Author: Chelsea

Overview

In August 2016, the national sports media provided details regarding the compensation package for Coach Jim Harbaugh at the University of Michigan. It comes as no surprise to anyone that Division I football and basketball coaches make a lot of money and usually more than the college presidents of the universities of where they coach. Personally, I have always personally questioned this practice, but I understand that college football is Big Business that pays a lot of bills for the universities.

The program described a life insurance purchase on the life of Coach Harbaugh for a policy with a $75 million death benefit and annual premiums of $2 million per year for seven years. Two years of premium ($4 million) were advanced in 2016. Most likely, the policy was backdated to save age facilitate the payment of premiums in the first policy year.

Charitable organizations from hospitals to universities have a difficult time attracting and retaining top executive talent from the world of public corporations. Public corporations provide competitive compensation along with the ability to acquire substantial personal wealth with equity-based compensation arrangements such as non-qualified stock options as well as attractive non-qualified deferred compensation arrangements. For college coaches at a Division I School the idea of financial security can be short-lived because a coach is only as valuable as the most recent “win-loss” record. Cash compensation is subject to taxation at ordinary. Qualified retirement plans provide little opportunity for the heavily compensated coaches to defer substantial amounts of money.

In the glory years of equity split dollar, tax-exempt organizations used split dollar as a method to provide additional supplemental retirement and death benefits for senior executives. Tax-exempt organizations receive constant scrutiny from the public that monitors the compensation of the organization’s leadership along with the percentage of funds allocated to the tax-exempt’s charitable purpose.

The split dollar program allows the tax-exempt organization to provide substantial contributions into the program while only reporting a small fraction of the contribution on the organization’s annual Form 990 to the IRS. The reporting requirements only required the reporting of the “economic benefit” and not the policy’s annual premium. Using this same methodology, Michigan would only have to report approximately $68,250 as annual compensation for the $2 million annual premium payment in 2016.

This article is designed to illustrate how split dollar strategy can provide substantial financial benefits during lifetime and at death for coaches and their families that can last substantially past a volatile coaching career.

Summary of the University of Michigan Split dollar Program

The Michigan program for Coach Harbaugh uses the loan method of split dollar. This article will outline the benefit of this technique for Division I coaches such as Coach Harbaugh. The financial planning and economic benefit for the coaches and their families is significant. A $75 million death benefit is nothing to sneeze at! College coaching is a precarious and volatile way to make a steady living. Here today and gone tomorrow!

This type of program can provide significant long-term financial benefits and security for the coach and his family.  According to a USA survey of 120 Division I football coaches, the average compensation package ranged from $500, 000 at the bottom to $7 million at the top. Division I basketball coaches make similar money. Coach K from Duke is at the top of the hill with total compensation around $7 million. Query: I wonder if his kids got free tuition at Duke. The program also allows the university to recover its cost when the coach dies. It also allows the University for tax compliance purposes to avoid reporting excessive compensation for university employees.

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. Importantly, IRS Notice 2007-34 provides that split dollar is not subject to the deferred compensation rules of IRC Sec 409A. See § 1.409A-1(a)(5).

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.

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 method 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.

Under the collateral assignment method, the employee or a family trust is the applicant, owner, and beneficiary of the policy. The employee collaterally assigns an interest in the policy cash value and death benefit equal to the greater of the cash value or cumulative premiums.

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.

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. The cash value in excess of the lender’s interest is available to the policyholder as a source of tax-free benefits during lifetime. The policyholder may take distributions as a recovery of basis tax-free and then take tax-free policy loans. The death benefit is also income tax-free and potentially estate tax-free.

Death Benefit Only (DBO) Plan Overview

The university may “piggy back” or add an additional benefit plan to allocate the death benefit that it receives as part of its cost recovery under the split dollar arrangement. These funds can be paid to the Coach’s family pursuant to a death benefit only (DBO) option. The DBO Plan is a contractual arrangement between a corporation and an employee or contractor. The corporation agrees that if the contractor or employee dies, the corporation will pay a specified amount to the employee or contractor’s spouse or other designated class of beneficiaries’ children. Payments can be made on an installment basis or in a lump sum.

The payments are taxable income but can be structured so that the payments are estate tax-free. If the payments are made to a designated beneficiary that does not provide the employee with the ability to right to change or revoke the beneficiary designation, the payments can avoid estate taxation. My planning suggestion is to have the designated beneficiary as the coach’s family trust.

Strategy Example

Joe Smith, age 45, is the head football coach at State University, a Division I powerhouse. His is about to sign a new seven contract. In lieu of additional cash compensation, the university has agreed to lend Coach Smith, $1 million per year for five years. The university is willing delay repayment and annual interest payments until the coach passes away into Football Heaven.

Coach Smith arranges a new family trust to purchase a $25 million policy on his life. The underlying is an equity indexed universal life policy. The crediting rate is 8.5 percent. In this case, the University bonuses the annual interest payment of $95,000 per year, based on the long term applicable federal rate of 1.9 percent.

Split Dollar Summary

University                                   Coach

Year	Age	Net Premium	Due as Loan Receivable	Cash Value (net of loan receivable)	Death Benefit
1	45	1 million	$1 million	0	$25 million
10	55	5 million	5 million	3.44 million	$25 million
20	65	5 million	5 million	14.55 million	$25 million
30	75	5 million	5 million	43 million	$43 million
40	85	5 million	5 million	98 million	$103 million

As you can see the program provides substantial benefits. At age 65, Coach Smith would have a cash value of $14.55 million that could be accessed on a tax-free basis as supplemental retirement income. In the event of death at age 85, the projected death benefit payable to the family trust would be $103 million, tax-free.

Summary

“Big Time” college sports is also very big business. The coaches are paid more than the university presidents of the universities where they coach. The financial justification is the revenue that a top football or basketball program brings to the university. From the perspective of the coach, the job is a “pressure cooker,’ and a financial blessing as long as it lasts. Coaches need to identify and implement tax-advantaged strategies for supplemental retirement income and wealth creation that reallocate current income taxed at ordinary rates. Joe Paterno donated $4 million to Penn State over is coaching career. The split dollar program and it substantial death benefit would also allow coaches to give something back to the school where they left so much of themselves while enjoying an excellent retirement with tax-free benefits.

https://www.jdsupra.com/legalnews/put-me-in-coach-using-split-dollar-life-97426/

Using Private Placement Variable Deferred Annuity (GAC) Contracts to Enhance the After-Tax Investment Return of Tax Exempt and Foreign Investors in Direct Lending Investments

Overview

Domestic and foreign institutional investors have increasingly turned to direct lending funds in an effort to increase fixed income investment returns in the face of decreasing bond yields over the last five years. The Barclay’s aggregate bond index has provided a return of 5-6 percent over the last several years while direct lending funds have returned 10-14 percent. These funds have been popular in Europe and have expanded popularity with large pension plans.

Domestic and foreign institutional investors in direct lending have to contend with tax considerations such as unrelated business taxable income (UBTI) and effectively connected income to a U.S. trade or business (ECI) which reduce the after-tax total return of these investments. This adverse tax treatment can reduce the overall benefit of direct lending investments for investors if these taxes need to be paid.

This article is designed to introduce and address a unique structure that generally has not been available to direct lending firms, and the large law firms that provide legal and tax structuring services for the direct lending fund sponsors. This structure will significantly enhance after-tax investment returns.

The group private placement variable deferred annuity (GAC) has been an effective structuring vehicle for real estate and a number of other alternative investment strategies for a number of years. Unfortunately, its use by institutional investors has not been widely publicized due to the fact that these investment offerings were largely made directly by life insurers using their wholly owned investment advisory firms without the use of intermediaries.

Over the course, of the last twenty or so years, at least $50 billion of investment transactions have been made through the GAC by insurers such as The Principal, Prudential, John Hancock, Met Life and others. In a legal environment where legal professionals tend to operate in their respective “silos” of expertise, it is time to embrace the use of new approaches and techniques to solve “tax leakage” problems.

Annuities 101- A Brief Overview

An annuity contract is a contract between the policyholder and insurance company to pay an annuity to the policyholder. Insurance companies offer two types of annuities – immediate and deferred. Immediate annuities provide a stream of payments at fixed intervals (monthly/quarterly/semi-annually or annually). The annuity is paid for a term of years or based on a life contingency such as “life only” or “joint and survivor” The payments end at the end of the fixed term or death of the annuitant (measuring life).

A deferred annuity is a deferral of that promise to make a series of payments to the policyholder. The deferral may be set for a fixed period of time. Many contracts list a maximum age of 85 or 90 for the deferral period. The account value in a “fixed” annuity is based upon the crediting rate based upon the insurer’s investment performance on general account assets. Most insurance general account investments are in investment grade bonds.

In a variable annuity the investment performance is based upon the on investment performance of separate account funds. These funds are segregated from the insurer’s general account assets traditionally, these funds are mutual fund clones or sub-accounts managed by investment management firms in the mutual fund industry. The investment performance for these accounts is a direct pass-through to the policyholder.

What is a Group Private Placement Variable Deferred Annuity?

The private placement version of this product is for accredited investors and qualified purchasers based upon the definition under federal securities law. Like PPLI, the products are institutionally priced with no surrender charges. The investment options include hedge fund, private equity and real estate options as well as traditional mutual fund-like options.

The institutional investor such as a pension plan, endowment, foundation or sovereign investor that purchases a private placement variable annuity purchases a group version of the product. This version features a class of annuitants and generally unallocated accounts. The institutional investor is the applicant, owner, and beneficiary of the group annuity contract. The policy features a group of annuitants (measuring lives) such as the officers and directors of a foundation.

Status as an annuitant within the contract does not confer any policy benefits or management and control of the annuity contract in favor of the annuitant. Furthermore, the policyholder is not required to annuitize, i.e. convert the account value to a stream of payments to the policyholder, over the annuitant’s lifetime. As a practical matter, institutional policyholders rarely (if ever) annuitize an annuity contract.

Dealer Status for Tax-Exempt and Foreign Investors

U.S. tax exempts and foreign investors and their investment advisors have a high degree of interest in tax structuring for investment in direct lending strategies that are effectively connected to a U.S. trade or business (ECI) or treated at UBTI. Generally, a foreign investor does not want to be in a situation where the investor has to file a U.S. tax return and come within the jurisdiction of the IRS or state tax authorities. The GAC would allow a foreign investor to avoid the IRS’ jurisdiction.

