The Family Pension Plan - An Innovative Strategy to Minimize the Impact of Tax Hikes

by Gerald Nowotny
Contact

Overview

Most of us are about ready to fall off the Fiscal cliff.  Is there an 11th hour idea that can make some impact in the taxpayer’s situation. The situation may be even worse for a W2 employee. The following idea discussed the creation of a family business – a family investment company designed to manage family investment assets.

This idea is pretty mainstream so far. The twist is the creation of a family pension plan with the family investment company to recharacterize some of the investment income and management fee income. Once you have earned income, you have the basis for a tax deductible contribution in a qualified retirement plan.

Qualified retirement plans are excellent investment vehicles that provide a taxpayer with the ability to make pre-tax contributions into a pension plan and allow the investment earnings to grow on a tax deferred basis. Investment accounts grow quickly when you can make contributions with pre-tax dollars while enjoying tax deferral. The problem is that the contribution limits for the highly compensated are often inadequate. At the same time, for the highly compensated or retirees, the combination of high tax rates and lack of an adequate retirement plan, make retirement planning difficult.

Most high income earners with primarily W2 income as statutory employees of an employer are somewhat hand tied when it comes to tax and retirement planning. Unlike a business owner who has the ability to take advantage of deductions through a business, most W2 income earners are limited to deductions taken on Schedule A (itemized deductions) of Form 1040. These executives participate in the employer’s pension plan which in current times means the employee defers part of his salary in a 401(k) plan and is lucky if the employer has some sort of match. Defined benefit plans have largely disappeared from the retirement planning landscape.

Unless you work for a state or municipal government, you are highly unlikely to be a participant in a defined benefit plan. Participants in defined benefit plan enjoy the eternal peace and comfort of knowing that they will receive the same fixed amount each month regardless of investment performance. With the current volatility of the market place, this type of benefit plan offers enormous comfort. Benefits are guaranteed by the Plan.

The family defined benefit plan envisions the creation of a business entity – a family limited liability company (LLC)- designed to serve as a management vehicle for family and personal investments. The LLC will pay the Client a salary or management fee for his role in the management of the family LLC. The family LLC and payment of the management fee are the legal basis of a tax deductible contribution to a newly formed defined benefit plan within the family LLC.

Fully insured Defined Benefit Plans under IRC Sec 412(e)(3) are specialty qualified retirement plans that are conservatively funded using life insurance and annuities. In most circumstances, fully insured DB plans yield the highest tax deductible contributions. Fully insured plans are the most simple and straight-forward of defined benefit alternatives in formation and administration. In most cases, the deduction for fully insured defined benefit plans is much greater than the deduction for a traditional defined benefit plan.

In recent times, many taxpayers have lost 40-60 percent of their retirement savings due to investment market volatility. The prospect of a guaranteed retirement benefit that is invested conservatively should have some appeal under the Will Rogers Economic Doctrine - "The return of your money is more important than the return on your money".

This executive summary is designed to outline the use of a family defined benefit plan and the requisite tax authority.

Proposed Solution

Step 1 – Formation of the Family LLC

The proposed solution envisions the creation of a family limited liability company (LLC) by the taxpayer. The taxpayer is an individual with W2 income and ample investment income. The taxpayer may also be any type of non-business owner such as a retiree.

The non-tax business purpose for the creation of the LLC is to facilitate the consolidation of investment assets and management for the family. This business is valid for tax purposes according to IRS guidelines and case law. The LLC may be a single member LLC that is member managed or alternatively may be a LLC that is managed by a Manager.

Following the creation of the family LLC, the taxpayer may transfer title to investment accounts and holdings to the LLC. Investment income flows in the Family LLC. The Client who serves as manager of the Family LLC is entitled to pay himself a management fee structured as a guaranteed payment or salary from the LLC.

The LLC structure under most state LLC laws confers important asset protection benefits in that a personal or business creditor may not compel a distribution or liquidation of the LLC in order to reach LLC assets or undistributed income. The LLC may only receive a legal remedy known as a “charging order” which essentially allows the creditor to stand in the shoes of the Client as an assignee. In other words, the creditor may only receive access to LLC assets and income when distributed from the LLC.

The Client may in the absence of a transfer of assets to the LLC may create an arms-length management agreement between the LLC and the Client to provide investment management services.

Step 2 – Conversion of Investment Income into Active Earned Income

Passive investment income is not a legal basis of determining contributions to a qualified plan. The Family LLC must either compensate the taxpayer through a management fee or a salary for serving in the capacity of managing member.

Step 3 – Adoption of the Qualified Plan as a Fully Insured Defined Benefit Plan

The Family LLC in its corporate minutes will formally authorize the adoption of the qualified retirement plan for the Family LLC. The Plan is a fully insured defined benefit plan under IRC Sec 412(e)(3). The benefit formula for the Plan is based upon the highest three year income of the participant, the Client. The Plan must be funded with annuities and/or life insurance. The combination of the two provides for the highest contribution.

