This article discusses the use of private placement products - private placement deferred variable annuities (PPVA) and private placement life insurance (PPLI)- in post mortem income tax and transfer tax planning. The executive summary is primarily geared to taxpayer’s large amounts of investment income.
The American Taxpayer's Relief Act of 2102 brought about some significant tax increases. The top federal marginal tax rate is now 39.6 percent for taxpayers filing a joint tax return with adjusted gross income (AGI) in excess of $450,000. The new long term capital gains rate is 20 percent. The tax rate for dividend income is also 20 percent. A new Medicare tax of 3.8 percent is assessed on investment income for joint filers with AGI in excess of $250,000.
The Pease limitation on miscellaneous itemized deductions and the phase out of personal exemptions has the effect of adding an additional two percent to the marginal tax bracket. Additionally, a Medicare surcharge of 0.9 percent applies for earned income in excess of $200,000. High income tax states such as California, New York and New Jersey add further insult to injury.
Marital trusts and credit shelter trusts are typically taxed as non-grantor trusts for income tax purposes. Investment in alternative strategies such as hedge funds and fund-of-funds has become very mainstream in asset allocation in order to provide non-correlated investment returns. The trade off in the pursuit of these investment objectives is short term capital gain taxation taxed at ordinary rates. For the New Yorker or Californian, this means marital trusts and credit shelter trusts could be taxed at rates as high 55-57 percent.
This article will discuss how customized and institutionally priced variable insurance contracts - PPVA and PPLI - can be used for tax advantaged wealth accumulation and wealth transfer purposes.
The American Taxpayer Relief Act - Estate Tax Changes
In January 2013, the American Taxpayer Relief Act of 2012 became the law of the Land. It permanently raised the federal estate, gift and generation skipping transfer tax exemptions to $5,000,000, indexed for inflation ($5.25 million in 2013). It also set the estate tax rate at 40%.
These changes may be short-lived. President Obama recently released his 2014 budget proposal, which calls for new $3,500,000 estate and generation skipping transfer tax exemptions and a $1,000,000 gift tax exemption. The President's proposal does not provide for indexing. The estate tax rate would be set at 45% and would become effective in 2018.
Congress made permanent the “portability” of a predeceased spouse’s unused estate tax exemption (currently, $5.25 million per spouse). The “portability” exemption is completely forfeited if the survivor remarries, or the executor of the predeceasing spouse’s estate fails to file a simplified estate tax return. A planning tradeoff in the "portability" option is the fact that it does not preserve the predeceasing spouse’s generation-skipping transfer (“GST”) tax exemption (which is not portable).
Another practical problem of the "portability" option it that it does not remove growth on the inherited assets (e.g. income and appreciation) from the survivor’s taxable as well as exposing the inherited assets to the survivor’s creditors (and new spouse).
The traditional drafting format in estate planning documents frequently provides for a credit shelter bypass trust and one or more marital trusts to fully allocate the GST exemption. In many cases, the QTIP election will have been made with respect to the marital trusts. These trusts will be taxed as non-grantor trust for income tax purposes.
Trusts that are not taxed as grantor trusts are taxed as separate taxable entities. Unfortunately, it takes very little investment income to push a non-grantor trust into the top marginal tax bracket- $11, 900. A non-grantor trust is a trust that does not fall within any of the provisions of IRC Sec 671-679. Unfortunately, the non grantor is taxed in the same manner as a high net worth taxpayer in the top marginal tax bracket.
Private Placement Insurance Contracts
PPVA and PPLI are customized deferred variable annuity and variable universal life policies respectively. These contracts are institutionally priced insurance contracts that are effectively "no load" or at the very least very "low load" insurance contracts. the contracts have no surrender charges. The hallmark feature of PPVA and PPLI is the ability to customize the fund options within the insurance contract to include alternative investments such as hedge funds and fund-of-funds. The cost "drag" associated with PPVA is approximately 50-100 basis points per annum and 80-120 basis points per annum.
How are Trust-Owned Annuities Taxed
The Non-Natural Person Rule of IRC Sec. 72(u) provides that deferred annuities lose the benefit of tax deferral when the owner of the deferred annuity is a non-natural person. The Legislative history of IRC Sec. 72(u) age and IRC Sec. 72(u)(1)(B) provide an exception for annuities that are “nominally owned by a non-natural person but beneficially owned by an individual”. This rule describes the typical arrangement in a personal trust. The IRS has ruled favorably this issue with respect to trust-owned annuities at least eight times in Private Letter Rulings.
IRC Sec. 72(s)(6) deals with the distribution requirements of an annuity that is owned by a non-natural person (e.g. a trust). It provides that the death of the primary annuitant is the triggering event for required distributions from the annuity contract. The primary annuitant must be an individual. Distributions must begin within five years following the death of the primary annuitant for the trust-owned annuity. At death, the annuity account balance may be paid out over the life expectancy of the beneficiary providing additional deferral.