Generally ECI tax treatment results from financing activities such as mezzanine funds; funds that invest in distressed bank loans or similar securities that may involve loan origination; loan syndicate participation, secondary market purchases of revolving loans, commitment or other funding fees as well as participation on creditor committees. Fees from portfolio companies may also constitute ECI.

Many of the tax structures currently used are very complicated and deliver results with a moderate to high degree of tax leakage.  The GAC has the potential to deliver very compelling results to the foreign investor private or sovereign wealth fund.

The GAC has the unique ability to convert the character of ECI for tax purposes into “annuity” income which is not subject to U.S. income and withholding under virtually all of the double tax treaties with the United States. Annuity income is specifically exempt from UBTI for tax exempt investors.  No other tax structure is without any tax leakage, low administrative cost and technical simplicity, e.g. once you understand what a variable annuity is and how and why it works.

The GAC is able to capture and convert all of this taxable income into non-taxable “annuity” income.  A life insurer is taxable on all of its investment income within the separate account and is able to take a reserves deduction for all of its investment income within the separate account.

A foreign investor is taxable in theory on annuity distributions or surrender of the annuity contract. Without the benefit of a tax treaty, a foreign policyholder would be subject to a 30 percent withholding tax under IRC Sec 871(a). Virtually all of the double tax treaties exempt annuity income from income and withholding tax treatment for U.S. purposes. Furthermore, planning exists that would allow an annuity policyholder without the benefit of a tax treaty to obtain similar results.

Sovereign wealth funds are taxed under IRC Sec 892. IRC Sec 892 treats an annuity contract as a domestic security whose income is tax exempt. As a result, the GAC has the ability to convert direct lending income that might be taxed as ECI into tax exempt income. Equally as important from a non-tax standpoint, the use of the GAC eliminates the need to file a federal and state tax return and also eliminates K-1 reporting to the foreign investor.

The GAC is a complete solution to this problem.  The life insurance company separate account is considered the legal owner of the investments and as a U.S. taxpayer, is not subject to any of the foreign withholding taxes under IRC Sec 1446. The quarterly distributions paid by the direct lending to the insurance company separate account are not subject to any withholding taxation.

The annuity provisions of the Model Income Tax Treaty have been incorporated in the majority of existing tax treaties.  Article 18 of the Model Income Tax Treaty provides favorable treatment for annuity income.

The Model Treaty provides that annuity income is only taxed in the home jurisdiction and not subject to taxation or withholding in the U.S.  Most pension plans will not be subject to taxation in the home jurisdiction. Many foreign jurisdictions also provide favorable taxation for life insurance and annuities.

Tax treaty definition of an annuity is quite basic in most cases. In a few of the newer treaties, the tax benefits are only applicable to annuities that are beneficially owned by individuals in a manner similar to IRC Sec 72(u).

Treaty provisions override the 30 percent withholding tax imposed under IRC Sec. 871. These overrides may apply even if it is determined that the annuity is not a valid annuity under U.S. tax law but nonetheless a valid “annuity” under the definition within the tax treaty.

As a practical matter, I believe that it is nonetheless advisable to issue a GAC that complies with the requirements of U.S. tax law.  For a high net worth investor, the policy should be issued by an offshore carrier that has made an IRC Sec 953(d) election. This carrier level election treats the offshore carrier as a U.S. taxpayer eliminating any withholding obligation for ECI.

Additionally, the annuity contract is not considered a U.S. sitused asset for federal estate tax purposes eliminating any potential estate tax exposure for the foreign investor.

IRC Sec. 892 provides an income tax exemption to foreign governments, which invest in domestic stocks, bonds, and “other domestic securities”. This income tax exemption does not extend to investment in direct lending and commercial activities including real estate.

However, Reg.1.892-3T(3) defines “other domestic securities” to include annuity contracts.  Therefore, a properly structured annuity with a direct lending investment option will not be subject to the normal taxation and withholding requirements for ECI and U.S. real estate investments or FIRPTA withholding requirements.

The character of the income is converted to annuity income, which is exempt income for the foreign government under IRC Sec. 892.  Additionally, the foreign government will not a tax filing income at the federal or state level.

Summary

Direct lending investments are very attractive investments in general. Total returns significantly exceed the bond market; however, UBTI or ECI take a significant “bite” out of the total return of direct lending investment. The GAC as an investment structure eliminates this tax bite. The GAC provides an effective structure without leakage for tax exempt and foreign investors. Funding structuring attorneys and investment management firms involved in direct lending investments should consider the GAC as the most efficient tax structure for tax exempt and foreign investors involved in U.S. direct lending activities.

https://www.jdsupra.com/legalnews/brother-can-you-spare-a-dime-17228/

Overview

The Emergency Economic Stabilization Act of 2008 ended the not so discrete secret of hedge fund managers, the deferred compensation arrangement with their offshore funds or as the New York Times described, “an unlimited Super IRA for the super-wealthy.”

As Judge Learned Hand (of blessed memory to tax attorneys) once said:

“Any one may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one’s taxes. Gregory v. Helvering, 69 F.2d 809, 810 (2d Cir. 1934).”

The addition of IRC Sec 457A effectively ended the ability of investment managers to defer tax recognition of the carried interest in the investment manager’s offshore fund. Under IRC Sec 457A, hedge fund managers must repatriate the offshore deferred compensation not later than December 31, 2017. IRC Sec 457A effectively eliminates the ability of investment managers to enter into deferred compensation arrangements with their offshore funds going forward.

IRC Sec 457A really deals with two problems. Problem #1 deals with existing deferrals that must be repatriated and Problem #2 deals with the inability to no longer defer the carried interest. A number of large accounting firms and law firms have proposed an option strategy that is similar to non-qualified stock options that are taxed as ordinary income once they are exercised. Presumably, the proceeds would be included in the hedge fund manager’s taxable estate, but the options issued in lieu of payment of the carried interest would provide for ongoing deferral.

This article will introduce an old concept that was effectively utilized by senior executives in Fortune 500 companies that participated in their company’s Supplemental Executive Retirement Plans (SERP). The senior executives in many cases were already wealthy and did not necessarily need any additional retirement income considering the SERP benefit was subject to both income and estate taxation, a “haircut” of 70-80 percent of the benefit. The senior executives opted to exchange their existing benefit for participation in a company-sponsored split-dollar life insurance plan. The benefit exchange was known as a “SERP Swap”.

In many respects, this technique is a better planning technique than the existing deferred compensation planning arrangement. After all, deferred compensation arrangements have tax problems, namely income and estate taxation that impose a whopping 70-80 percent “whack” on the deferred compensation assets. Life insurance is very tax-advantaged – (1) Tax-free accumulation of the cash value; (2) Income tax-free death benefit and (3) Estate tax-free death benefit. Under the split-dollar arrangement, the executive would be minimally taxed for both income and gift taxes.

The article will outline a technique that has been used for over sixty years in corporate America and how this “old school” life insurance technique may be more powerful than any derivative trading strategy in its ability to create and preserve wealth for a hedge fund manager. The strategy is far less complicated (to me at least!) than derivatives or hedge fund trading strategies, but probably “Greek” to the investment manager.

What is a SERP?

A SERP (Supplemental Executive Retirement Program) is a non-qualified deferred compensation plan where the executive and employer enter into an agreement in which the employer agrees to pay the executive a certain amount in the future. Actual money is not distributed until distributions are made according to the contractual terms of the deferral agreement. Under the “swap”, the participant and the employer agree to “swap” potential benefits under the SERP for a split-dollar life insurance arrangement.

The typical hedge fund deferred compensation program involves an agreement between the investment management firm and the hedge fund’s offshore fund, a foreign corporation. The agreement typically provided for the deferral of the offshore fund’s carried interest for a ten year period. As a result, many hedge funds tended to pursue and push investor funds into the offshore fund. Furthermore, most institutional investor funds such as pension, endowment and foundation funds are invested into the offshore fund due to tax issues related to Unrelated Business Taxable Income (UBTI).

The problem with the typical hedge fund deferred compensation arrangement is the same problem that any deferred compensation or pension arrangement faces – (1) taxation at ordinary rates on distributions: (2) Estate tax inclusion and (3) Income tax taxation on the plan balance at death. The combined taxes erode 70-80 percent of the benefit. The Strategy provides the ability to transfer of offshore carried interest income and estate-tax free at a minimal tax-cost. This result is superior to the prior deferred compensation arrangement and the current option strategy used by hedge funds.  More importantly, it is completely legal. Keep reading!

Split-dollar Life Insurance

Split-dollar 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 split-dollar arrangements exist; the endorsement method and the collateral assignment method. Importantly, IRS Notice 2007-34 provides that split-dollar is not subject to the deferred compensation rules set out in IRC Sec 409A. See § 1.409A-1(a)(5).

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 the regulations is that all new arrangements will fall under one of two regimes of split-dollar taxation – the economic benefit regime or the loan regime.

Split-dollar under the Economic Benefit Regime

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

Utilizing 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 premium. The company has an interest in the policy cash value and death benefit equal to the greater of the policy’s cumulative premiums paid 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.

Under the collateral assignment method, the employee or a family trust is the applicant, owner, and beneficiary of the policy. The employee collaterally assigns an interest in the policy cash value and death benefit equal to the greater of the cash value or cumulative premiums paid.

The economic benefit is measured using the lower of the Table 2001 term costs set by the IRS or the annual renewable term insurance cost set by the insurance company. This measure is utilized 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, usually anywhere from1-3 percent.

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.

Strategy Example

1. The Facts

Joe Smith, age 45, is the managing member of Acme Funds, a hedge fund.  Acme is a $1 billion fund with assets equally split between the onshore and offshore funds. The fee structure for fund provides for a two percent management fee and 20 percent carried interest. The fund earns 10 percent in 2012.  The expected carried interest for the offshore fund is $10 million. Joe typically splits half the carried interest with his managing directors and key traders.

Joe would like to forego $10 million of carried interest in the next ten years and allocate $1 million per year into a split-dollar arrangement. The projected death benefit in the

policy is $25 million. The policy will be owned by an irrevocable trust that will allow Joe to allocate two generation skipping transfer tax exemptions for he and his wife. His wife is the settlor of the Trust and Joe is a discretionary beneficiary of the Trust. The policy will be exempt from the claims of Joe’s creditors and the policy proceeds will be outside of his taxable estate.

