The Institutional Variable Annuity
Creating Tax Efficiency for Tax-Exempt Investors
By Jerry W. Hester, II CLU® - Founder/Principal of Hester Insurance Group LLC
The Institutional Variable Annuity (“IVA”) is another name for an institutionally priced private placement variable annuity offered to accredited investors who are qualified purchasers. IVAs offer tremendous tax benefits to tax-exempt investors. By investing via a IVA, tax-exempt investors, such as universities, hospitals and foundations, are able to eliminate federal taxation from investments unrelated to their business focus (“UBTI”). Under the Tax Cuts & Jobs Act of 2017, the UBTI rate was reduced from approximately 35% to 21%, a level which still has a significant impact on investment performance or is a deterrence to even making an investment.
Growing in popularity, this application of a IVA is not new but, for years, was generally limited to being offered by the investment subsidiaries of large insurance companies. These investment firms offer the option of making investments into UBTI-generating investment through an annuity structure provided by their parent insurer. This means that if a fund was not associated with an insurance company, such an annuity option was unavailable.
This has changed with the advent of private placement life insurance companies which offer the IVA structure and permitting the inclusion and customization of underlying investment options by third-party investment managers. In effect, something old is new again and being offered to a broader audience of investors.
Tax-Exempts & UBTI
Unrelated Business Taxable Income is defined in IRC §512 as income from a trade or business that is regularly carried on by the tax-exempt organization, but which is not substantially related to the exempt organization’s exempt purpose or function. Essentially, UBTI converts income that would otherwise be treated as tax-exempt into taxable income. Examples of investments which may generate UBTI income are:
Commercial & Residential Real Estate
Oil & Gas
Timber & Agriculture
Master Limited Partnership
How a IVA Works
Using a university endowment as an example, the U.S. Government created UBTI to establish a level playing field between what would otherwise be a “0% investor” and the general public. If a university wishes to invest into hedge funds, private equity, venture capital and publicly traded securities, they may likely face UBTI.
Traditionally, an endowment would go through the trouble of establishing and administering a C-corporation either through which to make UBTI-generating investments. These structures create some tax-efficiency by blocking most UBTI while the investments are held in the corporation. However, on the exit from the blocker corporation, UBTI is assessed.
If the investments are made through an IVA, UBTI is eliminated while the investments are held in the annuity and, when the money exits, it is characterized as annuity income and taxed at the tax-exempt’s 0% rate. IRC §512(b)(1) specifically exempts annuity income from UBTI treatment along with other categories of income such as dividends, interest, capital gains and rents. Therefore, the only cost of the investment is the fee for the IVA which is minimal at approximately 35 basis points a year.
Mechanically, the investments are technically owned by the insurance company and held in a segregated account. In return, the tax-exempt will own the IVA and be listed as the beneficiary. Like any annuity, there must be an annuitant or joint annuitants as measuring lives. Annuitants may be anyone professionally related to the tax-exempt such as “the last two remaining members of the board of trustees.” Having joint-annuitants is recommended since it gives the tax-exempt the ability to replace
annuitants if one dies in order to prevent the triggering of a payout from the annuity. These annuitants have no legal interest in the IVA or its benefits.
As with other private placement life insurance and annuity contracts, from a tax standpoint, an IVA must comply with IRC §72 which defines an annuity and with IRC §817(h) which sets out diversification rules for variable insurance products. The permitted structure of investments within an IVA are either a separately managed account (“SMA”) or an insurance dedicated version of a fund (“IDF”), the latter of which permits a single investment to be made.
Benefits of a Insitutional Variable Annuity (IVA)
Recharacterizes taxation on income from UBTI-generating investments to annuity income
Maximizes Tax Efficiency
Income and gains on the assets in the separate account generally are not subject to U.S. federal income tax under IRC §512
Tax & Cost-efficient Vehicle
An IVA at a minimal cost eliminates all tax leakage from the UBTI-generating investment
There is not a limit on premium contributions to the IVA
IVA Case Study
State University’s endowment wishes to invest $100 million into a UBTI-generating real estate fund. The fund is projected to double the return after eight years to $200 million. If the endowment does not use a corporate blocker or an IVA, the investment will have a value at exit of $179 million, net of the 21% federal tax. Using a corporate blocker structure, some tax-efficiency is created and the value at exit is increased to $182.15 million with an effective tax rate of 17.85%. If State University elects to make the investment through an IVA, the effective tax rate is 0% and the value at exit is $192.27 million, considering the annual IVA fee of 35 basis points. Using an IVA, the University was able to generate more than $13 million in value to be used for scholarships and campus improvements.
Broadening the Choices of Investments for Tax-Exempts
The IVA is a powerful tax structuring tool for tax-exempts and has largely remained under the radar of many of these investors. Previously restricted to investments associated with large, retail life insurance companies, investment managers may now partner with private placement life insurers to add IVA benefits to a wide offering of UBTI-generating offerings. Today, tax-exempts seeking a competitive edge through diversification have the freedom to enhance their returns with alternatives and similar asset classes. As with any variable life insurance contract, a professional producer should be consulted to identify and assist in structuring the ideal IVA to meet a specific need. For questions or to learn more about the Institutional Variable Annuity, please contact Hester Insurance Group.
This material is intended for informational purposes only and is not an offer or solicitation to purchase any securities or investments. Private Placement Institutional Variable Annuities should only be presented to Accredited Investors or Qualified Purchasers as described by the Securities Act of 1933 and Investment Act of 1940.
Private Placement Institutional Variable Annuities involve the investment risk of securities that include loss of value or total loss. Risks may include liquidity restrictions, lock-up periods, early redemption fees, transfer restrictions as well as other penalties that may apply to the underlying investments or securities. Additional risks could be associated with but not limited to government regulations that impact certain industries, changes in interest rates, pricing movement and transaction costs. Investments will fluctuate based on factors that include among others: performance, investment strategy, withdrawals and contributions. Actual investment results and performance will vary and are not guaranteed.
This document is not intended to constitute tax or legal advice and does not replace the professional advice of an attorney or tax advisor. Investors should consult with their own independent legal and tax advisors. Any tax and legal references herein are designed to provide accuracy with regard to subject matter. Hester Insurance Group LLC is not engaged in rendering tax or legal services.
The financial graphs/data in this document is purely hypothetical and solely for discussion purposes. Any illustration is not intended to predict or project future performance nor representative any actual investment results or performance.
A Private Placement Institutional Variable Annuity is entered into between the investor/policy owner and the insurance company. Policy owners should read the Private Placement Institutional Variable Annuity thoroughly.
Investors should consider the following before investing in a Group Annuity Contract: 1) investment objectives, 2) risks, 3) charges and expenses of any variable product before investing. A Private Placement Memorandum offering will include this and other important information about the investment company.
Securities offered through Spearhead Capital, LLC, a Registered Broker/Dealer, member FINRA/SIPC.
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