As a result, a trustee of a credit shelter bypass trust or a marital trust could purchase a PPVA contract as an investment within the trust. IRC Sec 72(u) does not apply in this case because the beneficial owners of the credit shelter bypass trust and marital trusts are individuals. As a result, the marital trusts established in the estate planning documents of the taxpayer would be able to enjoy tax deferral of investment income. I can say with almost complete certainty that trustees are not taking advantage of this technique. As a result, trusts are subject to taxation at unnecessarily high marginal tax brackets.
The surviving spouse does not need to be the annuitant or measuring life of the PPVA contracts owned by the marital trusts. Children or grandchildren can be used as the measuring lives for the PPVA contracts. It is the death of the annuitant that triggers a requirement to distribute any deferred income and not the death of the surviving spouse. Using a grandchild as an annuitant could provide a deferral period of 80-90 years. Furthermore, the children or grandchildren's status as the annuitant is not ownership. The trustee will retain for ownership and control of the PPVA contracts and distributions.
While PPVA can serve as an excellent income tax planning tool by providing long term income tax deferral within family trusts, split dollar life insurance using PPLI can achieve income tax deferral and powerful wealth transfer for estate and GST planning purposes.
Split Dollar - From the Grave
The unlimited marital deduction allows a married couple to defer the payment of federal estate taxes until the death of the surviving spouse. Depending the length of the over-life, i.e. the time between the death of the first spouse and the surviving spouse substantial appreciation in marital trust assets can take resulting in a much larger estate tax bill at the death of the second spouse. Adding further insult, the marital trusts are taxed as non-grantor trusts.
Split dollar life is a contractual arrangement between two parties to share the benefits of a life insurance contract. In a corporate setting, split dollar life insurance has been used for 55 years as a fringe benefit for business owners and corporate executives. Split dollar can also be used in a non-corporate setting and is referred to as private split dollar. Generally speaking, two forms of classical split dollar arrangements exist, the endorsement method and collateral assignment method.
In the collateral assignment method, the employee is the applicant, owner and beneficiary of the policy. The employee’s family trust may also serve as the policy’s owner. The company pays all or most of the premium. The company retains an interest in the policy’s cash value and death benefit equal to the greater of the policy premiums or cash value. The employee collaterally assigns an interest in the policy to the employer for its contributions and interest in the policy.
In a private split dollar arrangement, private non-corporate individuals are the parties to the split dollar arrangement. In a typical private split dollar arrangement, an ILIT will be the applicant, owner, and beneficiary of the policy. The patriarch or matriarch or both will enter into the split dollar arrangement with the ILIT to provide funding for the life policy.
The trustee of the ILIT will collaterally assign an interest in the policy cash value and death benefit to the patriarch equal to the greater of the cash value or premiums. The excess death benefit is paid to the ILIT during the course of the arrangement. The proposed insured(s) are the children and/or their spouses. A private split dollar arrangement can be formed between the marital trust and a dynasty trust established at the children or grandchildren's generation.
Restricted collateral assignment is the classical form of split dollar arrangement utilized by the majority shareholder of a closely held business. Under restricted collateral assignment split dollar, a restriction is added to the split dollar agreement which “restricts” the company’s access in the policy under the split dollar arrangement (greater of cash value or premium). The “restriction” limits the company’s access until the earlier of the death of the insured, termination of the split dollar agreement, or surrender of the policy.
The owner’s business purpose is driven by concerns of the estate tax inclusion of the death proceeds for the business owner under IRC Sec 2042. The incidents of ownership under IRC 2042 over the policy would be imputed to the business owner due to the owner’s control of the business as the majority shareholder. The proposed private split dollar arrangement would contain the same type of restriction contained in the classical split dollar arrangement.
Under split dollar, the employee is not taxed on the amount of premium paid by the corporation on its behalf but rather on the value of the economic benefit as measured by the lower of Table 2001 or the insurer’s one year term insurance cost. In the event the policy is owned by the employee’s trust, the same economic benefit is the measure for gift tax purposes for the deemed gift of the “economic benefit” to the trust. The economic benefit theory of taxation for split dollar creates significant tax leverage for the business owner.
The Split dollar restriction is contractually in effect until the earlier of the death of the insured or termination of the split dollar arrangement. The Patriarch at their discretion may decide to transfer by sale their interest in the split dollar arrangement, aka the split dollar receivable. The patriarch and matriarch establish a second ILIT (ILIT #2) to purchase the split dollar receivable. The split dollar receivable is valued based upon a third party valuation. The right of recovery under the split dollar arrangement is limited until the death of the insured, or the termination of the split dollar arrangement. The sales price based upon an independent valuation provides for a heavily discounted sales price – 75-90 percent.
New treasury regulations were added. Treas. Reg. 1.61-22. Split dollar arrangements after September 17, 2003 must be qualify for either tax treatment under the economic benefit regime or the loan regime. Under the loan regime, the policy owner is considered the owner and the non-owner (premium payor) is considered the lender. The below market rate rules of IRC Sec 7872 are considered.
