Editor's CommentaryFrom the monthly column: Blackman on Taxes
Small business owners (SBOs) have many legitimate complaints these days: taxes, regulations, competition, difficulty finding good people, etc. Add to that list the same question asked by millions of Americans: “Where do I invest my money?”
Almost all successful SBOs accumulate excess cash not needed in their businesses, and, naturally, they invest these funds. Many have abandoned the stock market and have turned to investing in CDs, tax-free bonds, U.S. Treasury notes or similar so-called “safe” investments, but these offer paltry rates of return, often lower than annual inflation percentages. Sadly, these investors’ wealth erodes.
Is there an alternative to Wall Street risks and low-yielding “safe” investments? Yes: life settlements (LS).
What is a Life Settlement?
An LS is simply an existing life insurance policy purchased by a third-party investor. The seller, typically a senior who no longer wants to pay premiums, gets more for the policy than the cash surrender value (CSV) he would get from the insurance company, and the investor eventually makes a large profit without risk.
For example, Joe is 79 years old and owns a life insurance policy with a $500,000 death benefit and an $80,000 CSV. Joe can cancel the policy and get the $80,000 CSV from the insurance company, or an investor or group of investors can buy his policy for $160,000, paid in cash to Joe immediately. The investor now owns the policy and must continue to pay the premiums, but will receive the $500,000 benefit when Joe dies.
Why the Secret?
There are basically two types of life insurance policies: permanent (have CSV) and term (no CSV), which is never used in an LS transaction. According to international actuarial firm Milliman and Robertson, 89.5 percent of Universal Life permanent policies never result in a death claim. The policies are either surrendered, or worse, allowed to lapse. (Universal Life is the most common type of permanent life insurance sold in the U.S.)
Terminated policies are highly profitable for insurance companies, so of course they want to keep the entire life settlement industry a secret. If Joe had cashed in his policy, the insurance company would have paid the $80,000 CSV, but it would have been off the hook for the $500,000 death benefit. The LS investor in the example above stands to make a gross profit of $340,000 ($500,000 death benefit, less the acquisition cost of $160,000), reduced by the premiums he will pay until Joe passes on.
Big-hitters Paved the Way
For many years, LS were solely the playground of institutional investors such as CNA, Morgan Stanley, Citibank, AIG and Berkshire Hathaway. These five giant companies and other big hitters provide immense credibility to the LS concept because of the due diligence they require before committing to invest their own dollars.
So why do the big hitters invest in LS?
• They are the ideal alternative to low-yield, fixed-rate investments.
• There is no correlation to stocks or bonds.
• LS policies are underwritten by highly rated (A or better) insurance companies.
• The return of principal and profit is tied to a certain event: death.
• A portfolio of policies helps reduce volatility and risk.
Interesting. My estate planning clients want alternatives to investing in Wall Street for exactly the same reasons.
Tax Consequences of LS
There are three potential tax consequences of an LS investment:
• Taxable. Your own funds or funds you control, such as your corporation or other business entities, family limited partnerships, and any non-charitable trust, are taxable. There are only two simple rules: 1) the tax on your profit is deferred until you actually receive your principal and profit, and 2) your profit is taxed as ordinary income.
• Tax-deferred. Almost everyone can play this profitable game via their tax-deferred qualified plans (IRAs, traditional or rollover; 401(k); profit-sharing; or any other qualified plan). The trustees of pension plans or other plans that are not self-directed can invest the plan funds in LS for the benefit of all participants.
• Tax-free. A Roth IRA can fatten your tax-free accumulations. Charitable entities, such as a family foundation, charitable lead trust or charitable remainder trust, are a perfect fit.
If you want to make a killing on your investments, LS are not for you. But if a high rate of return with no Wall Street risk is of interest to you, consider the life settlement alternative.