Hiding in Plain Sight
IRC Code Section 1.817.5
– More Than Diversification Requirements
Some question the authority of placing real property, partnership interests, commodities, mineral, oil, gas royalty interests, and debt instruments into a private placement life insurance or annuity contract. Where is this authority? For a U.S. compliant policy, it is in the same place that gives us the diversification requirements for these contracts, none other than 1.817.5 of the internal revenue code. The above list of assets comes from the definition section of this very code section.
This code section goes to some length in defining these terms. For U.S. domestic PPLI and PPVA policies issued by a domestic U.S. company, placing the asset classes above into policies runs afoul with non-forfeiture rules, but for international life insurance companies using a 953(d) election, there is clearly no barrier to placing these assets into a policy.
GAC Structures Are Huge
Group private placement variable deferred annuity (GAC) contracts are a prime example of how these diverse asset classes are used. Over the last twenty years or so, at least $50 billion of investment transactions have been made through GAC by insurers such as The Principal, Prudential, John Hancock, Met Life and others.
These assets have been structured in GAC transactions: timer, oil and gas, coal, natural gas, hotel and resort, development real estate projects, agriculture, residential real estate, private equity and venture capital, and mezzanine debt.
The institutional investor such as a pension plan, endowment, foundation or sovereign investor that purchases a private placement variable annuity purchases a group version of the product. This version features a class of annuitants and generally unallocated accounts. The institutional investor is the applicant, owner, and beneficiary of the group annuity contract. The policy features a group of annuitants (measuring lives) such as the officers and directors of a foundation.
A GAC Transforms UBTI
Why do tax-exempt public and private pension plans, endowments and foundations enter into these GAC transactions? All these entities are subject to Unrelated Business Taxable Income (UBTI). Under IRC Section 512(a) annuity income is exempt from UBTI. The annuity contract converts the character of the income for tax purposes from what would have been taxable income into tax-exempt income.
The treasury regulations support these types of investments allowing for a period of time to meet the diversification requirements of IRC 817(h). For non-real estate accounts, the regulations provide for a one-year period to meet the diversification requirements. Real estate accounts provide for a five-year period and a two-year liquidation period. Furthermore, the diversification regulations provide that an account that was diversified will remain diversified but for appreciation or depreciation in a particular holding within the fund.
The tax-exempt organization is the applicant, owner, and beneficiary of the GAC. The primary annuitants have no legal interest in the GAC or its benefits. The primary annuitants are strictly measuring lives in the event an annuity payment must be made in the event of a death of a primary annuitant.
The investor pays a premium to the specialty life insurer issuing the GAC. For legal purposes, the life insurer is treated as the owner of the investment assets. The investment performance flows through policy for the benefit of the policyholder. The institutional investor that is an endowment, pension plan, or foundation would list the GAC as the investment asset on its balance sheet rather than the underlying investments.
Foreign institutional investors also use GACs to recharacterize UBTI income, and also achieve the same result for income that is effectively connected income to a U.S. trade or business (ECI).
The average U.S. domestic PPLI/PPVA investment offerings are frequently a list of uninteresting mutual funds that have been recharacterized as IDFs.
Why not take advantage of what the internal revenue code lawfully sanctions, and open your investment choices to what GAC providers offer their investors? A EWP Financial we will be glad to assist you in opening up these vast asset structuring possibilities.
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