1. Solution

Acme’s offshore fund, a BVI corporation, enters into a split-dollar arrangement with Acme Investment Management, and the Smith Family Trust. Under the arrangement, Acme agrees to pay premiums equal to one-quarter of the carried interest calculation or $1.0 million as a premium in the split-dollar arrangement. Under the arrangement, Acme will have a collateral assignment interest in the policy equal to the greater of the policy cash value or policy’s cumulative premiums. Acme’s access to the cash value is restricted under the arrangement until the earlier of the termination of the split-dollar agreement, surrender of the policy or death of the insured (Joe Smith).

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.

During the first ten years of the arrangement, the split agreement will use the economic benefit regime and then switch to the loan regime beginning in Year 11.

Year	Income Tax	Gift Tax	Cum. Premiums
1	$14,250	$14,250	$1,000,000
5	$20,750	$20,750	$5,000,000
10	$28,750	$28,750	$10,000,000

The trustee terminates the collateral assignment agreement in exchange for a promissory note equal to the cumulative premiums paid to date, $10 million. The interest rate on the loan is the long-term AFR which is currently 2.65 percent per year.

The interest is capitalized and added to the promissory note.  The annual interest charge added to the policy is $1 million in Year 11. Ultimately, a portion of the death benefit equal to the accumulate principal and interest will be repaid to the Offshore Corporation. These repayments will be paid to Joe’s wife and family in a lump sum or on installments as part of a Death Benefit Only arrangement.

The trustee of the Smith Family Trust may take a tax-free policy loans and distribute the proceeds to Mrs. Smith who is a discretionary beneficiary of the Trust. The trust distribution is also tax-free.

In the event of Joe’s death, a portion of the policy death benefit would be paid to the offshore corporation as repayment for the loan plus any accrued interest. These funds never belonged to the offshore corporation and are paid to the Family Trust as a Death Benefit Only (DBO) arrangement.  The lump sum payment is subject to income taxation but not estate taxation. The excess death benefit, $25 million or more, would be payable to the Family Trust on an income and estate tax free basis.

Summary

The split-dollar strategy for hedge funds is extremely powerful beginning with the non-taxable treatment of the offshore fund (corporation) combined with the tax leverage of dollar split-dollar arrangement and life insurance. The replacement of the traditional deferred compensation arrangement for hedge funds with split-dollar provides an efficient mechanism to transfer the carried interest associated with a hedge fund’s offshore fund to the hedge fund manager.

The split-dollar program that uses a combination of the economic benefit and loan methods, aka Switch Dollar, provides the hedge fund manager with the ability to access the cash value of the life insurance policy on a tax-free basis during the hedge fund manager’s lifetime along with estate-tax free treatment upon death.  In many respects, the tax treatment of the split-dollar program is better and more tax efficient than the previous deferred compensation arrangement.

I don’t understand derivatives for investment purposes but I do understand life insurance and split-dollar arrangements. It seems to me that the combination of the tax advantages of life insurance combined with the tax leverage of split-dollar provides a tax-leveraged derivative that is more powerful than anything else in the hedge fund manager’s personal planning arsenal.

https://www.jdsupra.com/legalnews/split-dollar-life-insurance-a-tax-56180/

Overview

My love for Brazilian music precedes my study of Brazilian- Portuguese as a cadet at West Point. It was a very friendly and small department within the oldest engineering school in the Nation. The professors were very friendly in a place that was otherwise unfriendly, and the instruction was literally one-on-one. By the time I graduated I had the highest level of proficiency for a non-native speaker. At the same I further developed a great love for Brazilian music. My classmate in Portuguese class went on to become a Rhodes Scholar with a degree in Portuguese literature and later a two star general in the Army.

I recall hearing Bossa Nova as a ten year old at my neighbor’s house in the Panama Canal Zone – Sergio Mendes and Brazil 66. The Waters of March is one of many great songs written by Antonio Carlos Jobim and sung by Elis Regina. It remains one of my Brazilian favorites. Of course, none of this has anything to do with Charitable Lead Annuity Trusts (CLATS), but the idea of creating a series of cascading CLATs conjures up images of the Falls of Iguacu.

In order for the taxpayer to receive a deduction for the contribution to a CLAT, the CLAT must be a grantor trust Since the CLAT is treated as a grantor trust, i.e. the income is taxed to the taxpayer, life insurance and its tax advantages make it an excellent investment vehicle within the CLAT.

This article explores the idea of creating a series of CLATS over several years to fund a permanent life insurance contract on a non-MEC basis.

Charitable Lead Annuity Trust Basics

In the case of a CLAT that is treated as a grantor trust, the grantor retains powers which cause the trust to be treated as though owned by the grantor for income tax purposes. The grantor is allowed an income tax deduction in the year the trust is established for the actuarial value of the annuity or income stream to be paid to the charity.

A CLAT is a useful technique that can accelerate a charitable income tax deduction into the year in which the grantor has unusually high income. The CLAT is designed to produce a tax deduction equal to the contribution. The deduction (including cash contributions) is limited to 30 percent of adjusted gross income. Excess income tax deductions may be carried forward for five additional tax years.

Unlike a charitable remainder annuity which needs to pay out a minimum of five percent on the CRT’s value per year, up to a maximum of fifty percent per year, a CLAT, does not face these payout restrictions. The CLAT payout may as little as one percent or as high as 100 percent. The percentage used and the duration of the trust will merely produce a smaller or larger charitable deduction for income and gift or estate tax purposes.

Similarly, the CLAT has a high degree of flexibility in selecting the duration for the lead trust. A lead trust may pay to charity for the life of the donor, for a term of years, or even for the lesser of a life or a term of years. The CLAT does not have a limit for a term of years. A CLAT may be created lead trusts for thirty or thirty five years, with the CLAT remainder to grandchildren at the expiration of that term.

The charitable incomededuction is calculated using the Applicable Federal Rate (IRC Sec 7520 rate- currently 2.2 percent in September 2014) from the current month, or one of the two prior months. Since the payout is fixed with an annuity lead trust, the lower the IRC Sec 7520 rate, the less assumed earnings will accrue to the remainder recipient, and the smaller the taxable gift. Since all split interest calculations use an assumed interest or earnings rate to determine the value of the income interest, and the value of the remainder interest, the most favorable result for a lead trust is to use a low IRC Sec 7520 rate. As a result, the low interest rate environment has favored the use of CLATs for the last several years.

A charitable lead annuity trust pays a guaranteed annuity amount to one or more qualified charities at least annually. The annuity must be paid in all events. It is not permissible to create a lead trust in which the payment to charity is determined by the income earned by the trust. This aspect of the CLAT has spawned the use of the so-called Shark Fin CLAT. The Shark Fin CLAT provides for a minimal fixed and guaranteed CLAT payment to a charity with a large balloon payment in the final year of the CLAT’s term of years.

Excellent attorneys speculate on the legal authority for the use of the Shark Fin CLAT. Some attorneys view the language of Rev. Proc. 2007-45 as justification that the Shark Fin CLAT is a viable strategy. The language of the revenue procedure provides for a need to have a “guaranteed” annuity for term of years or life contingency that is paid annually. The CLAT payments must be ascertained at the time of the transfer without any regard to a minimum or maximum amount or percentage of the contribution. The Shark Fin CLAT meets these requirements based upon the requirements of Rev. Proc. 2007-45.

In the traditionally structured CLAT, there are two primary reasons a CLAT may fail to transfer wealth. First, if the assets of a “zeroed-out” CLAT do not have a total return that exceeds the §7520 rate (currently 2.2 percent), then no assets will remain in the CLAT at the end of the term. The term “zeroed-out” refers to the value of the remainder interest being equal to zero so that there is no value for gift tax purposes on the initial transfer to the CLAT.

Second, even if the CLAT assets have a total return that exceeds the IRC Sec 7520 rate, the CLAT may fail because of the “path of the returns”. In reality, the investment return is not static (a fixed return in every year), varying in some cases from day-to-day over a period of years. From an investment standpoint, the ability to backload the annuity payments in a CLAT allows the trustee to invest in higher volatility (and, theoretically, higher returning) asset classes and strategies.

CLATs and the Impact of the Charitable Split Dollar Rules

Since the CLAT is a grantor trust for income tax purposes, the grantor is taxable on any CLAT income. Advisors have reasoned that life insurance might be a strategic investment within the CLAT due to the inherent tax-advantages of life insurance. The trouble with this planning scenario is the potential application of the so-called charitable split dollar rules of IRC Sec 170(f)(10).

The rules provide that no deduction is allowed if the charitable organization directly or indirectly pays a life insurance premium. Advisors reason that the rules don’t apply because the CLAT is not an organization, i.e. a public charity. Other advisors reason that the rules don’t apply because the CLAT’s ownership and beneficiary status of a life insurance policy is not a split dollar arrangement as defined the treasury regulations.

Most advisors recognizing the issue recommend the purchase of life insurance outside of the CLAT on a single premium basis with the taxpayer contributing a the policy to the CLAT. The policy funded as a MEC allows the policy to accumulate on a tax-advantaged basis. The CLAT’s trustee may take loans to make the CLAT’s escalating payments.

The disadvantage of a life insurance policy that is a MEC within a CLAT is the tax treatment of policy loan or partial surrenders of cash value that are treated as ordinary income to the CLAT.

Some taxpayers may prefer a policy that is a non-MEC (modified endowment contract) which would allow the trustee of the CLAT or the trustee of a family trust in the future, to take tax-free withdrawals from the policy.

Tax Advantages of Permanent Life Insurance

Permanent life insurance provides strong tax advantages. The investment growth of the cash value accrues on a tax-free basis. In a non-MEC policy, the policyholder is able to distribute investment gains from within the policy through low cost policy loans and partial surrenders of the cash value. The investment gain is ultimately paid to the beneficiary as part of the death benefit on an income tax-free basis.

The trustee of the CLAT may take tax-free distributions from the policy each in order to make distributions to the CLAT’s trustee who in turn will use the proceeds to make payments to the Charity.

The range of policy choices include private placement variable life insurance, retail variable life insurance and equity indexed universal life insurance. The crediting rate of the traditional universal life insurance is likely not a good choice in the continuing low interest rate environment.

Cascading CLATs – A Workable Solution

The CLAT regulations and the charitable split dollar issues create a limitation for funding the policy over several years because neither the CLAT nor the charitable lead unitrust (CLUT) provide for ongoing contributions. Overlaying a LLC or limited partnership as part of the CLAT planning structure allows the taxpayer to contribute cash to the CLAT while the CLAT’s trustee makes a contribution to an investment LLC or LP.

