Carried interest and life insurance. These are generally two topics that are not discussed together but should be.
Why?
Using carried interest to fund life insurance can be a powerful technique that allows the purchase to occur tax efficiently and help in overall financial planning.
Before we show how all of this can work, what is carried interest?
Carried interest is a performance-based incentive commonly used in private equity, by hedge funds, and by some family offices to reward investment performance. By aligning the interest of fund managers and investors, it serves as a formidable motivator. Carried interest can sometimes be referred to as profit interests or carry. As an added bonus, carried interest is generally taxed at capital gains tax rates rather than at higher ordinary income tax rates.
Let’s take a look at four ways carried interest and life insurance can work together to help further planning goals.
The Basic Approach
First up, the simplest way to use carried interest and life insurance. The lower tax rate on carried interest leaves fund managers with more after-tax income. As a result, they can allocate a portion of carried interest to purchase a cash value life insurance policy. This strategic use of carried interest allows the manager to fund life insurance without depleting personal funds or affecting other financial goals.
For a bit of history, this was how private placement life insurance (“PPLI”) came to exist in the 1980’s when successful investment managers sought to reinvest their carried interest compensation. If a manager is earning enough carry, PPLI might be the right choice of policy to use in this situation (though cash accumulate based life insurance policies are also common policy choices).
For managers, having a cash value life insurance policy can provide the following benefits:
Tax-deferral: The cash value growth within a policy is tax-deferred, meaning that fund managers can let their carried interest income accumulate over time without immediate tax obligations.
Estate Planning: Life insurance can be instrumental in ensuring a smooth and tax-efficient transfer of assets to beneficiaries, minimizing potential estate taxes, and avoiding the need to liquidate valuable holdings.
Liquidity and Collateral: The cash value component of a permanent life insurance policy can provide a source of liquidity, which can be used for various purposes, including meeting financial obligations or leverage as collateral for loans.
Asset Diversification: With life insurance being more broadly recognized as an asset class with a high probability of a stable return, the policy can help balance a manager’s policy by providing a counterweight to more aggressive portfolio allocations.
The Second Approach: Act Like a Football Coach
If a manager does not have a need for the carried interest to be paid out in cash, they can take a page from the playbook of top football coaches and executives and get paid in life insurance. This is accomplished with a split dollar arrangement.
Split dollar arrangements allow a company and an employee to split the costs and benefits of a cash value life insurance policy. Either the company pays for and owns the policy and agrees to share the benefits with the employee (an economic benefit split dollar arrangement) or the company loans the manager the money to pay the premiums on the policy annually (a loan regime arrangement).
In this scenario, rather than distribute the carried interest to the manager, the management company retains that amount, pays applicable taxes, and then uses a portion of the after-tax amount to fund the split dollar policy. Depending on the terms of the split dollar agreement, the management company can use this structure as a retention tool for its managers.
For the manager, they do not have to pay the taxes they otherwise would have if they had received the carried payment interest in cash. While there are annual, minor tax implications to the manager based on the split dollar arrangement, this strategy would allow for a tax-efficient purchase of a life insurance policy.
Like any cash value life insurance policy, the manager can now access the policy tax-free through partial withdrawals and loans and their estate will be able to receive a tax-free death benefit.
The Third Approach: The Early Bird Gets the Worm
If a fund manager, or other recipient of carried interest or profits interest, has some foresight, they can implement a plan that is a more effective version of the first scenario.
When the carried interest is first granted to the fund manager (before any compensation is paid out), the value of that carried interest is likely zero of close thereto. With the basis at or near zero, the manager can therefore gift the carried interest into a trust and not worry about gifting limits or exemptions to those limits.
When the carried interest does result in cash payments, that money is in the trust and the trust can use all or some of that cash to purchase a life insurance policy on the life of the manager. This has the benefit of taking the policy out of the manager’s estate.
The Fourth Approach: A Case Study with Profit Interests, Split Dollar, and a Family Office!
Let’s now examine a real life Robin Glen case study that takes these concepts to the next level and applies them to a family office for generational wealth transfer purposes.
The family in question had completed a great deal of estate planning and G1 had already gifted and sold a large portion of their assets to dynastic trusts for the benefit of G3 (skipping G2). This left G2 with some annual disbursements from a trust, but little else in terms of wealth transfer.
Both members of G1 still had a significant amount of assets remaining after their initial planning. But through that planning, G1 had used their entire lifetime gifting exemption and still faced challenges transferring wealth to G2 without taking a tax hit in the process.
The family established a for-profit family office that is set up as a C-corporation. Members of G2 had employment or ownership ties to the family office, either working for the management company or serving on its Board of Directors. This presented an opportunity to effectuate a transfer in a tax efficient manner.
In exchange for managing the family’s investments, the family office receives a profit interest. The family office management company retains these earnings and, as a C-corporation, pays a 21% tax on that amount. The management company can then use the after-tax cash to fund a split dollar arrangement with the members of G2 in order to purchase cash value life insurance policies. Via this arrangement, the transfer G1 wanted to G2 takes place.
As in the prior scenario, the members of G2 can now access the cash value of the policy for income via withdrawals and loans during their lifetime. G3, already the beneficiary of the prior planning, will now have the added benefit of receiving the death benefit from these policies tax-free at the death of G2.
A further benefit of this structure is it will slow the growth of the estates of G1, meaning at death they will have a smaller estate subject to transfer taxes.
Carried Interest and Life Insurance Should Be Friends
Once one recognizes the utility of life insurance beyond simply providing money to loved ones at death, the planning possibilities are compelling. Those possibilities might not always be obvious, which is where a planning firm like Robin Glen can add tremendous value.
At Robin Glen, we use our expertise in income and estate tax, private capital, and insurance analysis and design to create unique solutions that deliver impactful results for our clients and advisor partners.
If you are a financial professional who receives compensation in the form of carried interest or profit interest, or a family office looking for ways to effectuate efficient wealth transfers, call us. We can help.