(Bloomberg) — The new hot thing in tax avoidance has a boring old name: insurance dedicated funds.
Introduced in the 2000s, IDFs have become so mainstream that banks such as JPMorgan Chase & Co. and Goldman Sachs Group Inc. are offering them. Hedge funds like Paulson & Co. and Israel Englander's Millennium Partners LP have been managing them for years.
For investors, the products provide a legal way to avoid taxes. For investment firms, the premiums are "sticky" — they make for stable, long-term sources of capital that act as a bulwark against client redemptions at a time when clients just pulled $75.6 billion from hedge funds in the five quarters through March, according to Hedge Fund Research.
How it works: The client buys a private-placement life-insurance policy. The insurance company invests in alternative assets such as hedge funds. Profits, if any, would ordinarily be taxed as capital gains, but because it involves an insurance company, which must abide by certain restrictions, the money can grow tax-free. Beneficiaries get their money when the insured person dies. For products structured correctly, there aren't any levies on death benefits.
$15 Billion
Many IDFs are owned inside of life-insurance policies, but they can also be held in annuity contracts, which have different tax implications. There's no official accounting of how much money has been invested, but according to Aaron Hodari, who keeps tabs for Birmingham, Michigan-based Schechter Wealth, it's at least $15 billion — triple what it was a decade ago.
IDFs have been a discreet maneuver for years because investors "don't want everyone to know how well it's going," said Richard C. Wilson, chief executive officer of the Family Office Club, a network of more than 1,500 registered family offices.
JPMorgan and Millennium declined to comment. Goldman Sachs and Paulson didn't respond to requests for comment.
"People use these partly for estate-planning reasons but the main advantage is to let the value of these investments accumulate without any tax," said Alex Gelinas, a tax lawyer at Sadis & Goldberg. "That will always be an appealing feature."
The Internal Revenue Service has strict rules for the funds. Policy owners can't try to affect, directly or indirectly, the investment decisions of the account managers. And insurance companies are prohibited from investing in certain assets.
"If the investor has too much control, the investor is taxed immediately," IRS spokesman Anthony Burke said in an email. "If the investor withdraws the amount, the investor must pay tax."
Word Spreading
Tax status makes a clear difference. If a 45-year-old, non-smoking man were to contribute $2.5 million to an IDF for four years, the investment would be worth $113 million within 40 years with a 6.5% internal rate of return, according to a presentation by wealth-planning law firm Giordani, Swanger, Ripp & Jetel. The account value would be $48.8 million if the investor paid taxes, the document shows.
Word is spreading at closed gatherings such as this month's Private Placement Life Insurance and Variable Annuities Forum in Boston. That's where Hodari spoke in front of some of the 250 attendees, who included employees of Goldman Sachs, Dan Loeb's Third Point LLC, GoldenTree Asset Management, Golub Capital and York Capital. There was a similar meeting in New York in September. Third Point, GoldenTree, Golub and York all declined to comment.
