Cash value life insurance in captives — Why it makes too much sense
By Roccy Defrancesco
The Wealth Preservation Institute
I’ve been reading quite a few industry blogs and articles lately about cash value life insurance (CVL) and its use inside captive insurance companies (CICs).
There are some who not only think it’s a bad idea, but state emphatically that CVL should never be used as an investment inside a CIC. I was so put off by what I’ve been reading that I was moved to write this article giving my opinion on why the so-called experts are wrong.
CICs are powerful risk mitigation and income tax planning tools
If you are not familiar with the power of using CICs for risk mitigation and income tax reduction for business owners, you should learn about them. Businesses can take deductions up to $1.2 million into small 831(b) CICs. For those who can only pay a premium of $100,000, they can use the “affordable” CIC.
What have the “experts” been saying about using life insurance in a CIC?
In short, they have been saying that under no circumstance should cash value life be used in a CIC. When I say used in a CIC, I mean used as an investment to protect and grow the cash reserves of the CIC.
Why are they saying CVL shouldn’t be used? Well, my initial response is because they are ignorant “experts” (if there is such a thing), but that’s an opinion and not a reason.
Their reasons all seem to stem from the abusive-tax transaction doctrines. What are those? The most common ones are:
1) substance over form;
2) sham transaction;
3) business purpose;
4) economic substance doctrine;
5) and step transactions.
In short, the abusive-tax doctrines have motivations of the client as their baseline that have nothing to do with the tool used to accomplish the ultimate goal of the client. With 419 and 412 plans, the goal is traditionally income tax reduction and buying life insurance using tax-deductible dollars.
This makes some sense. If you ask a client why they implemented a 419, 412, or many times, a CIC, their answer is to save taxes. If that’s the case, then there might be an argument the IRS can make based on one or more of the above-listed doctrines. But that’s not an argument based on a motivation to buy life insurance inside the CIC. What does this have to do with cash value life insurance in a CIC?
That’s a good question. The “experts” are not suggesting that the CIC itself is an abusive-tax sham; what they are suggesting is that the CIC is being used as a tool to buy CVL in a “tax-deductible” manner. As such, there is a form-over-substance issue or the transaction is a sham. Then they point to 419 and 412 plans and make an analogy as to why CICs that use CVL in the reserves should suffer the same fate.
When you understand what happened to 419 and 412 plans, and when you understand the abusive-tax doctrines, you’ll come to the same conclusion that I’ve come to, which is that the “experts” are clueless when they conclude and assert that any CIC that uses CVL is abusive.
Prudent investor rule (PIR)
The PIR is a legal doctrine which provides guidance to investment managers regarding the standards for managing an investment portfolio in a legally satisfactory manner.
Basically, prudent investing amounts to a process which one follows. If the process followed in making investment decisions is prudent (based on what is known and not known at that time), then the decisions being made are prudent, regardless of subsequent results.
A CIC is a real live insurance company. As such, the reserves of the CIC that accumulate need to be invested in conservative investments so that the money will be around in the event claims are filed. If we apply the prudent-investor standard to investing CIC reserves, it would not be prudent to invest the reserves in mutual funds, penny stocks, options, etc. To do so is too risky.
What about cash value life insurance?
Is it prudent to invest in a CVL policy where the cash won't go backwards when the market goes negative? When, over time, the expected rate of return should be significantly higher than fixed-return vehicles like CDs and money markets?
You don’t need an IQ above 50 to determine that any investment that can’t go backwards when the market declines and should do better than CDs and money market accounts would make for a prudent investment in a CIC. (And if you're thinking that CVL is still not prudent because of early high surrender charges, keep in mind that there are many policies with high cash value riders to make this point a non-issue).
So why are some saying that CVL should never be used as an investment in a CIC?
Again, to me, it’s ignorance run amok. But aside from that blanket statement, I believe it’s a misunderstanding of the tax-abuse doctrines.
This is clearly a complicated issue. I've written a longer version of this piece, which can be found here.