Frozen Cash Value Life insurance

I Overview

My friend and fellow University of Miami School of Law (LL.M) graduate is responsible for developing the concept of the Restricted Cash Value Life Insurance(aka frozen cash value life insurance) policy back in October 1994 when he wrote an article in Offshore Investment magazine. His article called The Hampton Freeze is well known among a small group of tax and estate planning attorneys. This development was ahead of its time. The private placement life insurance (PPLI) industry for high net worth individuals was in its beginning stages and awareness of PPLI among client advisors was also missing.

The time for Frozen Cash Value life insurance is now! The future tax landscape is clouded with problems for taxpayers. The expiration of the Bush tax cuts at the end of 2012 (before any actual tax reform) will result in an immediate tax increase for high net worth investors. The top marginal tax bracket will increase to 39.6 percent. The addition of the new Medicate tax will increase this to 43.4 percent for high net worth individuals. The long term capital gains rate will increase to 20 percent. The Medicare tax will increase this to 23.8 percent. Additionally, most states tax long term capital gains rates as ordinary income. As a result, most investors will be looking at a combined rate for long term capital gains rate of 27-30 percent. High net worth investors in New York and California are facing combined income tax rates in excess of 50 percent. Additionally, a Millionnarie’s tax of 5.6 percent is being considered that will bring the total federal rate to 49%.

On the estate and gift tax front, rates will increase to 55 percent with the exemption being decreased to $1 million per taxpayer. The President’s budget proposal calls for an exemption equilivalent equal to $3.5 million. It is questionable if any taxc changes are made before the 2012 Presidential election.

The prospects for corporate tax reform are also very high. It is well publicized that most multi-national corporations pay far less than the highest marginal tax bracket of 35 percent. Additionally, corporations are able to defer taxation on on their non-U.S. income. This article will also address the possibility of using frozen cash value life insurer in corporate owned life insurance (COLI and Bank Owned Life Insurance planning.

The planning need for legal tax structures which provide for tax-deferral is high. The Frozen Cash Value  (FCV) policy is unique planning opportunity to maximize tax-advantaged wealth  accumulation.

II What is Frozen Cash Value Life insurance?

Frozen cash value life insurance (“FCV”) is best known as a flexible premium variable adjustable (universal) life insurance policy that is issued by offshore life insurance companies domiciled in tax-haven jurisdictions such as Bermuda or the Cayman Islands. Recently, a new specialty life insurer has emerged in Puerto Rico that offers both traditional PPLI as well as FCV policies.

The policy is intentionally designed to violate IRC Sec 7702, the Internal Revenue Code tax law definition of life insurance. The other legal considerations are imposed under the insurance laws of the jurisdiction where the coverage is issued. Generally speaking, all of the carriers issue the coverage as variable life insurance.

In the beginning FCV policies were only issued by life insurers that had not made the election under IRC Sec 953(d) to be treated as a U.S. taxpayer. This election is important since the life insurer’s separate account is treated as a non-resident alien for income tax purposes. Without the election, certain categories of investment income would be subject to withholding taxation under IRC Sec 871(a) at a 30 percent rate. Recently, several life insurers have started issuing FCV policies in their IRC Sec 953(d) electing companies.

Under most FCV contracts, the death benefit is equal to the sum of guaranteed specified amount of death benefit plus the cash value on the claim date plus the policy’s mortality reserve value on the claim date. This amount is essentially the cumulative premiums plus or minus investment experience along with a death benefit corridor which most carriers express as a fixed percentage between 102.5% – 110%. A Puerto Rican life insurer referenced above issues policies with a fixed amount of coverage – $1 million above the initial premium and mortality reserve. In my view, no solid legal authority exists to support a minimum level of death benefit corridor.

The cash value under most FCV policies is defined as the fair market value of all assets constituting the policy fund, less any policy loans and less any accrued unpaid fees or expenses due under the terms of the policy.  The “Cash Surrender Value” of the of the Policy is the lesser of (a) the cash value or (b) the sum of all premiums paid under the Policy, computed without regard to, any surrender charges, and policy loans, under the terms of the Policy.

