Gimme (tax) shelter: The unlimited annuity shielding ultrawealthy clients

The tax benefits of private placement variable annuities for wealthy clients are drawing scrutiny and calls for a federal crackdown — but they're not going away anytime soon.

Deferral or the outright avoidance of taxes on income, capital gains and estates has drawn billions of dollars to private placement life insurance and annuities. The growth of the life insurance product — a similar but more complicated strategy with higher potential savings for clients — amounts to contracts totaling nearly $40 billion in policy value, according to an investigation earlier this year by Democrats on the Senate Finance Committee

Depending on the outcome of this year's election, those products and other "buy, borrow, die" tax planning methods for ultrawealthy taxpayers may face a serious threat to their existence as part of the looming policy debate around the potential sunsetting of many provisions of the Tax Cuts and Jobs Act of 2017 at the end of next year. For now, proposals by Sen. Ron Wyden of Oregon and in the Biden administration's Treasury Department funding request to Congress carry no impact beyond their pointed criticism of private placement annuities and life insurance.

"Anything being produced like that is something to be taken seriously," Sam Petrucci, the head of advice, planning and fiduciary services for New York-based Neuberger Berman Private Wealth, said in an interview about the February report and principles released by Wyden, the committee's chairman. "As the laws are currently written, a wealthy person can take advantage of these laws."

READ MORE: Senate probes $40B tax shelter in private placement life insurance

The annuities work like a "supercharged IRA" for wealthy clients — with some cautions and caveats, Petrucci noted. Financial advisors, tax professionals and their clients should remember that they would need to wait to take any withdrawals from a private placement variable annuity until they're at least 59 ½ years old. They also need to ensure that the savings and duty-free investment gains accumulate for at least a decade or more to reap the advantages of the underlying cost of the annuity. 

In the meantime, they can avoid the headache of K-1 filings that often necessitate extensions past Tax Day while booking investment returns that compound tax free. Clients won't get hit by charges from Uncle Sam until they take a withdrawal from the annuity — although they won't be required to take assets out until they reach 95 years old.

That's why they're "something that is being utilized more and more by wealthy taxpayers," Petrucci said. The other strategy, private placement life insurance, comes with "more complexity and cost," he noted.

Petrucci explained the appeal of private placement variable annuities by comparing the limitless contributions to the maximum allowed in IRAs and using an example of a taxable investment that yielded 10% in a year for a client in the wealthiest bracket. If that client lives in a high-tax city and state like New York, the short-term capital gains rate and other duties would leave the customer with about 4.6% of those returns, he said. In a private placement variable annuity, the client can net the 10% return without paying any taxes and let those yields stay in the account to keep building for the long term.

"The problem with your retirement plans is you can only own so much in those respective plans," Petrucci said. "By [using a private placement variable annuity], you're able to increase your return by a substantial amount. This is something that we see great interest in, from an income-tax planning perspective."

READ MORE: How a life insurance strategy could save some wealthy estates millions

Annuity and life insurance planning ideas have emerged in recent years as a popular possible workaround to plans for taxing the wealthiest households. Seven of the largest private placement insurance providers were carrying more than 3,000 policies in force at the end of 2022 with $9.5 billion in assets under administration and a combined value of $39.7 billion, according to the Senate Finance Committee's report. One of those companies told the committee staff that its average client typically had income above $7 million and an average net worth above $100 million. 

While Wyden described private placement life insurance in a statement as "just a tax shelter for the investments of the mega-rich masquerading as life insurance," the committee's report specifically called out annuities as well in a list of seven principles it said will guide future bills. In addition, the committee vowed to design legislation targeting not only new products after its enactment but the existing policies and contracts already in place, too.

"Legislation must address both private placement life insurance and private placement annuity contracts to prevent high net-worth individuals from merely shifting assets from a private placement life insurance policy to a private placement annuity contract," the report said. "The tax preferences for private placement annuities may not be as lucrative as PPLI but they are still very attractive. Legislation must provide that PPLI and certain annuity contracts will not be treated as life insurance or annuity contracts under federal tax laws, with the resulting effect being that all earnings of the contract will be taxed currently instead of accumulating tax-free."

In its proposal on pages 157-162 of the Treasury Department's 2025 budget request to Congress, President Joe Biden's administration asked for an effective date at the beginning of that year. The life insurance contracts usually carry required annual premiums of at least $1 million for several years, and most policyholders are "very high net worth individuals" or businesses that have a net worth of $20 million or more and at least $10 million in liquid assets, according to the document. 

"PPLI and PPA [private placement annuity] contracts allow very affluent purchasers to select from an array of investment options that are not accessible generally to purchasers of registered policies," it said. "For example, PPLI and PPA separate accounts may be invested in unregistered hedge funds and private equity funds or in more exclusive portfolios closely tailored to the investment preferences of private placement policyholders (possibly including real estate and other assets deemed attractive to the specific investor). PPLI contracts are highly investment-oriented policies, provide legally minimal life insurance protection relative to the amounts invested, and are available only to the wealthiest taxpayers to whom income tax and/or estate tax benefits are far more important than the provision of insurance for their heirs."

Treasury's proposal would slash the tax advantages by defining contracts "that are predominantly investment oriented and denying these contracts most of the tax benefits that are generally granted to life insurance and annuity contracts."

READ MORE: The 'Buy, Borrow, Die' tax strategy: A new twist on death and taxes

The Biden administration's idea would likely garner legal challenges that could prove successful in blocking it on equal-protection grounds, according to an attorney who spoke with the publication Tax Notes about the proposal. Another legal expert who spoke with the tax news outlet, Luís Carlos Calderón Gómez of Yeshiva University's Benjamin N. Cardozo School of Law, told the publication that the Treasury proposal would target "the cases where we're really worried there is some abuse going on." The IRS would need leeway to stem the flow into other routes around paying taxes, Calderón Gómez said. 

"Giving a bit of flexibility to the IRS in the statute is important here, because we've seen that these are highly sophisticated taxpayers who have been able to deftly structure and adapt these transactions," he said.

Absent those changes, the private placement variable annuities remain available to advisors and their clients under the existing laws, which allow for removing the assets from a customer's taxable income forever by donating them, Petrucci noted.

"They can also be an effective planning tool if you leave your PPVA structure to charity," he said. "Ultimately, if you leave it to charity, it's entirely tax free."

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Tax Practice and client management Politics and policy Investment strategies Portfolio strategies Annuities Estate planning
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