Given the recent attention in the media on investing in hedge funds without paying taxes on current income, it seems well timed to revisit the basic elements of insurance dedicated funds for the sake of the fund manager that might be interested in adding such a product to their platform in order to attract new capital for their firm or to retain existing capital that a manager might otherwise lose due to tax inefficiencies in its investment strategy.
Insurance dedicated funds (or “IDFs”) are named in this fashion because, as a general rule, they are only open for direct investment by insurance carriers (or funds-of-funds only open to insurance carriers). Individuals are only able to invest in the IDFs through private placement life insurance (“PPLI”) or variable annuity (“PPVA”) policies they purchase from insurance carriers.
Although IDFs are usually structured as standard investment vehicle limited partnerships, typically organized in Delaware, there are certain key substantive requirements for these funds.
One of the primary substantive requirements for an IDF is that the IDF’s investments be diversified in accordance with Treasury Regulation § 1.817-5(b). In short, this means that the IDF must have at least 5 investments measured at every calendar quarter and any combination of up to four of such IDF’s investments must be apportioned in line with the tax regulations. Of note, is that other hedge funds (including those managed by the IDF manager) could count as a distinct investment for the IDF to meet diversification. In addition, diversification is measured on a gross long basis such that leverage can be utilized to meet diversification.
Another principal substantive requirement for IDFs is that the hedge fund manager must at all times comply with the “investor control” doctrine. “Investor control” is a doctrine espoused by the IRS (and validated in a fairly recent Tax Court opinion) that states that in circumstances where enough incidents of control exist (such as the ability to exercise control over the purchase or sale of underlying assets), an insurance policy owner will be treated as the owner of the assets of an account supporting the insurance policy, which, in this context, means the IDF. If a policy owner is considered the owner of the IDF’s assets, then such owner could be presently taxed on the income and gains from the IDF, and the policy owner may be liable for interest and penalties on back taxes. As one might suspect when contending with a doctrine that has not been codified, “investor control” can get complicated and must be analyzed early and carefully by any manager considering an IDF.
The final key substantive requirement for an IDF is that incentive compensation must be structured as a fee, rather than an allocation, in order for an insurance carrier to be able to look through an IDF for diversification purposes under the applicable tax regulations.
The above is just the ABCs of IDFs. In practice, setting up such an investment product requires specialized experience, especially in devising IDF compliance policies and procedures and negotiating with the insurance carriers regarding the IDF terms that relate to diversification, investor control and other variable insurance industry characteristics that can impact the terms of an IDF (e.g., special liquidity for death benefits).
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Kleinberg Kaplan has been a leader and innovator in IDFs since their inception over 30 years ago. We have extensive experience negotiating and working with all key market participants in the IDF market place. Due to our experience and focus on this space, we have a highly sophisticated understanding of the legal and regulatory issues that apply to IDFs and have developed innovative solutions for our clients on all these issues. We would be happy to provide our expertise and counsel to any managers interested in entering the IDF market. We also have significant experience with investors purchasing PPLI and PPVA.
Maurice Collada will be attending the Private Placement Life Insurance Variable Annuities Event in Chicago on June 13-14 (which is the primary annual IDF conference). He would be glad to meet with anyone attending the conference to discuss IDFs in person.
For more information about IDFs, PPLI and PPVA, you may also be interested in past content we have generated or contributed to on the topics. You may click the following links to jump directly to such materials.
• Tax Court Case Uses “Investor Control” Doctrine to Tax Inside Build-up of Private Placement Life Insurance (July 2015)
• Insurance Dedicated Funds Offer Hedge Fund Exposure Plus Tax, Underwriting and Asset Protection Advantages for Investors (July 2013) (subscription required)
• Recent Developments Could Increase the Attractiveness of Hedge Fund Life Insurance And Annuities (Fourth Quarter 2006)
• PPLI Invested In Hedge Funds (May 2006)
• Tax Management-Building Wealth, Reducing Taxes (February 2005)