The plan provides for a pre-retirement death benefit. Unlike a traditional defined benefit plan, the fully insured plan does not require annual actuarial certification which makes it a much simpler plan to administer. The accrued benefit under the Plan is equal to the cash value of the insurance contracts which also feature a strong guaranteed component.

As an additional planning bonus, the taxpayer may also adopt and make an additional contribution to a profit sharing plan equal to six percent of payroll in the Family LLC. In the event the Client and his spouse are not participants in a 401(k) plan with their employer, they may make contributions as salary deferrals within a 401(k) within the Family LLC. The combination of these contributions can be quite significant - $16,500 in 2011 with a catch up provision of an additional $5,500 for taxpayers 50 and older.

Pension law allows the Family LLC to provide a minimum benefit of $10,000 under a defined benefit plan regardless of absence of compensation for a non-working or compensated spouse.

In the event the family investment enterprise was structured as a regular corporation (C Corporation), contributions could result in a tax loss to the corporation that could be carried back three tax years or forward for fifteen tax years. The corporate tax rate for small regular corporations is much lower than the top individual rate.

Strategy Example

Facts

John Doe, age 51, is a managing director in a private equity firm in New York City. He has W2 income each year of $1.5 million. As a resident of New York City, his combined marginal tax bracket is 48 percent. He participates to the maximum extent in his company’s 401(k) plan. He is married and has two children. John and his wife (Mary) file a joint tax return and report investment income each year of approximately $350,000 per year.

Solution

John forms a LLC in Delaware – Acme Investments. John and Mary are the members. Acme is member managed by John and Mary jointly. John and Mary assign their investment accounts and holdings in various alternative investments – hedge funds and private equity – to Acme. John will receive a management fee of $245,000 per year. Mary will receive a management fee of $10,000 per year.

Acme adopts a new fully insured defined benefit plan. The plan will be funded using annuities and life insurance. The Plan is administered and funded with insurance contracts issued by The Good Life Insurance Company of America. The projected contribution to the plan on John’s behalf in 2011 is $400,000. His account features a pre-retirement death benefit of $4 million. Mary’s projected retirement contribution is $8,300. His account features a pre-retirement death benefit of $4.6 million. The combined contribution is $408,000

John will have a retirement benefit of $16,250 per month at age 62. Mary will have a benefit of $750 per month at age 62 and a pre-retirement death benefit of $235,000.

The Does are sophisticated investors who are able to reinvest the tax savings at a higher rate of return than the conservative guarantees available through the fully insurance plan in private equity investments. However, they realize that the fully insured defined benefit provides the highest tax deductible contributions and that the benefit of the planning is the combination of the plan benefits plus the tax savings created by tax deductible contributions that might be reinvested at a higher rate of return than the Plan return in annuities and life insurance.

They also understand that under a defined benefit plan, higher investment returns only serve to reduce future contributions. The ultimate retirement benefit is finite regardless of investment performance within the Plan.

Tax and Legal Authority

IRC Sec 412(e)(3) provides the tax authority for using life insurance and annuities as the funding for defined benefit plans. Fully insured defined benefit plans were the original defined benefit plans before the adoption of ERISA. The plan unlike a traditional defined benefit plan does not require annual actuarial certification of the Plan. The Plan must exclusively use individual annuity and life insurance as the underlying investment vehicles of the Plan.

The use of life insurance is limited to the incidental best test for life insurance in a qualified plan. These limits would allow a policy death benefit that provides for up to 100 times the anticipated benefit at normal retirement age. Another benchmark for contributions would allow up to fifty percent of the contribution to be invested in life insurance.

Under the limited liability company statute of all of the states, the proposed business purpose of “investment management” would be a valid business purpose. This business purpose would also be valid for federal tax purposes under the tax rules governing partnerships.

The Family LLC is subject to all of the existing rules dealing with ERISA and qualified retirement plans – non-discrimination, coverage, et al. The Family LLC is a planning concept that creates a closely held business separate and apart from the Client’s role and status as a statutory employee of his employer.

Summary

The Family Defined Benefit Plan is a planning concept that seizes creative license and opportunity within existing tax law. In a certain respect, it is not that unusual as so many taxpayers have become entrepreneurs by design starting Internet-based businesses or real estate investment businesses. Only a small amount of planning and legal vision is necessary to incorporate that idea as a standalone incorporated business. Family LLCs and limited partnerships have been on the landscape for the fifteen years for estate planning purposes. The Family Defined Plan is an extension of the same idea.

The retirement and tax planning benefits of the Family Defined Benefit Plan are substantial. The contribution limits far exceed the benefits of an Individual Retirement Account (when available). Defined Benefit Plans provide for the largest retirement contribution in most cases. The “fully insured” version of the defined benefit plan furthers enhances the benefits. Depending upon the level of investment income, a combination plan might be possible adding a 401(k) and a profit sharing plan into the mix.

These limits provide an additional $16,500 for the 401(k) deferral plus an additional $5,500 “catch up” for a taxpayer 50 years old or older as well as a six percent of compensation in a profit sharing plan. For a 50 year old tax payer with $100,000 of investment income (and management fee income), this combination of plans might provide for close to $100,000 of tax deductible contributions – fully insured define benefit plan ($70,000); profit sharing ($6,000), and 401(k) with catch up provision ($22,000).

