Tax Reduction and Deferral Strategies for Trial Attorneys – Part 5 : Structured Settlement Life Insurance – A Tax-Free Pension Plan

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I Overview

This installment is Part 5 of my series on a tax reduction and tax planning strategies for trial attorneys. This installment introduces a completely new concept in the structured settlement industry- structured settlement life insurance. This strategy is designed for high income trial attorneys who represent plaintiffs that earn a contingency fee based on the damages awarded by a jury or settlement.

Part I of this series focused on tax reduction and deferral strategies for trial attorneys with contingent fee income using private placement variable deferred annuities in lieu of fixed annuities for structured settlement payments.

Part 2 of this series focused on the use of closely held insurance companies (aka captive insurance arrangements) to provide tax reduction and deferral of contingency fee income. In Part 2, the captive insurer functions as a multi-line insurer (property and casualty as well as life insurer) that issues the structured settlement annuities for the contingency fee deferrals referenced in Part I of this series.

In Part 3, the trial attorney was able to gain a charitable tax deduction equal to the amount of the contingency fee and invest that money on a tax-deferred basis using PPLI contracts. Part 3 combined several sophisticated planning techniques - a Charitable Lead Annuity Trust with back loaded payments to a charity; a preferred partnership in order to transfer growth in excess of a preferred partnership return to a family trust, and  tax-free treatment on investments within the CLAT using private placement life insurance to create the tax benefits..

In Part 4, I focused on the use of Qualified Settlement Funds under IRC Sec 468B as an unlimited pension plan for trial attorneys. QSFs provide for unlimited contributions from a pension plan perspective, and unlimited tax deferral without a need for required minimum distributions and participation as required in pension law.

In Part 5, I focus on the utility of the QSF from an investment funding perspective to illustrate how private placement life insurance can be used in a split dollar life insurance funding format in order to to create a scenario where the trial attorney is able to create a retirement fund that exploits the tax advantages of life insurance – (1) Tax-free inside build up (2) Tax-free lifetime distributions through policy loans and withdrawals. (3) Income and Estate-tax free death benefit.

Generally, most trial attorneys have not utilized structured settlement annuities which are conservative fixed deferred annuity products issued by large life insurers. Apparently, trial attorneys have been content paying taxes at ordinary rates. Why?

II Again and Again - Why Now?

I am beginning to sound like the proverbial “broken record” regarding the impending tax law changes on the horizon.  The tax bugle sounds once again as a “call to action” for trial attorneys and their advisors.

The tax environment for high income tax payers is set to undergo a substantial change. The top federal marginal tax rate is scheduled to increase to 39.6 percent in January 2013. High income tax payers will incur an additional 3.8 percent tax on unearned income for taxpayers with AGI in excess of $250,000. High income tax payers are also subject to a phase out of personal exemptions and itemized deductions which have the effect of increasing the marginal tax rate by 1-2 percent. State marginal tax rates can add another 4-10 percent to the overall tax rate. What this means is that many trial attorneys will have a combined marginal tax rate in excess of 50 percent.

The top marginal estate tax bracket is also set to increase to 55 percent. At the same time the exemption equivalent for federal estate and gift taxes is decreasing from $5.12 million to $1 million per taxpayer. The bottom line is that “earned income” as the trial attorney’s largest asset, is more highly taxed much than any other asset class. The combination of income and estate taxes on this windfall income can be as high as 75-80 percent.

III  Qualified Settlement Funds (QSF)- A Quick Review

QSFs are trusts that are designed to resolve litigation and satisfy claims of the litigation even if they are not the subject of litigation. The QSF is authorized and governed by the provisions of IRC Sec 468B. Depending upon the complexity of a case, number of plaintiffs or defendants, and the level of uncertainty regarding distributions, the QSF can last for a few weeks or a few years. The key point here is that no statutory time limit exists within IRC Sec 468B or the treasury regulations in regard how long a QSF may be kept in place. 

The QSF has benefits for both plaintiffs and defendants. From a defendant’s perspective, the ability to transfer assets to a QSF can resolve the claim and release the defendant from further liability while achieving an immediate tax deduction regardless of when claimants actually receive distributions. This is a significant tax planning point for the defendant.

The plaintiff is able to achieve numerous benefits. Claimants can use the QSF to time the receipt of their income. Plaintiffs are not taxed until they actually receive distributions from the QSF. The QSF provides the plaintiff and their attorney with the ability to work out the details of their distribution.

In Part 4 of this series, I outlined the legal requirements necessary to create a QSF as well as the operational and administrative guidelines. Please refer to Part 4 for a review of these concepts. One important point regarding taxation is the fact that QSFs are taxed at the maximum level for trusts (39.6%) in 2013. QSFs will also be subject to the new 3.8 percent Medicare tax on investment income as well as state taxation. All in all, we are talking about “all in” tax rates that hover between 43.4 and 53 percent. As a result, tax deferral on investment income is a key component of investment and tax planning for QSFs.

