Did you know this about Asset Structuring? – Part 2 – 7702(g)

7702(g)–The Battleground of FCV Policies

Who Comes Out on Top?

Three mighty camps all claim the correct interpretation of IRC code section, 7702(g). I shall refer to them as the Middle-earthers, MEs for short, holding the middle ground, as well as the Snapers, the most rejecting camp, and the Envelope Pushers, the most permissive of them all. We shall pit them against each other and see where we come out. Full of suspense? Indeed. Read to the end, and see for yourself.

IRC code section 7702(g) vastly enhances the potential of a Private Placement Life Insurance (PPLI). Through its lens, it becomes much more an asset structuring tool than an insurance policy per se. This is demonstrated clearly by the use of the Frozen Cash Value (FCV) design in combination with assets of significant size, $50M and up. This is where the asset structuring techniques mirror those of a private foundation, but have greater flexibility and less administrative burdens.

Great potential, what we all like. However, code 7702(g) is not interpreted uniformly by advisors, indeed, there is a wide range of opinions on how to interpret it.

I will divide these interpretations into three camps:

  • Those who consider the use of 7702(g) to support FCV policies as a complete aberration of the original intent of this code section. I call them the Snapers after the character of Severus Snape in J. K. Rowling’s Harry Potter. Snape was ready to sanction Harry at every turn;
  • Those who embrace the idea that 7702(g) fully supports the FCV policy design, are dubbed the Middle-earthers, or MEs for short. I borrowed this term from J. R. R. Tolkien. Both The Hobbit and The Lord of the Rings take place on Middle-earth;
  • The last camp opines that the MEs are not taking full use of 7702(g), and much more is possible with FCV policy designs. I call these advisors the Envelope Pushers, as in the phrase push the envelope.

Snapers Speak

The Snapers argument is simple: the creation of the FCV policy is a fiction; it is cooking the books. Snapers declare that life insurance companies have reverse engineered 7702(g) to create a policy design that can’t possibly exist with the enactment of IRC code section 7702 in 1984 and state that it is just a false creation of the international insurance market.

7702 was a big game changer in defining life insurance. It established the first comprehensive federal tax definition of a life insurance contract. Before this time there was not a clear cut definition of life insurance in the internal revenue code, especially on the relationship of the cash value to the death benefit. Indeed, before this time it was possible to construct a policy with a very low death benefit, and a large cash value.

7702 uses two tests, the guideline premium test (GPT), and the cash value accumulation test (CVAT) to determine the relationship between the cash value and the death benefit. If a policy fails either of these two tests, it comes under the guidance of 7702(g).

From 7702(g), “If at any time any contract which is a life insurance contract under the applicable law does not meet the definition of life insurance contract under subsection (a), the income on the contract for any taxable year of the policyholder shall be treated as ordinary income received or accrued by the policyholder during the year.”

In other words, if contracts fail either the GPT or CVAT tests, they are going to receive a very unfavorable tax result that is far from the original intent of a life insurance policy which gives the policyholder tax-deferral and not the taxable ordinary income result from 7702(g).

MEs to the Rescue

We return to the name, Frozen Cash Value, as the key point in the MEs camp. The section quoted above from 7702(g), speaks about “the income on the contract.” What if there was no income, yes, you guessed it–what if it was frozen.

The design of a FCV policy is such that all “income on the contract” is paid out as part of the death benefit when the insured live(s) pass away.

By contractually binding the policyholder to only withdrawing from the policy the premiums paid, and not any investment gain in the contract, the MEs have eliminated “income on the contract.” Of course, not in the eyes of the Snapers, who would comment, “This is a mere deceit. Of course, there is ‘income on the contract.’ You are just postponing it to be paid as part of the death benefit.”

What about the tax-free nature of the death benefit?

7702(g) apply supplies the correct answer for the MEs. “If any contract which is a life insurance contract under the applicable law does not meet the definition of life insurance contract under subsection (a), the excess of the amount paid by the reason of the death of the insured over the net surrender value of the counteract shall be deemed to be paid under a life insurance contract for purposes of section 101 and subtitle B.”

In other words, the investment gain in the policy that is paid out as part of the death benefit, the frozen part, is in this section sanctioned to be part of the death benefit, and in doing so, the contract is still considered a valid life insurance policy.

Code section 101 addresses the payment of death benefits under life insurance contracts, and gives a broad definition of what constitutes a death benefit. Subtitle B addresses the payment of death benefits in relation to estate taxes.

FCV policies also solved another issue for wealthy families. The current reinsurance market can’t support a large enough death benefit on an individual life to place large amounts of cash value into policies. Most FCV policies are issued with a death benefit that is between one and five percent above the cash value of the policy.

Since a FCV policy is mainly an asset structuring tool, and very wealthy families are not in need of a large death benefit, this relatively small death benefit in relation to the cash value fits well into the overall design of the structure.

The Envelope Pushers Turn

The Envelope Pushers come in several varieties. Some simply say that code section 7702(g) should be read without reference to any other code section, so the diversification requirements of section 817(h) and the investor control doctrine are not applicable, so they don’t apply to a FCV policy. I call this Position One.

Position Two is for families with very significant assets, and is an escape hatch away from all these issues. They simply form their own insurance company that will issue a FCV policy design that is not a variable contract. Since section 817(h) and the investor control doctrine only apply to variable contracts, they are out of the picture.

The family can then manage their own assets without any restrictions from the investor control doctrine, and they don’t even have to consider diversifying their assets under 817(h).

Since Position Two is a rarified solution only available to a few select families, I will concentrate on exploring Position One.

In articles on 7702(g) it is sometimes referred to as a remediation procedure for addressing life insurance contracts that fail to satisfy the requirements of 7702, the GPT and CVAT tests. The Snapers might add, “Yes, and hence the MEs and Envelope Pushers are just reading between the lines for their own self interest.”

So if 7702(g) is telling us how to handle a failed life insurance contract, is the sum total of this section our only guidance, and there should be no reference to any other code section?

Again, 7702(g) might be giving us guidance in the direction of Position One in its last section: “If any contract which is a life insurance contract under the applicable law does not meet the definition of life insurance contract under subsection (a), such contract shall, notwithstanding such failure, be treated as an insurance contract for the purposes of this title.”

What kind of insurance contract is it then? An insurance contract that has lost its status as a variable contract, so it is no longer subject to the investor control doctrine or diversification requirements under 817(h)? This is the thinking of Position One.

I have compiled my tale of the Snapers, the MEs, and the Envelope Pushers from many conversations and articles on the subject. If one enjoys exploring tax codes–some would say this is an oxymoron– this enjoyment is in part formed by seeing how these dry bits of prose are interpreted over time.

For example, when GRATs were first introduced at the famed Heckerling institute long ago, many commented that they would never work. Now they are a staple of estate planning.

What will be the outcome of this battle over 7702(g)? The suspense continues… My interest in this battle is not in the outcome, but in the many skirmishes along the way. In structuring our FCV policies at EWP Financial, we are mindful of all interpretations of 7702(g), and create an asset structure that works for both the families and the tax authorities involved.

Contact Us for any questions you may have.


by Michael Malloy, CLU TEP RFC.
CEO, Founder @EWP Financial

~ Your best source for PPLI and EWP

Michael Malloy-CLU-TEP







Leave a Comment

Your email address will not be published. Required fields are marked *

Translate »
Scroll to Top