The idea is to create a new CLAT for each year that a premium contribution is contemplated in to the policy owned within an investment LLC. The trustee of the CLAT contributes the cash to the LLC or LP in exchange for an interest in the LLC. The managing membership in his capacity as manager causes the LLC be the applicant, owner and beneficiary of the policy. Each subsequent cash contribution in exchange for additional LLC interests provides the LLC with the additional liquidity to complete the LLC funding.

From the perspective of IRC Sec 170(f)(10), the trustee of the CLAT has invested in a LLC that is treated as a security for state and federal law purposes that is not subject to registration.

Each CLAT is designed so that the CLAT payment scheme produces a charitable deduction equal to the amount of the contribution based upon the prevailing IRC Sec 7520 rates.

Strategy Example

Facts

Joe BigSpender, age 55, is the owner of a closely held business in California which has substantial excess income each year. The company’s S corporation status results in the income being taxed at the highest marginal rates for federal and state tax purposes – 53 percent. The company has a large number of employees making a defined benefit plan an expensive solution. Joe has strong charitable inclinations and is willing to make a commitment that helps public charities while helping himself.

Solution

Joe forms a CLAT in Yr. 1 and contributes $1,000,000 in cash. The CLAT provides for a twenty year term. The 7520 rate is 2.2 percent. The CLAT trustee contributes cash to an investment LLC in exchange for an interest in the LLC. The manager of the LLC uses the cash to purchase a second-to-die equity index universal life insurance policy with a $25 million death benefit. The LLC is the applicant, owner, and beneficiary of the policy.

The CLAT provides for an income pattern that provides for an annuity stream that increases by twenty percent each year. The payment in Year is $7,480; Year 5 is $15,510; Year 10 is $38,595; Year 15 is 96,037. The payment in Year 20 is 238,970. The total payments to charity over the twenty years is $1,396,420. The amount of charitable deduction is equal to the contribution amount- $1 million. The deduction is limited to 30 percent of AGI.

In Year 2, Joe creates CLAT #2 and contributes $1 million to the CLAT. The payout design provides for an ascending annuity increasing by twenty percent per year. The amount of taxable deduction is equal to the amount of the contribution. The trustee of the CLAT contributes

In Years 3 and 4, Joe creates CLAT #3 and CLAT #4 respectively. The process outline above is repeated. The trustee accesses cash value using a partial surrender up to the amount of the policy basis in order to make the CLAT annuity payments to the public charity.

At the end of the CLAT term, the policy reverts to the BigSpender Family Trust along with all of the interests of the LLC that were owned by the CLAT. At that point, the policy and all of its future benefits should be received on an income and estate tax basis. The trustee may also make tax-free distributions to trust beneficiaries.

Summary

The cascading CLAT strategy can serve as a supplemental retirement plan while providing a significant charitable benefit over a term of years. The use of life insurance provides for tax-advantaged wealth accumulation and transfer within the CLAT. High income W-2 wage earners (think MDs, lawyers and corporate executives) should consider the CLAT using life insurance as a mechanism to reduce current taxation and provide for future supplemental income while supporting a favorite public charity(ies).

https://www.jdsupra.com/legalnews/the-waters-of-march-the-benefits-of-own-31889/

Overview

We have all heard our share of lawyer jokes. From War of the Roses – “What do you call a bunch of attorneys at the bottom of the ocean”? Answer – A good start!  Everybody hates lawyers except their own and the “piranha” that represented your “Ex”.

As far as commercial welfare is concerned, these are not the best of times for trial lawyers. Personal injury attorneys tell me that insurance companies have been dragging their feet to settle while lawyers representing the insurance company seem to be working for minimum wage. Nobody is happy! However, tomorrow is another day and the next big case is right around the corner.

When that day arrives and a large settlement for the trial attorney is aligned in the trigger hairs, here is a combination of planning techniques to consider in order to maximize retirement planning for the trial attorney.

When the “Good Ship Lollipop” in port, you need to know where and how to get on.

Qualified Retirement Plan Considerations for the Attorney

It is my contention that every business owner would like to have a defined benefit retirement plan providing the business owner does not have to contribute to  the plan for his employees. Qualified retirement plans remain as one of the best tax planning options to reduce corporate and personal income. In the realm of qualified retirement plan considerations, the defined benefit (DB) plan is the option that allows for the largest contribution and benefit. The maximum retirement benefit, under a DB plan in 2013 is $205,000 with maximum compensation of $255,000 being considered. The largest defined  contribution plan contribution is $51,000 in 2013.  Contribution levels can exceed the defined contribution limit by multiples.

In general DB Plans come in two versions – fully insured and traditional. The fully insured DB plan is funded exclusively with annuities and life insurance. The combination of annuities and life insurance produces the largest tax deductible contribution into the plan in most case. At retirement (absent a lump sum payment and rollover to an IRA), the retirement annuity benefits are contractually guaranteed by the life insurer that issued the annuity contracts and life insurance.

Life insurance within the Plan provides pre-retirement death benefit. A guaranteed and fixed retirement benefit is not such a bad thing as the foundation of your retirement income when you consider the multiple precipitous stock market declines over the last thirty years. Similarly, unlike Detroit’s pension plan and those of many states and municipalities that are horrendously underfunded, the fully insured defined benefit plan can never be underfunded.

Regardless of the countless benefits in favor of  fully insured benefit plans, investment advisors who may have a bias against insurance-based solutions from an investment standpoint, may recommend a traditional DB plan or a split funded plan that is funded with investments and insurance. The maximum retirement benefit under the plan is $205,000.

The split funded defined benefit plan is comprised of an investment account along with life insurance to fund a pre and post retirement death benefit for the participant’s beneficiary. The Plan may also include a provision for a disability benefit and a medical account to fund post retirement medical costs.

Did I Tell You that You Do (Not) Need to Contribute for Your Employees!

Congress has passed any number of tax rules designed to prevent business owners from discriminating against their employees in the adoption of pension plans. Part of these rules are the controlled group rules of IRC Sec 414(b) and (c) and affiliated service group rules of IRC Sec 414(m). These rules are designed to prevent the business owner from circumventing the discrimination and participation rules through the creation of multiple entities with fewer or no employees to avoid pension contributions for the employees.

The affiliated service group rules are set up for service businesses such as health, law, accounting, dentistry, engineering, architecture et al. The material determination whether or not a business is a “service business” for purposes of the rules is whether or not capital is a material factor in the production of income. In the case of law, there is no legal uncertainty, it is a service business subject to the affiliated service group rules. The consequence of the affiliated service group rules is treat to aggregate all of the employees into a single group for benefits purposes.

An affiliated service group refers to a related group of employers made up of two or more organizations that both a service and ownership relationship. An affiliated service group falls into three categories – (1) A-Organization Group (A-Org) – Consists of at least one A-Org and a First Service Organization (FSO)  (2) B-Organization Group (B-Org) and (3) Management Group. A FSO must be a service organization (incorporated or unincorporated) who principal business is the performance of services (such as law) as defined in IRC Sec 414(m)(3).

Clear as mud? An A-Org must meet two tests – (1) Ownership Test – An A-Org must have an ownership interest in the FSO. The attribution rules under IRC Sec 318(a) are applicable and (2) The A-Org must regularly perform services for the FSO or is regularly associated with the FSO in the performance of services for third parties.

A “B-Org” meets the following requirements – (1) It performs all of its services for a FSO or A-Org determined with respect to a FSO or both (2) The services must be of a type historically performed by employees in the service field of the FSO or A-Org and (3) 10 percent or more of the organization must be held by highly compensated employees in the aggregate who are highly compensated employees of the FSO or A-Org.

What does this look like in the context of a law firm?  Attorney Smith is the 100 percent shareholder of Smith, PC. Attorney Jones is the 100 percent shareholder of Jones PC. Smith PC owns 50 percent of Smith-Jones Attorneys, LLC as does Jones PC. Smith-Jones, LLC employees six legal secretaries and paralegal s.

In this example, Smith-Jones is a FSO that is regularly associated with performance of services for third parties. Both Smith, PC and Jones PC are members of Smith-Jones, LLC, a FSO (First Service Organization). Smith, PC and Jones, PC are both A-Orgs. Both professional corporations regularly perform services for the FSO, Smith-Jones and is regularly associated with the performance of services with the FSO for third parties. It is an affiliated service group. All of the employees will be aggregated as a single employer for benefits purposes.

The affiliated service group rules are highly restrictive and very complex and difficult to circumvent. importantly, IRC Sec 410(b)(3)(A) provides an important exemption that allows the law firm to exclude the firm’s employees from participation in the firm’s pension plan. This Code section exempts employees that are covered for retirement as well as employee benefits under a collectively bargained agreement that is the result of good faith negotiations with a bona fide labor union.

A qualified defined benefit plan under IRC Sec 401(a)(26) must benefit at least the lesser of (1) At least 50 employees of the Employer or (2) The greater of 40 percent of employees or two employees (or if there is one employee, such employee. IRC Sec 410(b)(3)(A) provides for the legal exclusion from participation in the Plan.

Structured Settlement Annuities and Qualified Settlement Funds (QSF) – A Non-Qualified Pension Arrangement for Trial Attorneys

In Childs v. Commissioner, 103 T.C. 634 (1994), aff’d 89F3d 856 (11th Cir 1996), the Tax Court ruled in favor of an attorney fee deferral arrangement. This decision was the first and only case supporting the right of an attorney to defer contingency fee income. The Court ruled that the attorney did not have constructive receipt of the attorney’s fees because the attorney did not have any right to a fee until the settlement agreement was signed.

Federal tax legislation introduced IRC Sec 409A to the Internal Revenue Code in 2004. This tax legislation deals with the requirements for deferred compensation arrangements. The Treasury Department issued its “Guidance on Deferred Compensation” on December 21, 2004. The FAQ Section of the IRS notice provides that the limitations of IRC Sec 409A do not extend to attorney fee deferral arrangements.

Regardless of the favorable ruling, the structured settlement annuity for trial attorneys that elect to defer all of part of their contingency fee income, has not been robust compared to the market for plaintiffs. In my view, there are several reasons for this- (1) The unattractive investment return and lack of investment flexibility in fixed annuities used in the structured settlement annuity market. (2) The inability to structure contingency in non-qualified (non-personal injury or medical malpractice) cases. (3) The absence of better product and tax planning options. I have previously rather extensively on the use of private placement insurance products

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. A QSF has no statutory time limit within IRC Sec 468B or the treasury regulations in regard to 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 particularly for non-physical injury tort cases.