IV Tax Advantages of Life Insurance

Life insurance agents and attorneys have one thing in common. Everybody hates lawyers except their own lawyer. Life insurance agents get clients to take action in an area of their lives that they would rather avoid – their own mortality. The decedent’s family is very grateful after the fact. In Woody Allen’s film “Take the Money and Run”, solitary confinement is made more onerous by having to spend it with a life insurance agent.

Nevertheless, life insurance agents have the best game in town from a tax perspective. Life insurance is the most tax advantaged investment. The inside buildup of the policy’s cash value is tax-free meaning that the policy’s investment earnings within the policy are not taxed. The policyholder also has the ability to access those investment gains from the policy during lifetime on a tax-free basis using low cost policy loans and partial surrenders of the policy cash value. The policy death benefit receives income tax-free treatment and the policy death benefit may receive estate tax-free treatment if owned by a third party such as a family trust. Not bad!

Private placement life insurance is a state of the art institutionally priced variable universal life insurance policy that allows for customized investment options including a wide range of investment options such as hedge funds and private equity funds. The policy is effectively a low load or no load life insurance policy making it very efficient but also the primary reason why it isn’t sold more.

V Structured Settlement Life Insurance

The thrust of the structured settlement life insurance strategy is use of the QSF as a source of funds to invest in a PPLI contracted owned by the trial lawyer’s family trust using a split dollar life insurance arrangement. Split dollar life insurance is a funding technique that has traditionally been used as a funding technique used by an employer to provide life insurance coverage for key executives. The earliest reference to split dollar is Rev. Rul 55-713. Hence, split dollar is older than I am.

Specifically, this arrangement calls for the use of a split dollar technique known as Switch Dollar. Switch dollar starts out as a traditional split dollar arrangement using the economic benefit regime under the final split dollar regulations promulgated in September 2003. As the economic benefit tax cost to the trial attorney increases, the arrangement is switched to a split dollar arrangement under the loan regime.

The four stages of the arrangement:

  1. Economic Benefit Phase – the QSF funds the entire policy premium. The trial attorney has a tax cost equal to the value of the economic benefit (term insurance cost) for the trial attorney’s (Family Trust) interest in the policy.
  2. Switch – The split dollar agreement terminates. The Family Trust issues a promissory note to the QSF. The initial premium is equal to the cumulative premiums. The note has no interest rate and is a demand note. The trial attorney has reportable income equal to the long-term applicable rate.
  3. Loan Phase – The loan interest accrues and is added to the principal of the loan. The family trusts owns the policy in its entirely. The trustee of the is able to take a partial surrender of the cash value and policy loans and make tax-free payments each year to the trial attorney or his spouse.
  4. The End – The loan and any accrued interest is repaid at the trial attorney’s death to the QSF. The trustee of the QSF uses the repaid loan proceeds to make the payments on a taxable basis to the trial attorney’s estate or beneficiaries.
  1. Split Dollar Overview

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. Generally speaking, two forms of classical split dollar arrangements exist, the endorsement method and collateral assignment method.

The IRS issued final split dollar regulation in September 2003. These regulations were intended to terminate the use of a technique known as equity split dollar. The consequence of these regulations is to categorize into two separate regimes – the economic benefit regime or the loan regime.

  1. Split Dollar under the Economic Regime

Under the economic benefit regime, the employee or taxpayer is taxed on the “economic benefit” of the coverage paid by the employer. The tax cost is not the premium but the term insurance cost of the death benefit payable to the taxpayer. The economic benefit regime usually uses the endorsement mehtod but may also use the collateral assignment method.

In the endorsement method within a corporate setting, the corporation is the applicant, owner and beneficiary of the life insurance policy insuring a corporate executive. The company is the applicant, owner, and beneficiary of the life insurance policy. The company pays all or most of the policy’s premium. The company has in interest in the policy cash value and death benefit equal to the greater of the policy’s premiums or cash value. The company contractually endorses the excess death benefit (the amount of death benefit in excess of the cash value) to the employee who is authorized to select a beneficiary for this portion of the death benefit.

The economic benefit is measured using the lower of the Table 2001 term costs or the insurance company’s cost for annual renewable term insurance. This measure is the measure for both income and gift tax purposes. Depending upon the age of the taxpayer, the economic benefit tax cost is a very small percentage of the actual premium paid into the policy -1-3 percent.

  1. Split Dollar Under the Loan Regime

The loan regime follows the rules specified in IRC Sec 7872. Under IRC Sec 7872 for split dollar arrangements, the employer’s premium payments are treated as loans to the employee. If the interest payable by the employee is less than the applicable federal rate, the forgone interest payments are taxable to the employee annually.  In the event the policy is owned by an irrevocable trust, any forgone interest (less than the AFR) would be treated as gift imputed by the employee to the trust. The loan is non-recourse. The lender and borrower (employer and employee respectively) are required to file a Non-Recourse Notice with their tax returns each year (Treas Reg. 1. 7872-15(d) stating that representing that a reasonable person would conclude under all the relevant facts that the loan will be paid in full.