The cash value increases or decreases depending upon the investment experience of the policy fund.  FCV policies do not provide for or guarantee any minimum cash value.  The insurer holds the appreciation of the assets (in excess of the amount of cumulative premiums) held in the separate account as a mortality reserve within the insurer’s separate account solely for the purposes of funding the payment of the death benefit payable under the FCV policy.

Under most FCV contracts, the policyholder may take a tax-free partial surrender of the policy cash value up to the amount of cumulative premiums within the policy. The policyholder may also take a policy loan up to 90 percent of the policy’s cumulative premiums. The policy loan terms will vary from company-to-company. The significance of a partial surrender versus a policy loan is that the partial surrender will not leave the policy with a liability. The surrender and loan proceeds are tax-free under any circumstance and provide the policyholder with access to policy assets on a tax-free basis.

The tax authority for FCV policies is very straight-forward. Several large national law firms have opined favorably on this type of policy. The legal analysis is straight-forward in IRC Sec 7702(g). The policyholder is taxed on any inside build up of the cash value and mortality charges except that the policy be definiton does not provide for any inside build up.. The mortality corridor is also very small. IRC Sec 7702(g) states that a tax-defective policy still receives income tax-free treatment for the death benefit under IRC Sec 101(a).

III. Overview of Planning Scenarios

A.  Use in the High Net Worth Marketplace

One way to look at the FCV policy is that it effectively is like a variable deferred annuity only with better taxation for the taxpayer. Similarly, it is like a Modified Endowment Contract (MEC) without being subject to the MEC rules.

FCV policies are extremely efficient for accumulating wealth with a minimal cost “drag” due to the policy’s low mortality cost for the net amount at risk in the policy. Whether a carrier has a fixed percentage corridor of 105-110 percent or a fixed amount corridor of $1 million, the FCV policy is very efficient for wealth accumulation purposes. The death benefit ultimately delivers the investment accumulation in excess of the initial premium on a tax-free basis. The policyholder is able to take withdrawals or  loans from the FCV policy on a tax-free basis in amount equal to 90 percent of his cumulative premiums in case the taxpayer needs to access his investment.

The policy is well suited for taxpayers whose single premium would exceed the available reinsurance capacity for an insured. This amount is believed to be approximately $65 million on a world wide basis. The tax -free death benefit is a much stronger result that the taxation of a deferred annuity at death.

A future blog post will discuss how FCV policies can be combined with inter-generational split dollar to accomplish substantial and income and estate tax savings. All tax proposals under discussion look to limit the minium term of years for grantor retained annuity trust and possible  sales to intentionally defective grantor trusts.

(2)     Use in the Corporate and Bank Owned Life insurance Marketplace

To the best of my knowledge, FCV policies have not been used in the COLI and BOLI markets. Generally, large corportations use life insurance as a cost recovery mechanism to reimburse the corporation for its obligations under non qualified deferred compensation programs. Banks use life insurance to boost the investment return on Tier I capital. FCV policies because of its reduced requirements for mortality coverage can enhace the internal rate of return within the policy an additional 30-50 basis points. The tax compounding of this effect of 20-30 years is very substantial and worth considering.

Additionally, these companies insure a large number of employees who may or may not be employed by the corporation at the time of death. IRC Sec 101(j) was added to the Code in 2006. The provision taxes the net amount at risk as income to the corporation. Several key exceptions apply if the insured is employed within 12 months of the employee’s death or alternatively, if the employee is among the highest 35 percent of employees, or is a highly comepensated employee as defined under the pension rules. Frozen cash value can minimize the amount of taxation at the death of the employee as a result of the lower face amount.

IV Summary

FCV policies are a niche product that have much wider planning application than is currently being utilized. When you consider that the retail variable annuity market is a two trillion market, it would seem that FCV pprovides for a much better planning result for high net worth taxpayers. Future blog posts will illustrate how this product can be used in tax planning.

About gerrynowotny

I am a tax and estate planning attorney with a JD and LL.M in estate planning from the Univesity of Miami School of Law. I have worked in the life insurance industry for twenty three years and the last eleven in private placement life insurance.
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