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.

Structured settlement annuities provide an important form of non-qualified deferred compensation plan. Effectively, the ability for trial attorneys to defer contingency fee income is an IRA or qualified retirement plan without a limit.

I am suggesting that a law firm or trial lawyer coordinate these plan elements into a single integrated and cohesive retirement planning strategy combining the benefits of qualified arrangements (defined benefit, 401(k) and profit sharing) and non-qualified (structured settlement annuity).

Strategy Example

Bob Jones, age 50, is a solo practioner with five employees. Bob has a trial practice including personal injury  and medical practice. Bob routinely  settles medical malpractice cases.  In a good year, his income can double to $1 million or more. In a bad year, his income can be $255,000. His typical compensation is $400,000-500,000.

John has had a late start in his retirement planning and would like to make up for lost time.  With his children’s college expenses behind him and his house paid for, he determines that he must make his retirement his financial priority. John has a half dozen medical practice cases in various stages of trial preparation along with a solid inventory of personal injury cases.

He decides to have his employees covered under a union plan. He forms a split funded defined benefit plan along with a 401(k) and profit sharing plan which allow for flexible contributions.  John’s retirement goal is an income of $410,000.

The defined benefit plan provides for retirement at age 62 and will provide him with a projected retirement benefit of $205,000 per year.  The additional goal will be made up from payments in a non-qualified retirement plan created through the deferral of contingency fees. The pension actuary will create the funding assumptions for the non-qualified component of the plan.

The plan is loaded with ancillary benefits – (1) 100 percent joint and survivor retirement benefit so that Mrs. Jones does not experience any reduction in benefits upon John’s death (2) Pre and post retirement death benefits equal to 100 percent of the monthly retirement benefit.(3) Disability benefits  (4) Post retirement medical and long term care benefits.

In 2013, John expects to settle a medical malpractice income  receives contingency fee income of $1 million so that his total income is  expected to be $1,500,000. John expects able to make a tax deductible contribution of $465,000. He makes a 401(k) contribution of $23,000 as well. His profit sharing contribution is $15,300. The total contribution of $465,000 to his defined benefit plan,  the maximum contribution, to fund his target retirement benefit of $205,000 per year at age 62.

The funding pattern for the DB plan has some flexibility. If John has a bad income year in 2014, he can make a minimum contribution of $24,000 in to the defined benefit plan. The recommended annual contribution is $170,000. The total projected contribution in 2013 is $503,000. He has the option of adding Mrs. Jones as a participant if he desires to increase the level of contribution into the Plan beyond the $503,000 cumulative contribution for John’s account.

John’s engagement agreement with his legal  client has John agreeing to defer receipt of his  of one-half of his contingency fee of $1.5 million – $750,000. The funding target under the non-qualified portion of the defined benefit plan has the pension actuary targeting an amount of approximately $2.7 million at normal retirement age under both plans in order to provide a non-qualified benefit of $205,000 per year on a joint and survivor basis for the lifetime of John and Mrs. Jones.  The total retirement benefit under both the qualified and non-qualified plans is $410,000 per year.

Even if John decides not to utilize the union exemption under IRC Sec 410(b)(3)(A), a combination of plans and cross testing should allow John to receive in excess of 95 percent of the qualified plan contributions.

Summary

The article is designed to make you think about a few things. First, defined benefit plans are the retirement dream of business owners and professional. But for having to contribute for employees, every business owner would have a defined benefit plan in his business. Second, most business owners are unaware of the exemption to exclude workers under IRC Sec 410(b)(3)(A). Third, even if you don’t utilize this exemption, there are a number of plan techniques such as multiple plans and cross testing to skew benefits and contributions in favor of the business owner.

Fourth, defined benefit plan design has the potential to dramatically increase the level of the tax deductible contribution into the Plan. Fifth, the tax rules regarding defined benefit plans now provide for a range of contribution levels to accommodate a bad year. Lastly and most importantly, the trial attorney should be integrating his qualified plan planning together with the non-qualified deferral of contingency fee income towards a singular retirement goal.

The ability of the trial attorney to defer contingency fee income is effectively an IRA or plan without a contribution cap. Use it or lose it!

https://www.jdsupra.com/legalnews/law-and-disorder-rethinking-retirement-86412/

Overview

Large institutional investors including pension plans and endowments and foundations have made significant investments in timberland over the last forty years. These same investors have also made significant investments in agriculture but to a lesser extent. The price per acre of farmland has appreciated dramatically over the last 70 years.  Institutional investment in U.S. timberland is often part of a global timber investment strategy. Needless to say, taxation is an important component in investment restructuring. Taxes represent a direct and significant reduction in the investment return of the investor.

This article is designed to outline an alternative investment structure for foreign investment in U.S. timberland and agriculture. The proposed investment structure is a private placement group variable deferred annuity contract (GAC). This structure is not only less costly but is also dramatically more efficient that the current structures being used by timber investment management organizations (TIMO).

The only problem that the GAC has is a lack of familiarity by TIMOs and the belief by TIMOS and investors alike is that the results are too good to be true. Hopefully, by the end of this article you will conclude that it is true.

Timber and Agricultural Investing

Since the mid-70’s large institutional investors began investing in timberland. This investment coincided with the passage of ERISA in 1974 which required a fiduciary obligation to diversify investments. The investment trend was from fixed income to stocks as well as commercial real estate. The ownership of timberland provided another investment diversification opportunity. Around the same time, forest product companies began to evaluate the strategic role of timberland holdings seeing the opportunity to sell their timberland and invest in wood-processing facilities. Pension funds and endowments and foundations became the logical buyers of this timberland.

Timberland has unique investment characteristics. It provides a hedge against inflation and provides investment returns that are non-correlated with stocks and bonds. Timber is a renewable resource that increases in value as trees mature. Investment returns are generated through timber sales, lease income and land sales. As of 2011 the amount of institutional investment in timberland approached $45 billion.

Agricultural investments have many of the same investment attributes as timberland – current income from leasing activities, crops and capital appreciation. The crops range from permanent cropland types such as almonds, apples, and walnuts. The range of corps can also include grapes, cranberries, pears and wheat. Agricultural investments provide an inflation hedge, and non-correlated investment returns to the stock market and current income.

Current Tax Structuring for Foreign Investment in U.S. Timberland and Farmland Investments.

Sophisticated tax structuring is generally involved in the investment activities of foreign private and sovereign investors in U.S. timberland and farmland investments that generate portfolio income that is subject to withholding taxation and FIRPTA withholding related to the sale of the underlying real estate.

The focus of this investment structuring generally at accomplishes several important tax and non-tax objectives:

1. Avoidance of the need on the part of the foreign investor to file a U.S. income tax return and falling under the scrutiny and jurisdiction of the IRS.
2. Recharacterization of income that would be otherwise subject to taxation at the top corporate rates into interest and dividend income that is subject to lower tax rates under applicable tax treaties with the U.S.
3. Avoidance of withholding for FIRPTA on the underlying real estate
4. Minimization of corporate taxation on the “blocker” corporation structure frequently used as part of this planning.

Taxation of Portfolio Income

IRC Sec 871 provides for a 30 percent withholding tax for fixed and determinable or periodic gains (FADP) unless a tax treaty provides for a lower rate of withholding. IRC Sec 871(h) provides an exemption for portfolio interest income. Dividends are frequently taxed at a 15 percent rate under many treaties.

What is FIRPTA?

FIRPTA introduced a federal withholding system which requires the buyer of the property to deduct and withhold ten-percent of the gross sales price and remit to the federal government within twenty days of the sale. The rules for FIRPTA are found in IRC Sec 897.

When a foreign person engages in a trade or business in the United States, all income from sources within the United States connected with the conduct of that trade or business is considered to be Effectively Connected Income (ECI).

This applies whether or not there is any connection between the income, and the trade or business being carried on in the United States, during the tax year. Taxes are withheld at a 35 percent rate. The foreign taxpayer is taxed according to the graduated rate structure. Corporate taxation at the state level can also apply.

The Standard Offshore Blocker Corporation Arrangement

The standard blocker corporation arrangement focuses more on the need to avoid filing a U.S. tax return and avoid the jurisdiction of the IRS than tax savings. The standard blocker corporation is a low cost arrangement. The standard arrangement involves the creation of a corporation in a jurisdiction that has no corporate taxation such as the Cayman Islands. The blocker corporation invests directly into the private equity real estate fund.

The blocker corporation (rather the foreign investor) is responsible for filing a U.S. tax return and is subject to any withholding taxes under FIRPTA at 35 percent. Additionally, the blocker corporation could also be subject to the Branch Profits tax bringing the effective tax rate to 54 percent.

The investor might avoid the branch profits tax by creating the blocker corporation in a jurisdiction that has a tax treaty with the U.S.  However, the corporation would most likely subject the corporation to taxation in the foreign jurisdiction potentially offsetting any of the benefit of the U.S. blocker corporation.

The Standard U.S. Blocker Corporation Arrangement

A foreign investor may alternatively invest in a U.S. corporation that is taxed as a regular corporation. The U.S. Corporation invests into the fund. As a result, the foreign investor will avoid the need to directly file a federal tax return. Instead, the U.S. Corporation will file any federal or state tax returns that are needed.

Additionally, the U.S. blocker corporation will not be subject to FIRPTA withholding tax treatment. However, the U.S. blocker corporation will be responsible for any federal and state level corporate taxes. The top federal rate is 35 percent and the average state income tax rate is 5-8 percent. As a result, taxation in the blocker corporation could be taxed at a combined bracket of 35-40 percent. After the payment of corporate taxes, dividends distributed to the foreign investor will subject to withholding taxes.

The Leveraged Blocker Corporation

The leveraged blocker corporation is frequently used in private equity real estate transactions. The strategy is designed to convert ECI into portfolio interest which is exempt and dividend income. In the leveraged blocker corporation, the foreign investor invests in a Delaware corporation. The corporation is capitalized with a mix of equity and debt. The common ratio of debt-to-equity is 3:1. It is not uncommon for a fund manager to structure the leveraged blocker corporation as a series partnership or series LLC.  The interest payments reduce taxation at the corporate level.

