The use of irrevocable family trusts that minimize future estate tax and generation skipping transfer taxation across multiple generations
High net worth investors seek tax-planning structures that provide for tax efficient wealth accumulation and wealth transfer. This planning objective has become more challenging as these investors have made larger investment allocations to alternative investments such as hedge funds, real estate and private equity. Some of these strategies such as hedge funds are fundamentally tax inefficient producing a high percentage of short-term capital gain income that is taxed at ordinary tax rates.
Private Placement Variable Universal Life (“PPLI”) insurance and Private Placement Variable Deferred Annuities (“PPVA”), collectively known as Private Placement Insurance Products )”PPIP”), have emerged as a solution for the high net worth investor.
PPLI is an institutionally priced variable universal life insurance policy that is offered exclusively to accredited investors and qualified purchasers as defined in Federal securities law. PPLI provides for tax-deferred accumulation as well as tax-free access to investment gains within the policy through either partial surrender of the cash value or policy loans. The policy death benefit is income tax free. The policy’s ownership may be structured to avoid estate taxes as well.
Like PPLI, PPVA is an institutionally priced variable deferred annuity that is offered exclusively to accredited investors and qualified purchasers. PPVAs also provide for tax-deferred accumulation, with the proviso that withdrawals are treated as income (as compared to return-of-principal) first and that there is a 10% penalty tax on withdrawals prior to age 591/2 (subject to certain exceptions). There are no policy loans and death benefits are not income tax free.
The difficult challenge of PPLI is not its planning premise, policy features and benefits, or pricing. PPLI is a complex policy that requires detailed medical and financial underwriting which is very intrusive to a high worth client’s desire for privacy and anonymity. Large investments into PPLI require the purchase of policies with large face amounts, which, in turn, present underwriting challenges as the life reinsurance market has shrunken in capacity through industry consolidation and the recent poor financial performance by reinsurance companies in general.
Many wealthy families have been successful accumulating wealth in multi-generational trusts such as Dynasty or generation skipping trusts. These trusts are very efficient for wealth transfer tax purposes but not necessarily for wealth accumulation purposes. For example, the level of trust investment income required to trigger the top marginal income tax bracket is quite low, $9,300. Therefore, tax efficient let alone tax advantaged wealth accumulation is a planning objective for Dynasty Trusts particularly as trustees continue to make larger allocations to hedge funds.
The application of the Dynasty Annuity strategy is readily available considering the large amount of wealth transferred to irrevocable trusts through such techniques such as Sale to an Intentionally Defective Trust and Charitable Lead Annuity Trusts that revert to irrevocable trusts.
Private Placement Variable Deferred Annuities (PPVA)
As mentioned above, PPVAs are institutionally priced variable deferred annuities designed for accredited investors and qualified purchasers. These products allow for an expansion of the contract’s investment menu to sophisticated investment options such as non-registered funds (e.g. hedge funds).
PPVA contracts may be a more viable tax advantaged vehicle for wealth accumulation than PPLI for the high net worth family with significant assets already in multi-generational trusts. A wealthy family may not have a traditional need for life insurance and/or may be adverse to the level of medical and financial disclosure required in the life insurance medical underwriting process.
Additionally, the family may have some difficulty gaining the cooperation of younger family members in the life insurance planning process. The PPVA transaction process is much more straightforward in a manner similar to any other investment transaction. Moreover, the cost structure of the PPVA is approximately one-half of the cost of PPLI since there is no cost of death cost of death benefit charges.
This cost differential contributes to a significant degree of difference is tax-deferred compounding which, of course, grows significantly as the time period for compounding grows. The downside is that death benefits are taxed as ordinary income.
Retail Deferred Annuities versus PPVAs
The domestic retail market for variable deferred annuities currently has $2.1 trillion of assets under management. According to the National Association of Variable Annuities, the average annual cost of a deferred annuity is approximately 140 basis points not counting fund expenses.
The average annual cost of a PPVA with a $1 million account balance is approximately 50 basis points.
The greater difference between retail variable annuities and PPVAs is the degree of investment flexibility. Retail annuities almost exclusively feature registered funds that are very similar to mutual funds. PPVA contracts may feature alternative investments- real estate, hedge funds, LBO, and private equity.
The vast majority of states have relaxed the investment liquidity requirements of PPVA contracts to accommodate less liquid investment strategies. PPVAs may also incorporate registered funds on a customized basis as well to provide a complete array of investment options.
PPVA and Tax Considerations
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 reviewed this issue with respect to trusts at least eight times in Private Letter Rulings (PLR9204014, PLR199905013, PLR199933033, PLR199905015) has ruled favorably for the benefit of the taxpayer in each instance.
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.
The Solution – The Dynasty Annuity
The solution to the problem of accommodating the problem of medical underwriting and the lack of reinsurance availability for PPLI is the Dynasty Annuity . The Dynasty Annuity involves the purchase of a PPVA contract by the Trustee of the Family Trust. The trustee selects young annuitants as the measuring lives of the annuity in order to maximize tax deferral within the PPVA contract. This structure maximizes tax deferral for the over the lifetime of the PPVA’s young annuitant
The steps of the transaction can be summarized as follows:
1. Purchase of a PPVA Contract. The trustee of the Family Dynasty Trust is the applicant, owner, and beneficiary of a PPVA contract(s).
2. Selection of Young Annuitants. The critical element in the maximization of tax deferral is the selection of a young annuitant(s) with the greatest potential of living to normal life expectancy for each separate PPVA contract. The trustee may purchase multiple policies with different individual annuitants to “hedge” against the possibility of exposing the trust to a tax burden as a result of distribution requirement caused by the pre-mature death of the annuitant.
Dynasty Annuity Strategy Example for John Doe Children's Trust
The trustee of the children's trust is the applicant, owner, and beneficiary of a PPVA contract for each of the Doe children. Each PPVA contract is owned within the trust of each respective child. Each child is the annuitant for the PPVA contract owned within their respective trust.
The PPVA contract issued by Acme Life Assurance Company (Acme) will feature at least two different investment options within its Private Placement Memorandum (PPM) – (1) Acme Money Market Account and (2) Customized Investment Account (“Customized Account”). An independent investment advisor that manages funds for the Doe Family will manage a diversified portfolio within the PPVA contract. The Customized Account will be structured as an insurance dedicated fund.
All of the investment income and gains from the Customized Account will accrue within the contract on a tax deferred basis. Prior to the death of the annuitant, the trustee may request a distribution from PFLAC in order to make a distribution to a trust beneficiary. At the death of the annuitant, the trustee will be required to make a distribution of the annuity based upon the life expectancy of trust beneficiaries over the life expectancy of trust beneficiaries (presumably the surviving Doe Children).
The approximate cost of the PPVA contract is 40 bps per year. The PPVA contract has the investment flexibility to add investment options to the contract. The Customized Account provides an open architecture allowing the investment advisor to manage based upon its asset allocation model and changes to the model.
The ownership of PPVA contracts is a powerful wealth accumulation technique. In the present case, the trust is taxed as a grantor trust. Upon the death of the grantor, the trust will be taxed based on trust brackets. The income threshold for the top bracket is very low- $9,3000. The PPVA is an institutionally priced variable deferred annuity contract that provides investment flexibility in a manner that is not available. The ability to structure the trust owned PPVA contract based upon the life of the annuitant using a young life with a long life expectancy is a powerful wealth accumulation mechanism as a result of achieving tax deferral for up to 60-80 years in the present case.