Split dollar under the loan regime generally uses the collateral assignment method of split dollar. In a corporate split dollar arrangement under the loan regime, the employee or a family trust is the applicant, owner, and beneficiary of the policy. The employer loans the premiums in exchange for a promissory note in the policy cash value and death benefit equal to its premiums plus any interest that accrues on the loan. The promissory note can provide for repayment of the cumulative premiums and accrued interest at the death of the employee.

Switch dollar is a method of split dollar life insurance that commences using the economic benefit method and then converts to the loan regime when the economic benefit costs become too high.

IV   Strategy Example

A.The Facts

Joe Smith, age 50, is a partner is a plaintiff's law firm. The firm’s partnership agreement provides that the partner who wins a trial gets a 60 percent compensation credit on the contingency fee with the remaining partners getting a 20 percent compensation credit. The firm allocates the remaining 20 percent to cover the firm’s fixed expenses and to fund future cases. His combined marginal tax bracket for federal, state and city purposes is 40 percent.

Joe recently settled a product liability case with a $60 million settlement. The fee agreement provides for a $19.8 million contingency fee to the firm. Joe receives a compensation credit equal to $11.88 million.

Solution

During the course of settlement discussions, the firm, claimant, and defendant agree to create a QSF. The defendant likes the fact that it can take a deduction for its transfer of insurance proceeds to the QSF rather than taking a deduction as the claimant receives payment. The firm petitions the probate court in the firm’s hometown to issue an order authorizing the creation of the QSF. 

The Smith Family Trust is an irrevocable trust designed to provide multi-generational benefits to Joe’s wife, children and grandchildren. The trustee of the family trust is the applicant, owner, and beneficiary of a private placement life insurance policy insuring Joe’s life. The policy will have premiums of $2.5 million per year for 4 years for a total of $10 million. The policy will have a death benefit of $40 million.

The policy will be funded by the trustee of the QSF. The trustee of the QSF enters into a collateral assignment split dollar arrangement with the trustee of the Smith Family Trust. During the first ten years of the arrangement, the split agreement will use the economic benefit arrangement and then switch to the loan regime. The average annual economic benefit (tax) cost during the first ten years of to Joe is $50,000. This is the cost for both income and gift tax purposes each year. During that time, the QSF has an interest in the policy cash value and death benefit equal to the greater of the policy premiums or cash value.

At the end of Year 10, the trustees agree to switch to the loan regime. The trustees terminate the collateral assignment agreement in exchange for a promissory note equal to the cumulative premiums paid to date, $10 million. The cash value in the policy at the end of Year 10 is $20 million. The interest rate on the loan is the long-term AFR which is 2.34 percent per year. The interest is capitalized and added to the promissory note.  The annual interest charge added to the policy is $234,000 in year. Ultimately, a portion of the death benefit equal to the accumulate principal and interest will be repaid to the QSF. These repayment will be paid to Joe’s wife and family in a lump sum or on installments.

The trustee of the Smith Family Trust takes a tax-free policy loan of $1 million per year beginning in Year 10 and distributes the proceeds to Mrs. Smith who is a discretionary beneficiary of the Trust. The distribution is also tax-free.

In the event of Joe’s death, the death proceeds ($40 million) are income and estate tax-free. At death, the trustee of the Family Trust will reimburse the trustee of the QSF in amount equal to $10 million (cumulative premium) plus any accrued interest. Lastly, Joe’s estate will be paid $10 million in a lump sum as payment for the original compensation paid to the SQF, the contingency fee. This payment is taxable income to the estate.

Summary

The ability to use QSFs as a funding vehicle for other trust investments that provide tax-free benefits for trial attorneys, is more than compelling. The results dramatically exceed those found in a typical structured settlement annuity arrangement for trial attorneys.

This article focuses on one version of a new concept- structured settlement life insurance for trial attorneys. The technique uses an investment by the trustee of the QSF to fund a split dollar arrangement with the trustee of the trial attorney’s family trust. The arrangement funds a PPLI contract.

This strategy uses an executive benefits strategy- split dollar life insurance that has been used by virtually every Fortune 1000 company in the Land. The program provides tax-free retirement income,’ tax-deferral and a substantial income and estate tax free death benefit for the trial attorney and his family. On top of those substantial benefits, the trial attorney’s family receives a final lump sum (equal to the original contingency fee benefit) from the QSF when the trial attorney dies.

The next installment (Part 6) will focus on a few different versions of structured settlement life insurance for trial attorneys. Stay tuned!