A separate leveraged blocker exists for each investment or series within the partnership. Otherwise, absent the series partnership or LLC structure, the foreign investor would invest in a separate U.S. corporation for each investment within the fund.

The payout of proceeds from the corporation represents a return of capital, interest and dividends to the foreign investor. The return of capital is paid out income tax-free. Dividends are paid out subject to a 30 percent withholding rate or at a lower rate if available under a treaty.

Principal payments on the debt portion of the capitalization are not subject to withholding taxes. Additionally, the blocker corporation should not be taxed on liquidating distributions from the corporation since the corporation is holding cash from the disposal of real estate and not an interest in other real estate within the partnership. Capital gains taxes are not subject to withholding taxation for foreign investors.

From a cost standpoint, the legal costs in the creation and administration of the leveraged blocker corporation are high. The level of complexity is also very high. .An estimate of legal costs in Year 1 would be than $100,000.

Some of the additional tax considerations impacting the utility of the leveraged blocker corporation include the tax rules dealing with thinly capitalized corporations under IRC Sec 385 and interest deduction rules of IRC Sec 163(j). Generally, these rules seek to limit the ability of corporations and investors from converting operating income into interest income that is either not taxed under a treaty or taxed at lower rates under the treaty.

IRC Sec 163(j) defines excess interest means “interest” that exceeds more than 50 percent of a corporation’s’ adjusted taxable income. The second threshold for these rules is a debt-to-equity of 1.5 to 1. Excess interest in a tax year is carried over into future tax years.

The issue with respect to the use of leverage in U.S. blocker corporation investments with respect to timberland investments and agriculture is the lack of liquidity and relatively low income from these investments in order to make interest payments. Additionally, the blocker corporation is frequently structured with a high level of interest for the purpose of creating tax-free income and high interest payments to reduce corporate taxation at the blocker corporation level. The nature of the cash flows and projected investment return does not support the use of high interest debt at the blocker corporation level. Even in the best case scenario, the corporation will be taxed in the 23-25 percent level for federal purposes with an additional 5-8 percent for state tax purposes.

Private Placement Group Variable Deferred Annuities (GAC)

The GAC is a private placement group variable deferred annuity (GAC) contract issued by a U.S. life insurance company or an offshore life insurer that has made an IRC Sec 953(d) election to be treated as a U.S. taxpayer. The GAC contract is institutionally priced and transparent allowing for complete customization of the investment menu to include multiple real estate investments. The policy may be issued on either a group or individual policy form.

Under state insurance law, separate account investments are expressly authorized on a non-guaranteed or variable basis. The separate account assets belong to and are titled in the name of the insurance company.

Separate account contract holders have no right to receive in kind distributions, or direct the purchase or sale of separate account assets. Ownership and control of separate account assets legally and contractually rest with the insurer. GAC contracts are taxed as a variable deferred annuity under the appropriate provisions of the Internal Revenue Code (IRC Sec 72).

The planning opportunity for foreign institutional investors is the fact that third party life insurers issue the GAC without necessitating a connection to the life insurer, i.e. you don’t have to be doing business with John Hancock in order to utilize this strategy. Policies must satisfy the federal tax requirements for investment diversification and investor control. The separate account is not treated as a separate entity from the insurance company for tax purposes.

Since the assets and liabilities of the separate account belong to the insurance company, any income, gains, or losses of the separate account belong to the insurance company. Changes in the value of the separate account assets are treated as an increase or decrease in tax reserves under IRC Sec 807(b).

IRC Sec. 817(h) imposes investment diversification requirements for variable life insurance and annuity policies. IRC Sec. 817(h) stipulates that a single investment may not exceed more than 55% of the account value, two investments more than 70%, three investments more than 80%, and four investments more than 90%. Therefore, an investment account must hold at least five different investments.

The tax regulations, Reg. 1.817-5 specify that all of the interests in the same real property project represent a single issue for diversification purposes. The regulations allow a five-year initial period for real estate accounts in order to comply with the diversification requirements. The same regulations provide for a two-year plan of liquidation provision in which the fund may be non-conforming with the investment diversification requirements.

The other significant component for U.S. tax qualification is the Investor Control Doctrine. The Investor Control Doctrine has been developed as a series of rulings and court cases.  Under the traditional variable annuity or life contract, the insurer and not the policyholder is considered the owner of the underlying separate account assets.

Taxation of Annuity Income for Foreign Investors

IRC Sec. 871 subjects “fixed and determinable” income including annuities to a thirty percent withholding tax. Article 18 of the Model Income Tax Treaty dealing with pensions and annuities overrides the taxes imposed under IRC Sec. 871.  Article 18 essentially provides that the annuity is not subject to U.S. income and withholding tax.

The annuity income is only taxed in the foreign jurisdiction. Many foreign jurisdictions provide tax advantages to life insurance and annuity income for individuals.  Alternatively, annuity income may be exempt from taxation under treaties as “other income” not specifically defined within the treaty.

IRC Sec. 892 defines the income tax treatment of foreign government entities. IRC Sec 892 provides an income tax exemption to foreign governments that invest in stocks, bonds, and other domestic securities. This income tax exemption does not extend to investment in commercial activities including real estate. However, Reg.1.892-3T(3) defines “other domestic securities “to include annuity contracts. Therefore, annuity income is exempt income for a foreign government entity.

FIRPTA is not applicable in the use of the GAC. The life insurer, a U.S. taxpayer, is the direct investor and owns the investment in its insurance company separate account under state insurance law. The foreign investor does not have a direct or indirect ownership interest in the U.S. real property. The foreign investor is policyholder that is able to receive the pass-through performance of an allocation of premium (investment) in a Timber Account managed by the TIMO.

Therefore, as long as the GAC is a U.S. tax qualified annuity, FIRPTA withholding should into apply. Furthermore, the life insurance company is able to take reserves deduction for any investment income that it receives in its separate account. Additionally, the FIRPTA rules provide for an exemption from FIRPTA withholding when there are no income taxes due.

Strategy Example

Timber Using a U.S. Blocker Corporation

Acme Investment Management is a timber investment management organization investing  in several different U.S. timber markets – Southeast; Northeast and Pacific Northwest. The fund is raising $100 million ($100 million ) from a UK pension plan. The investor will invest $100 million in the U.S timberland.

One structure being considered is a U.S. blocker corporation. The corporation is a Delaware limited liability company that will be taxed as a corporation.  Under the treaty, the dividend payments to the UK pension plan will be non-taxable to the pension plan. The ultimate liquidation of the corporation should also be non-taxable as a capital gain to the pension plan.  The timberland investments will be owned by the corporation and will not be subject to FIRPTA.

The intended timberland investment will produce current income of 5 percent or $5 million per year in  lease income and cutting rights. Acme expects to liquidate the holdings in twenty years with an expected price of $386 million based upon a 7 percent growth rate. The blocker corporation will be in a 35 percent tax bracket for federal purposes and 5 percent bracket for state purposes.

The blocker corporation will pay corporate taxes on income and gains on the timber investments before it makes dividend distributions. The combination of taxes will erode the expected investment return of 12%  by approximately to a net return of 7.2 percent.

The GAC

Acme creates an insurance dedicated fund (IDF) with Corona Life, a Delaware domiciled life insurer, to invest in U.S. timberland. The IDF is structured as a Delaware LLC. The only investor will be Corona Life on behalf of its policyholders and the Corona separate account. The GAC is U.S. tax qualified and will meet all of the requirements of IRC Sec 817(h) and IRC Sec 72.

Based upon the total premium (investment) commitment, Corona charges the policyholders 25 basis points per annum. The total cost per year is $250,000 per year. Over the course of the twenty year life of the fund-the total projected GAC costs are $5 million. The total cost of the GAC is roughly equal to the investor’s tax liabilities using the blocker corporation in the first 2-3 years.

The GAC will not have any withholding for FIRPTA. Under the treaty, annuity income is not subject to U.S. income and withholding taxes. Therefore, neither Acme nor Corona will be required to withhold anything on its distribution.

Assume the same facts as the description above except for the fact, that the GAC structure has no tax leakage. Corona does not have any withholding tax obligation on the income distributions of  any of the annuity payments or at liquidation of the investments. Corona is not subject to withholding under FIRPTA on the sale of the real estate.

Summary

In the area of foreign investment in U.S. real estate, the use of the standard blocker corporation is an ‘old trick” for foreign investment in U.S. real estate.

The GAC provides better tax results by large measure than either of the two techniques. The use of the GAC with timberland  is a new structure for foreign investors but is well known because of Hancock Natural Resource’s use for tax exempt investors.

The tax treatment of variable annuities is reasonably well settled.  The GAC converts income that would otherwise be subject to withholding under FIRPTA and ECI into “annuity” which under most tax treaties is not subject to U.S. income and withholding taxes.

The next time that a timber investment management organization decides to create a new fund for foreign investors in U.S. timberland or agriculture, consider the GAC as an investment structure that can dramatically enhance the after-tax return of the foreign investor.

https://www.jdsupra.com/legalnews/seeing-the-forest-through-the-trees-43394/

Overview

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.

Non-Grantor Trusts

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) .

Strategy Example

Facts

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.

Strategy Implementation

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.

Summary

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.

https://www.jdsupra.com/legalnews/tales-from-the-crypt-post-mortem-plan-05338/

Overview –

Trial attorneys are extremely vulnerable to a tax landscape that is becoming hostile territory. The result of the American Taxpayer Relief Act of 2013 (ATRA) is that earned income is taxed at substantially higher rates than investment income. It is certain that is not how most high income taxpayers spell “R-E-L-I-E-F.” The top marginal income tax rate increased to 39.6 percent. The phase out of personal exemptions and miscellaneous itemized deductions could effectively add another 2 percent to the marginal bracket. State marginal tax brackets can increase taxation 7 to 10 percent to a total marginal bracket of 50 percent.

The long-term capital gains rate increased to 20 percent and most states tax capital gains as regular income. Additionally, as a result of the 2010 health care legislation, many high-income attorneys in 2013 will face the impact of a new Medicare 3.8 percent tax on investment income. Fortunately, the estate tax changes provided some solace. Although the top rate rises from 35 to 40 percent, a still higher 55 percent rate would otherwise have come back into effect, and ATRA leaves the exemption equivalent at $5.2 million per taxpayer. All in all, however, high-income attorneys have plenty of incentive to try to reduce the taxes they will owe when they earn large contingency fees.

