H.R. 133, signed into law on Dec. 27, 2020, included a significant change to the interest rate assumptions underlying Internal Revenue Code Section 7702. These interest rates are a fundamental part of the calculus for a contract to qualify as a life insurance policy for income tax purposes. While these changes were appropriate given the low interest rate environment, the effect will be to increase the amount of premium that can be deposited into a life insurance policy for a given amount of mortality risk. As a result, private placement life insurance (PPLI) should be more attractive to high net worth and ultra-high net worth clients. Given the potential for tax rate increases, the attractive nature of PPLI will likely only increase in coming years.
Why the Change?
Section 7702 defines a life insurance contract for federal income tax purposes. The consequences of satisfying the definition of a “life insurance policy” are threefold: investment returns are not subject to current taxation, the policy owner can take out distributions tax-free within certain defined limits and the death benefit is not subject to income tax. Under Section 7702, a policy will be treated as a “life insurance contract” for income tax purposes if it satisfies either the cash value accumulation test (CVAT) under Section 7702(b) or the guideline premium test and cash value corridor test (GPT) under Section 7702(c). Both the CVAT and GPT are based on the same principal: simplistically, the maximum amount of premium or the maximum amount of cash value cannot exceed the amount of a single premium required for the stated face amount at maturity assuming the life insurance company delivers only the performance that is guaranteed under the policy contract.
The issue was that Section 7702 contained set interest rate assumptions for making this calculation: 4% for the CVAT and 6% for the GPT. Life insurers had to match these rates in their assumptions or risk violating Section 7702 after the premium payment period and for paid-up additions. The new law relaxes these assumptions. The assumed rate for 2021 is 2% for guideline level premiums and 4% for guideline single premiums; in future years the rates will be floating based on specific indices.
PPLI policies are generally designed to optimize the use of a life insurance policy as a tax-shielded investment account within the statutory safe harbor of Section 7702. PPLI policies are designed to maximize the amount of deposits that can grow tax-free or tax-deferred (in the case of a private placement annuity).
For high net worth individuals and ultra-high net worth individuals, the amount that can be deposited into the policies is typically limited by the face amount of policies that can be obtained. With lower interest rate assumptions, the amount of deposits can be increased for the same available amount of insurance, making the use of PPLI even more attractive.
The change to Section 7702 is a positive development for all types of permanent life insurance. Moreoever, if income tax rates increase — whether on ordinary income, capital gains, or both — Private Placement Life Insurance will become even more attractive as the benefit of the tax deferral or tax elimination will be magnified. High net worth and ultra-high net worth individuals who have considered PPLI in the past will likely be motivated to implement PPLI as part of their income and estate tax plan, further driving the demand for permanent life insurance.
This article is a brief synopsis of a longer article that is appearing in Trusts and Estates Magazine, co-authored by Michael Liebeskind.