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IT’S viewed as an insider’s secret for the affluent: a legal way to invest in hedge funds and other potentially lucrative assets, all without paying taxes on the gains.
But private placement life insurance, as it is known, is still unfamiliar to many wealthy people — and trickier to design properly than even some savvy investors realize, tax lawyers and financial advisers say.
“It sounds so good — ‘I can invest tax-free and get the money’ — but it’s actually very complex,” said Jon.
Private placement life insurance is an investment wrapped inside an insurance policy. The Internal Revenue Code treats the taxation of insurance differently from that of investments, like stocks or hedge funds, And the Internal Revenue Code does not levy federal income tax or the 15 percent capital gains on a life insurance policy when it pays out upon the death of the holder.
So by stuffing an otherwise taxable investment inside a tax-free life insurance policy, investors can reap the compounded gains of that investment and the death benefit, all tax-free.
The insurance is a form of variable life insurance whose cash value depends upon the performance of investments held in the policy. It is particularly lucrative because hedge funds, which trade frequently, otherwise often carry the 35 percent short-term capital gains tax. William said that demand for hedge funds, even in a down market, “is driving a lot of the private placement insurance market.”
Still, he said, the private placement life insurance industry was relatively small; the cash value of all policies outstanding amounts to perhaps $4 billion to $5 billion. While brokers pitched the policies to many family offices West Coast offices appeared less tapped.
There are other lucrative benefits besides the absence of income taxes.

When structured properly, the gains and the death benefit can escape estate taxes and go to your heirs tax-free when you die. If structured through an offshore entity, like a foreign trust, the gains can remain out of reach of creditors or those who might sue you.
But investors appeared to be shying away from the foreign variant, Mr. Waxman said, in part because “you have very sophisticated estate planning lawyers in the United States, but they don’t necessarily have offshore practices.”
Investors may also be able to borrow up to 90 percent of the gains from the policy without paying taxes on the loan. One exception is when the policy is structured as a modified endowment contract, or M.E.C.; then, the amount borrowed is taxed at ordinary rates, typically 35 percent, and may carry a 10 percent penalty tax.