sound, strong hands.

US tax law allows for the tax deferred build-up of assets in a variable annuity and variable life contracts. To qualify for the favorable tax treatment, the investment portfolio must be adequately diversified which effectively requires that at least five different investment assets be owned in the account. Due to a recent change in the regulations, a variable annuity policy must be issued by an insurance company that is subject to US tax. The issuing company may still be offshore, and the policy may still be offshore. The variable life contracts allow for the entire value of the death benefit to pass to the beneficiary completely free of income tax. Finally, in a private variable life contract, the policy owner may borrow against the cash value tax free once the policy is fully paid for. The primary advantage of SPVL vs. VL is that SPVL offers the opportunity of getting the maximum amount of cash into the policy as soon as possible. The primary disadvantage is that the ability to borrow tax free is lost.

To qualify as life insurance under US tax law, the total death benefit of the policy must exceed the cash value by a certain amount (the exact amount varies, and is calculated according to a complex formula). Typically, most of the pure death benefit would be re-insured by a large, very strong reinsurer.

Historically, life insurance has not always been a good investment. The private life products described here are different. They are designed to incur the minimum amount of life insurance cost while still gaining the very valuable tax benefits which the law provides to life insurance. The average annual cost of these contracts typically ranges around 150 basis points. Organizational costs vary between a few tens of thousands to a few hundred thousand dollars.

The benefits

Each of the three products has the following benefits and features for the investor:

1. Tax deferred compounding allows assets to grow much faster than assets which are taxed on a current basis.

2. Flexibility: while an investor cannot directly manage his own investment account, he can select an investment manager (or managers) of his choice. The investor can determine the allocation of the assets, and can change that asset allocation over time. The ability to invest on a tax advantaged basis is particularly valuable with hedge funds, because hedge funds often produce returns which are subject to tax at the maximum rate.

3. Liquidity: private variable products can be structured so that the investor has maximum liquidity. There is no lock-up period, although in certain circumstances there may be costs to early termination of the program. For PVA and SPVL, there may be a tax penalty for withdrawals made before age 591/2. This rule generally parallels the rule for early withdrawals from IRA accounts and other pension accounts.

4. Very large amounts can be sheltered: there is no limit at all on the amount of investment assets that can be sheltered using a PVA product. With the VL and SPVL products, large amounts can be sheltered. The exact amount that can be sheltered with these products will depend on a variety of particulars, but it will typically be at least $25 million.

The great benefits available to the investor in a PVA, VL or SPVL policy also translate into major benefits for the investment advisor who manages the assets invested in such a product. As assets grow on a tax-deferred basis, the investment advisor can attract and retain substantially more assets under management over a long period of time.

Onshore vs. Offshore

The choice between onshore and offshore is usually not driven by tax considerations. There are minor differences in the way these types of products are taxed depending on whether they are onshore or offshore. Generally, but not always, there is a slight tax advantage to being offshore. The differences in tax treatment mainly relate to federal excise taxes (which apply to premiums paid to offshore insurers, but not to US insurers), state premium taxes (which vary from state to state, and apply to insurance products sold in the state), a federal tax called the DAC tax (which is a complex tax on US insurers), and the potential application of withholding taxes on certain payments. In most cases, these more or less balance each other out.

More important considerations are often regulatory issues, non-tax cost issues, marketability issues (offshore, non-US-registered products cannot be marketed in the US), and flexibility issues (i.e. it's often easier to negotiate the specific deal needed in the offshore market).

Negotiating the Privately Placed Deal

There are a large number of factors which must be adequately addressed before a privately placed variable deal should be entered into. This applies onshore, and arguably even more so offshore. In some cases, a suitable off-the-shelf private placement variable policy may not be available. In such instances, there are a number of considerations which must go into the negotiation of a suitable policy.

Among the areas that must be satisfied are actuarial issues, reinsurance, choice of custodian, custody arrangements, methods of payments and cash flow management, obtaining required legal and/or tax opinions, awareness of and compliance with relevant excise taxes, communications, compliance with any relevant securities and/or insurance laws, as well as a sound economic analysis to determine whether the contemplated transaction is likely to achieve the desired goals for the client.

Conclusion

Privately placed, tax-advantaged investment vehicles of the type described here represent some of the best opportunities for maximizing after-tax wealth that we are aware of. A large and growing number of sophisticated, high net-worth individuals and families are currently taking advantage of the unique planning opportunities presented by these types of vehicles. And it's easy to see why. For actively traded investment funds subject to US income tax, the benefits of tax deferral or tax avoidance are tremendous. The great tax and other benefits available to investors with private variable policies offer tremendous opportunities to advisors who can help their clients obtain these benefits. Investors with long term investment wealth, with asset protection trusts, or who are involved in estate planning might all benefit from the investment vehicles described here. u

 
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