Please see full alert below for more information.

https://www.jdsupra.com/legalnews/structured-settlement-planning-for-trial-95213/

Overview

High net worth and income taxpayers find themselves in a world of hurt following tax reform at the end of 2012. The top marginal bracket for taxpayers with more than $400,000 (single and $450,000 married) increased to 39.6 percent. Taxpayers with adjusted gross income in excess of $250,000 will pick up an additional 3.8 percent on unearned income raising the top marginal bracket to 43.4 percent.

These same taxpayers will also be exposed to the phase out of personal exemptions and miscellaneous deductions. These phase outs effectively raise the marginal bracket by 1-2 percent. Taxpayers in the top marginal bracket will end up with a top federal bracket of 45.4 percent. High income states such as New York and California add an additional 8-10 percent bringing taxpayers to a combined marginal tax bracket of 53-56 percent.

While the federal estate tax exemption did not fall to $1 million, the federal estate tax is alive and well with an increase in the top rate to forty percent. The income taxation of trusts adds additional pain to the taxpayer with investment  income during the settlor’s lifetime  taxed to the settlor and  at the death of the settlor when the trust loses its grantor trust status, a trust reaches the top marginal tax bracket with only $11,950 of income.

This article focuses on the Intra-Family Loan,  an tax and estate planning technique that is not well known and even less frequently implemented. The common notion of the Intra – Family Loan is the lending of cash by the senior generation to a junior generation. As a practical matter assets other than cash can be the focus on an Intra – Family Loan. How many times did you borrow something other than cash from a brother or sister (with or without interest depending upon whether or not it was a big brother or sister.

Intra-Family Loans

The typical intra-family loan is a cash loan between family members. Usually the loan is between the senior generation as lender to a junior generation as the borrower. The loan arrangement is captured in a promissory note with or without security for the loan.

In order to avoid the tax rules for below market interest rate loans under IRC Sec 7872, the minimum interest rate for the loan must be equal to or greater than  the applicable federal  rate based upon the length of the loan. The current AFR for short term; mid-term and long term loans for March 2013 is as follows:

Term                          Time Period                                  Rate

Short Term              3 years or less                                .22%

Mid-Term                Less than 9yrs (greater than3)      1.09%

Long Term               More than 9 yrs                             2.63%

The low interest rate environment makes the Intra Family Loan an ideal estate planning strategy.

The traditional advanced estate planning technique of a “ Sale to an Intentionally Defective Trust”  is related to the Intra-Family Loan. The strategy is a highly effective estate freeze technique. The technique typically involves the down payment of an asset by the trustee of an irrevocable family trust and purchase of a capital asset on an installment basis.

The interest rate on the installment note is equal to at least the AFR. The sale is not taxable to the grantor because of the application of the grantor trust rules. Additionally, the interest payments under the installment note are non-taxable.

The Intra-family loan may be a more accessible technique to certain types of asset classes than the sale to a grantor trust. Certainly, it could be used to finance the purchase of a family start up business or to finance the purchase of a home by a child. Why couldn’t a high net worth taxpayer make a loan of an “in kind asset” such as land or an art portfolio.

The Intra Family Loan could provide for the capitalization of the interest and principal that can be repaid at death. The purchase of life insurance might be considered as a mechanism to provide the liquidity for repayment upon the death of either the lender or borrower..

The potential leverage between historically low AFRs and the rate of return of an asset or portfolio makes the Intra Family Loan a simple and straight-forward estate freeze technique.

The technique is further enhanced when private placement insurance products are thrown into the planning mix.

Strategy Example #1

Facts

John Smith, age 60, is a high net worth investor. His portfolio has generated an 8 percent annual return over the last ten years. He has $10 million invested in hedge fund strategies and would like to maximize the tax advantage of his investments for both income and estate tax purposes. He is an a combined marginal tax bracket of 50 percent (39.6 Fed+3.8% Medicare +7% state). John and his wife utilized both of their estate tax exemptions in 2012.

Strategy

John makes a loan to his Family Trust. The terms of the loan provide for a loan of $5 million at the long term AFR for March 2013 – 2.63%. The loan is a 29 year loan that provides for the capitalization of interest and principal, i.e. any accumulated interest and principal will be paid at the end of the loan term. The loan will be an unsecured loan.

Additionally, the loan has a self-canceling feature. The self-canceling feature adds an additional risk premium of $4.85 million that will be added to the principal at the time of repayment at death or repayment. Additionally, the accumulated interest due at repayment in Year 29 is  $11.2.  million. The total repayment is $26.05 in Year 29.

The trustee of the Family Trust purchases a single premium PPLI contract insuring John’s life. The initial premium is $10 million and the initial death benefit is $35 million. The policy is a MEC. In Year 29, the projected cash value assuming a net return of 8 percent within the policy is $71.5 million. The projected death benefit is $73 million which will be paid to the Trust income and estate tax free to the family trust.

In the event of death before the repayment of the Note in Year 28, the accumulated interest ($11.2 million) is treated as income to John’s estate for its final income tax return. Any unrecovered principal amount and risk premium are taxed to the estate on a capital gain basis.

The interest taxed at ordinary rates (39.6 percent  plus 7 percent state) creates a tax liability of $5.2 million. The taxation of the unrecovered principal amount and premium  is 27 percent rate (20 percent  federal and 7 percent state) creating a tax liability of $4 million. The combined income tax liability is $9.2 million.

The Intra Family Loan leveraged with PPLI has resulted in an income and estate tax free payment of $73 million in Year 30. The leverage in the Intra Family Loan combined with private placement life insurance has created an investment windfall of nearly $65 million over the loan period.

The loan without the benefit of a benefit of PPLI would have accumulated $93 million. The difference is the income tax payments at 46% made by the settlor over the same time period. The tax drain to John and the family in income tax payments due too the grantor trust rules  is substantial over a 29 year period.

The projected tax payments invested at the same investment rate of 8 percent would accumulate to $35-40 million over the same time period. The use of PPLI at a cost of approximately one percent of the investment return provides this level of tax savings for the family over the life of the loan.

Summary

The Intra Family Loan is a technique that receives little attention. In general, it is less complicated than many other advanced estate planning technique. What is not complicated is the idea that if you can borrow money at the long term AFR and earn an investment rate of return on a tax-advantaged bas in excess of the long term AFR, outside of the taxpayer’s estate, the taxpayer wins by a landslide.

The historically low interest rates in the current environment provide unprecedented opportunities to generate and conserve wealth. Combined with the tax-advantaged treatment of life insurance, the Intra-Family Loan is an opportunity to turbo charge the return for both income and estate tax purposes.

1. Taxation of Grantor Trusts

The tax rules for grantor trusts are found in IRC Sec 671-679. Grantor trusts have been a mainstay of advanced tax and estate planning for the last 15-20 years using a number of advanced techniques. Advanced planning has focused on the combination of the use of tax valuation planning techniques such as family limited partnerships and family limited liability companies (LLC) with the sale of those limited partnership or LLC interest to a grantor trust.

Under the grantor trust rules, the trust settlor is considered the owner of trust assets for income tax purposes. As a result, all trust income and losses flow through the trust to the settlor. The trustee is able to accumulated assets without any depletion for income tax purposes. The grantor or settlor’s payment of the income tax liability is not considered an additional gift to the trust.  At the same time, the trust assets are outside of the settlor’s taxable estate.

The sale to a grantor trust is an outstanding estate freezing technique. In the typical sale to a grantor trust, the taxpayer sells capital assets to the grantor trust. The sale results in no gain to the Seller. The Seller is the settlor of the trust. The sale is usually made on an installment basis with the interest rate on the note set at the long term applicable rate. Interest rates have been at historically low rates for the last 5-7 years.. In the event the trust, sells the underlying asset, the taxable gain is reportable to the settlor and paid by the settlor. The settlor’s estate is reduced by the amount of the tax liability. The trust corpus has not been eroded.

Virtually any estate planner on the Planet would agree that the tax results associated with the sale to an intentionally defective trust aka grantor trust, are outstanding. The author agrees with everyone else. However, the author believes that the tax results are greatly enhanced even more if the grantor does not have to reduce his taxable estate by the amount of the annual income tax.

The likelihood of increased marginal tax rates at both the federal and state level along with an increase in the capital gains tax make the benefits of tax-advantaged compounding even more compelling.

1. Taxation of Non-Grantor Trusts

Trusts that are not taxed as grantor trusts are taxed as separate taxable entities. In general, marital trusts and most testamentary trusts are non-grantor trusts. Most asset protection trusts are also non-grantor trusts for income tax purposes. Unfortunately, it takes very little investment income to push a non-grantor trust into the top marginal tax bracket- $11, 200.

Many wealthy families have generation skipping trusts that are taxed as non-grantor trusts. A non-grantor trust is a trust that does not fall within any of the provisions of IRC Sec 671-679. The necessary trust provisions in order to classify a trust as a NGT is retention of a power by the settlor to name new trust beneficiaries or to change the interest of trust beneficiaries except as limited by a special power of appointment (ascertainable standard). The settlor’s transfer to a trust with this power renders the transfer an incomplete gift for gift tax purposes. The second method to avoid grantor trust treatment is to require the consent of an adverse party on any trust distributions.

The major focus of this article is tax-advantaged wealth accumulation across multiple generations. Many wealthy families and family offices have multi-generational planning as a component of their tax planning. It makes a lot of sense to reduce the “drag” of income taxation along with the avoidance of future estate and generation skipping transfer taxation.

https://www.jdsupra.com/legalnews/the-family-loan-shark-leveraging-the-a-85522/

I Overview

I am sure every trial attorney remembers his or her first trial and the first large verdict or settlement that represented the financial breakthrough , i.e. the day that everything changed financially and professionally.

Unfortunately, it is human nature to believe that success is the result of our own professional efforts without any assistance. Law firms are not immune to this problem. Law firms in general and particularly plaintiff’s firms are made up of mix of two different types of lawyers. One set of partners has excellent business acumen and business development skills. The other set of partners has excellent legal skills. Behind the scene of the law firm is a staff of excellent staff of professional and administrative support personnel who have a tremendous ability to put the case and evidence together for litigation. The settlement or verdict is the result of a team effort and not the result a single person’s efforts.