The Family Defined Benefit provides multiple benefits – (1) Secure retirement income (2) Conservative and guaranteed investment growth (3) Asset protection (4) Pre-retirement death benefit. (5) Significant tax savings. It can easily become the most important investment and tax planning tool in the planning arsenal of the high income executive or retiree.

 

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Gerald Nowotny, Law Office of Gerald R. Nowotny | Attorney Advertising

Written by:

Gerald Nowotny
Contact
more
less

Law Office of Gerald R. Nowotny on:

Readers' Choice 2017
Reporters on Deadline

"My best business intelligence, in one easy email…"

Your first step to building a free, personalized, morning email brief covering pertinent authors and topics on JD Supra:
Sign up using*

Already signed up? Log in here

*By using the service, you signify your acceptance of JD Supra's Privacy Policy.
Privacy Policy (Updated: October 8, 2015):
hide

JD Supra provides users with access to its legal industry publishing services (the "Service") through its website (the "Website") as well as through other sources. Our policies with regard to data collection and use of personal information of users of the Service, regardless of the manner in which users access the Service, and visitors to the Website are set forth in this statement ("Policy"). By using the Service, you signify your acceptance of this Policy.

Information Collection and Use by JD Supra

JD Supra collects users' names, companies, titles, e-mail address and industry. JD Supra also tracks the pages that users visit, logs IP addresses and aggregates non-personally identifiable user data and browser type. This data is gathered using cookies and other technologies.

The information and data collected is used to authenticate users and to send notifications relating to the Service, including email alerts to which users have subscribed; to manage the Service and Website, to improve the Service and to customize the user's experience. This information is also provided to the authors of the content to give them insight into their readership and help them to improve their content, so that it is most useful for our users.

JD Supra does not sell, rent or otherwise provide your details to third parties, other than to the authors of the content on JD Supra.

If you prefer not to enable cookies, you may change your browser settings to disable cookies; however, please note that rejecting cookies while visiting the Website may result in certain parts of the Website not operating correctly or as efficiently as if cookies were allowed.

Email Choice/Opt-out

Users who opt in to receive emails may choose to no longer receive e-mail updates and newsletters by selecting the "opt-out of future email" option in the email they receive from JD Supra or in their JD Supra account management screen.

Security

JD Supra takes reasonable precautions to insure that user information is kept private. We restrict access to user information to those individuals who reasonably need access to perform their job functions, such as our third party email service, customer service personnel and technical staff. However, please note that no method of transmitting or storing data is completely secure and we cannot guarantee the security of user information. Unauthorized entry or use, hardware or software failure, and other factors may compromise the security of user information at any time.

If you have reason to believe that your interaction with us is no longer secure, you must immediately notify us of the problem by contacting us at info@jdsupra.com. In the unlikely event that we believe that the security of your user information in our possession or control may have been compromised, we may seek to notify you of that development and, if so, will endeavor to do so as promptly as practicable under the circumstances.

Sharing and Disclosure of Information JD Supra Collects

Except as otherwise described in this privacy statement, JD Supra will not disclose personal information to any third party unless we believe that disclosure is necessary to: (1) comply with applicable laws; (2) respond to governmental inquiries or requests; (3) comply with valid legal process; (4) protect the rights, privacy, safety or property of JD Supra, users of the Service, Website visitors or the public; (5) permit us to pursue available remedies or limit the damages that we may sustain; and (6) enforce our Terms & Conditions of Use.

In the event there is a change in the corporate structure of JD Supra such as, but not limited to, merger, consolidation, sale, liquidation or transfer of substantial assets, JD Supra may, in its sole discretion, transfer, sell or assign information collected on and through the Service to one or more affiliated or unaffiliated third parties.

Links to Other Websites

This Website and the Service may contain links to other websites. The operator of such other websites may collect information about you, including through cookies or other technologies. If you are using the Service through the Website and link to another site, you will leave the Website and this Policy will not apply to your use of and activity on those other sites. We encourage you to read the legal notices posted on those sites, including their privacy policies. We shall have no responsibility or liability for your visitation to, and the data collection and use practices of, such other sites. This Policy applies solely to the information collected in connection with your use of this Website and does not apply to any practices conducted offline or in connection with any other websites.

Changes in Our Privacy Policy

We reserve the right to change this Policy at any time. Please refer to the date at the top of this page to determine when this Policy was last revised. Any changes to our privacy policy will become effective upon posting of the revised policy on the Website. By continuing to use the Service or Website following such changes, you will be deemed to have agreed to such changes. If you do not agree with the terms of this Policy, as it may be amended from time to time, in whole or part, please do not continue using the Service or the Website.

Contacting JD Supra

If you have any questions about this privacy statement, the practices of this site, your dealings with this Web site, or if you would like to change any of the information you have provided to us, please contact us at: info@jdsupra.com.

- hide
*With LinkedIn, you don't need to create a separate login to manage your free JD Supra account, and we can make suggestions based on your needs and interests. We will not post anything on LinkedIn in your name. Or, sign up using your email address.