If the split dollar loan is considered as a below market loan, then interest will be imputed at the applicable federal rate (AFR) with the owner and the non-owner of the policy considered to transfer imputed amounts to each other. The restricted collateral assignment non-equity split dollar arrangement is taxed under the economic benefit tax regime.
If the split dollar arrangement is not treated as a loan, the contract’s owner is treated as providing economic benefits to the non-owner. Economic benefit treatment will generally occur in an endorsement arrangement and also in a collateral assignment arrangement where the only economic benefit interest to the employee is a death benefit. The Treasury regulations were designed to eliminate the use of “equity” split dollar arrangements. In an “equity” split dollar arrangement, the corporation had an interest in the policy equal to the less of cumulative premiums or cash value.
Cash value in excess of cumulative premiums accrued on a tax-free basis for the employee. The only taxation to the employee was the economic benefit. As a result, equity split dollar arrangements conferred significant benefits to taxpayers. Depending upon the relationship between the owner and non-owner, the economic benefit may be treated as compensation income, a dividend or a gift. The value of the economic benefit is equal to the cost of the life insurance protection to the non-owner; the amount of cash value the non-owner has access to, or the value of other benefits provided to the non-owner.
Under the new regulations, the employee is taxed on the value of the economic benefit he receives from the employer’s participation in the split dollar arrangement. The IRS revoked the P.S. 58 Table rates and introduced Table 2001. If the insurer publishes standard rates that are lower than the Table 2001 rates, the taxpayer may use the lower rate. Only the standard rates of the insurer may be used.
Under the split dollar arrangement, the employer may not deduct the premium payment. IRC sec 264(a)(1). Upon the dearth of the employee, the portion of the death benefit received by the employer and employee are exempt from federal income tax as life insurance proceeds. . IRC Sec 101(a) .
Jane Smith, age 75, is a widow. Her husband Bob was a wealthy business owner who died of prostate cancer two years ago. His estate plan provided for a traditional distribution - a credit shelter bypass trust for an amount up to the exemption equivalent and a marital general power of appointment trust. The marital trusts currently have $15 million of assets - mostly investment assets that are generating a substantial income to the trust. Additionally, the assets are appreciating at a rate that exceeds the rate of inflation. Jane's children and grandchildren are beneficiaries of the trust.
The trustee would like to minimize the tax impact of current income to the trust. The income is mostly short term capital gain income and interest income.
Acme Trust Company serves as the trustee of the Delaware trusts. The trusts are non- grantor trusts for federal income tax purposes. The trustee implements a strategy that utilizes PPVA and PPLI. The trustee is the applicant, owner and beneficiary of a PPVA contract issued by Corona Life, a Delaware based life insurer. The PPVA offers several fund of fund options that are attractive to the trustee. The income will be tax deferred.
Rather than a single annuity, the premium is allocated to three PPVA contracts issued by Corona. Each contract features one of Jane's grandchildren as the annuitant. They are 5, 7 and 9 years old respectively. The PPVA contracts can provide tax deferral on investment income if desired until the death of each annuitant.
The trustee also decides to purchase a PPLI contract insuring the lives of Jane's son, Bobby and her daughter-in-law, Penny. The policy is a second-to-die policy with an annual premium of $1 million per year for a five year period. The death benefit is $25 million. The policy will be structured as a split dollar arrangement between the marital trust and the credit shelter bypass trust using the restricted collateral assignment technique described above. The marital trust will pay the premiums and have an interest in the policy death benefit and cash value equal to the greater of cumulative policy premiums or the cash value. The right to reimbursement is the earlier of the death of the insureds or termination of the split dollar arrangement. The program uses the economic benefit method of split dollar. The economic benefit based upon the age to the two insureds will be the measure of the distribution from the marital trust/
At the beginning of Year 6, the trustee of the Marital Trust proposes to sell its interest in the split dollar arrangement, i.e. the right to recovery at the death of the insureds who are 55 at the time. A valuation specialist values the split dollar receivable at $1.25 million. The trustee of the credit shelter bypass trust purchases the split dollar receivable in a single payment. At the time of the transfer, the policy cash value is $7.5 million and the death benefit is $25 million. As a result of the transfer, the value of the marital trust is reduced by $6.25. The cumulative value of the economic benefit during the first five years is $5,000!
The credit shelter bypass trust is increased by an asset, a PPLI contract, that is growing on a tax-advantaged basis. The ultimate death benefit will also be income and estate tax free. The policy cash value is also available to the trustee to take tax-free loans for distribution to trust beneficiaries.
Higher tax rates not only create a problem for high net worth individuals but also trusts - grantor or non-grantor. Unless I missed that day of class, it seems that not much attention has been given in periodicals on the reduction of the tax burden for trusts such as marital trusts. PPLI and PPVA are state of the art life insurance contracts that are not as heavily utilized as they should be in my opinion. Use within marital trusts is something that should be strongly considered particularly as trustees make larger allocations to tax inefficient hedge funds and fund of funds.