This article is designed to discuss the ability and importance of plaintiff’s firms to attract and retain key personnel – partners, associates, and key litigation staff in the plaintiff’s law firm. The article outlines a supplemental retirement plan as a long-term plan to ensure the retention and financial security of key personnel in the plaintiff’s law firm (Law-SERP or Law- Supplemental Executive Retirement Plan). The mechanism to finance the supplemental plan is the contingency fee which is the financial engine of the plaintiff’s law firm. The Law-SERP is a plan that supplements the firm’s qualified retirement plans.  I have discussed throughout this series that qualified retirement plans provide a small degree of long-term financial security due to the regulatory constraints of these plans.

II The Approaching Tax Storm

The tax environment for high income tax payers is set to undergo a substantial change in a few months. 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 rate by 1-2 percent. State marginal tax rates can add another 4-10 percent to the overall tax rate. What all of these changes mean is that many trial attorneys will have a combined marginal tax rate in excess of 50 percent.

III The Limitation of Qualified Retirement Plans

The current economic environment has placed a strangle hold on many law firms and their ability and commitment to make contributions to employer-sponsored retirement plans. As a result, many law firms have limited their qualified retirement plan to a 401(k) plan which allows a firm employee to defer up to $17,000 on a pre-tax basis with a catch up contribution of $5,500 for employees over age 50. The firm may make matching contributions of fifty cents on each dollar contributed to the plan or a dollar-for-dollar matching contribution up to three percent of the employee’s earnings.

The same regulations that provide for non-discrimination regarding participation and contributions are the same regulations which limit the ability of a law firm to provide meaningful long-term benefits not only for retirement but other important milestone obligations – children’s college education or  the purchase of a home or second home. As a result, the plaintiff’s law firm is in a unique position to provide exceptional long-term financial security for key personnel – lawyers as well as paralegals.

Unlike a qualified retirement plan arrangement, the Law-SERP with respect to the trial attorney does not have a cap on contributions to the non-qualified plan or a limit on the amount of trial attorney income that can be considered. The rules do not have minimum contribution or participation rules for other employees of the law firm. The non-qualified arrangement does not have early withdrawal penalties for distributions made before age 59 ½. The QSF does not have minimum distribution requirements at age 70 ½.

IV What is the Law-SERP?

The Law-SERP is a non-qualified deferred compensation arrangement or supplemental retirement plan for plaintiff’s law firms. The Plan is a contractual arrangement between the law firm and a group of key employees (lawyers and paralegals) to provide supplemental benefits over and above the firm’s qualified retirement plan and benefit plans. The cost of the Law-SERP is informally funded by contingency fees that are deferred from case settlements and verdicts. Contingency fees payable to the law firm will be deferred within  a Qualified Settlement Fund (“QSF”) whenever it can be used or an assignment company. The plan will also allow partners to defer their compensation as part of the Law-SERP.

The goal of the Law-SERP is to provide certain key members of the firm with supplemental retirement and compensatory payments along with death benefit payments. The Law-SERP provides for funding levels that go well beyond the limitations of ERISA-based plans and a vesting schedule that serves as a “golden handcuff” to key firm members that participate in the Plan. The Plan provides for a forfeiture of benefits if an attorney or key employee terminates employment prior to a specified age or goes to work for a competing firm or an attorney becomes a key competitor.

Under the Law-SERP, the participants are not taxed on benefits until the participant actually receives a distribution from the plan. The Plan benefits will grow on a tax-deferred basis through the use of private placement variable annuities and life insurance as the funding vehicles within the Plan.

Generally speaking, non-qualified deferred compensation arrangements in traditional law firms would be funded with after-tax dollars due to the corporate structure of most law firms. Many firms are structured as limited liability partnerships (LLP) which are pass-through entities for tax purposes. The contingency fee nature of the Plaintiff’s law firm and the ability to structure these fees for payment on a deferred basis places these law firms in a unique situation.

V Basic Requirements for the Law-SERP

The foundation of the  Law-SERP is a firm resolution authorizing a legal agreement between the firm and participating employees within the firm. The agreement specifies promises by the firm to make specified payments upon the occurrence of certain triggering events such as death, retirement, long-term disability as non-traditional events such as down payment for a purchase of a home, college tuition of children). These payments are conditioned upon the continuing services of the attorney or employee. The firm’s resolution notes the importance of the employee to the firm.

A second firm resolution authorizes the purchase of private placement variable deferred annuities (PPVA) or private placement life insurance (PPLI) to indemnify the firm for the significant costs it will incur at the death of the employee before retirement. The managing member of the firm and the participating employee together sign the deferred compensation agreement. The assets to fund the plan are held in the QSF. The firm files a one-page ERISA notice which is filed with the Department of Labor.

The funding assets technically remain on the firm’s books as a firm asset subject to the claims of the firm’s creditor. However, in many respects the QSF functions as a form of Rabbi Trust which has been traditionally used in corporate non-qualified deferred compensation arrangements. A separate article in this series will discuss the jurisdiction for the trust.

II   What is a Qualified Settlement Fund (QSF)?

QSFs are trusts that are designed to resolve litigation and satisfy the claims of the litigation or 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 could 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.

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 to work out the details of their distribution.

V Taxation of the QSF

A QSF is taxed on its modified gross income at the maximum income for estate and trusts. The top marginal tax bracket for trusts in 2013 will be 39.6 percent not including state taxation which can easily add another 4-10 percent to the tax rate.

Amounts transferred to the QSF do not include amounts transferred to resolve the claim for which the QSF was established. Additionally, the investment income from public utilities and federal, estate and municipal securities under IRC Sec 115 is also excluded. A QSF may take deductions for its administrative costs, investment losses. Distributions of cash or property are excluded from the QSF’s gross income.

When a QSF makes a distribution to a claimant, the QSF will obtain a release from that claimant. The QSF must file an annual tax return on or before March 15 of the year following the close of its taxable year.

VI Private Placement Life Insurance and Variable Annuities

Previous installments in this series have discussed ad nauseam the benefits of private placement insurance products – institutional pricing, unlimited investment flexibility and the tax advantages of life insurance and annuities.

VII   Strategy Example

A. The Facts

Joe Smith, age 50, is a partner is a plaintiff’s law firm Smith Associates, LLP. The firm is established as a Delaware limited liability partnership. The firm has five partners including Joe and five associates. The firm also has five paralegals that provide important litigation support. The firm is expecting a $10 million dollar contingency fee this year from a product liability case that is expected to settlement before year’s end.

The firm currently provides a 401(k) plan and provides matching on a dollar-for-dollar basis. Joe and his fellow partners would like to create a non-qualified retirement plan that provides long-term financial security for key personnel for the following contingencies – long-term disability, death and retirement. The partners would also like a plan that will provide distributions for key lifetime events such as the purchase of a home as well as tuition payments for children.

The partners would like a plan that serves as a “golden handcuff” for plan participants by requiring them to remain with the firm at least twenty years while preventing plan participants from working for competitors by terminating benefit payments. Benefits are 100 percent vested in the event of death or long-term disability.

Firm  Census

Name                              Position          Earnings                   Years of Service

Joe Smith                       Partner          $2 million                        10

Bob Jones                       Partner          $1.75 million                   10

Alex Johnson                 Partner          $1.25 million                     7

Maria Gonzalez             Partner          $750,000                            5

Mary Axelrod                Paralegal        $100,000                           5

Sally Pearson                Paralegal        $100,000                           5

Eddie Rodriguez            Associate       $225,000                           5

Sy Goldstein                  Associate        $375,000                           5

B.Solution

The firm seeks to adopt the Law-SERP as a non-qualified deferred compensation solution for key partners, attorneys and paralegals within the firm. The firm will initially invite all five partners, two associates that have been with the firm at least five years and two key paralegals that have been with the firm at least five years into the Plan.

The Plan provides for retirement, long-term disability, and a death benefit provisions. The plan is a defined contribution style of plan that will provide for plan contribution equal to 100 percent of the participant’s earnings in the current year. The plan will also have a schedule of contributions based upon the amount of contingency fee deferral made by the firm. The plan will provide for a vesting schedule that provides for 50 percent vesting after ten years of service with the firm and 100 percent vesting after twenty years with the firm.

Plan participants will forfeit benefits if they leave the firm to work for a competing law firm during this time period. Agreements not to compete may be unenforceable in the legal industry but should not affect the termination of benefit payments pursuant to a non-qualified deferred compensation agreement. The Law-SERP’s non-compete provisions do not relate to a lawyer’s ability to practice law but terminate benefit payments under the non-qualified plan of the former firm.

The will also provide for long-term disability payments of the participant’s account balance over a ten year period following an elimination period equal to the elimination period under the firm’s long term disability program. The Law-SERP provides for a lump sum death benefit to a designated beneficiary of the plan participant equal to 10 times earnings in the current year.

The trustee of the QSF purchases private placement life insurance insuring the life of each plan participant in order to fund the death benefit provisions of the plan. The life insurance will also serve as the funding vehicle for payment of future benefit distributions. The insurance will provide for tax-free accumulation of investments within the QSF. The policy is structured as an endorsement split dollar arrangement with each participant. The QSF is the applicant, owner and beneficiary of the policy. The trustee of the QSF has an interest in the policy cash value and death benefit equal to the greater of cash value and premiums. The excess death benefit is endorsed to the plan participant who may irrevocably endorse the plan’s death benefit to an irrevocable trust.

The plan participant will have reportable taxable income each year for the economic benefit of the death protection under the plan. The economic benefit is measured by the term insurance cost of the death benefit. The amount of taxation is minimal compared to the participant’s benefits under the plan.

The trustee will be able to access the policy cash value to make plan distributions for lifetime contingencies or alternatively, use the life insurance as a cost recovery vehicle in order to reimburse the firm for its costs under the plan.

Summary

The Law-SERP is a unique deferred compensation plan designed for the Plaintiff’s law firm. The plan is able to use pre-tax dollars from contingency fees that are structured for deferral using Qualified Settlement Funds or assignment companies to finance the benefits of the law firm with its participating attorneys and firm employees under the agreement. The agreement provides for flexible and substantial plan benefits for death and retirement as well as specialized distributions for college education and the purchase of a home (or second home). More importantly, it can overcome the ability to use “golden handcuffs” with plan participants by cutting off substantial benefits for the attorney or key paralegal that is looking to walk across the street to work for the firm’s biggest competitor.

The next several installments  will focus on different aspects of the Law-SERP. Stay tuned!

https://www.jdsupra.com/legalnews/tax-reduction-and-deferral-strategies-fo-83373/