In 2010, the former $100,000 AGI limit to convert an IRA to a Roth IRA was permanently repealed.  No matter their age or income, anyone with an IRA has the option to convert it to a tax-free Roth IRA, at any time, as long as the income taxes on the conversion are paid.

Often, younger taxpayers in their 30’s or 40’s who have not yet accrued large balances in a traditional IRA are tempted to make the taxable conversion.  This is because all future growth and future normal retirement distributions from the Roth IRA will be tax-free.  Younger clients with 401(k) accounts who “separate from service” of their employers may choose to transfer the 401(k) funds to a traditional IRA and then convert this IRA to a Roth IRA.

Older and wealthier clients in their 60’s or 70’s with large IRA balances may be looking for ways to efficiently finance the payment of large income taxes due upon a conversion from their IRA to a Roth IRA.  This requirement to pay the income taxes in the same year as the conversion takes place is a major stumbling block, and often, wealthier IRA owners with large balance IRAs will keep their IRA and not take any action.

Is there a method where a Roth IRA conversion can be financed and allow clients to achieve the dream of unlimited tax-free income for their family over an extended period?  The answer is yes, and life insurance provides the key to unlocking the golden door to a tax-free future for a surviving spouse and family.

Basic Roth IRA Conversion Rules

• The former $100,000 AGI limit to convert an IRA to Roth has been permanently repealed.
• For those that wish to convert an IRA to a Roth IRA, 100% of the income tax due upon conversion is due in the same tax year as the conversion takes place.
• Part or all of a traditional IRA may be converted into a Roth IRA.  For retirement planning purposes, individuals may wish to keep part of the IRA in an IRA and convert only part of their funds into a Roth IRA for more extended estate planning purposes.

Step-by-Step Procedure for a Married Couple to Achieve a Tax-Free Conversion   

1. IRA owner names spouse as IRA beneficiary.  The owner must take required minimum distributions (RMD) from the IRA upon reaching age 70 ½ until death.
2. IRA owner buys a no-lapse Universal Life (UL) policy on his/her life and names the spouse as beneficiary of the policy.  If desired, the IRA owner may allocate any after-tax RMDs for premium payment.
3. At the death of the IRA owner, the surviving spouse first executes an IRA to IRA spousal rollover.  This rollover is accomplished with no tax consequences.
4. Then, the surviving spouse converts all or part of the spousal rollover IRA into a Roth IRA.  The spouse names the children/grandchildren or trusts as the beneficiary of the new Roth IRA account(s) for their benefit.
5. The spouse receives the life insurance death proceeds income tax-free.  The proceeds paid to the spouse qualify for the federal estate tax marital deduction.
6. The spouse uses all or part of the tax-free insurance death benefit to pay the income taxes on the Roth IRA conversion.
7. The spouse is now the owner of a Roth IRA and, if needed, may take tax-free distributions from the account.  There are no required distributions while the spouse is alive.
8. At the spouse’s subsequent death, the balance of the Roth IRA is included in the gross estate. With proper planning, a no lapse SUL survivorship life policy owned by an ILIT could have been purchased and allocated while both spouses were alive to offset any second death estate taxes.
9. The beneficiaries of the Roth IRA (children/grandchildren or trusts for their benefit) have two distribution choices to receive the “inherited Roth IRA”.
   1. Choice #1 is the so-called “5-year rule” … that is, the Roth IRA account must be completely distributed within five years after the death of the IRA owner.
   2. Choice #2 is the “life expectancy rule” … that is, the account can be paid out annually over the life expectancy of the beneficiary using the Single Life Table factor if RMDs start no later than December 31^st of the year after the death of the Roth IRA owner.  When a trust is the beneficiary of the Roth IRA, the trust beneficiary with the shortest life expectancy will be the measuring life for annual RMD distributions to that trust.  The trustee will then distribute tax-free Roth IRA distributions to the trust beneficiaries each year, and issue trust K-1 to report the tax free income.

The 3 Phases of IRA and Roth IRA Account Management

Phase #1 During the lifetime of the IRA owner, RMDs are distributed according to the Uniform Lifetime Table

Phase #2 At the death of the IRA owner, the surviving spouse completes the Roth IRA conversion process (see conversion sequence above) using the life insurance proceeds to pay income taxes due upon the conversion.  No RMDs from the Roth IRA are required for the remaining lifetime of the spouse.

Phase #3 Roth IRA beneficiaries receive income tax-free distributions either according to the “5-year rule” or the “life expectancy rule”.  If the life expectancy method is chosen, the Single Life Table will determine the length of the tax-free RMD payout based on the life expectancy of the beneficiary.  Children could easily have a life expectancy of 25 to 35 years, and grandchildren could easily have a life expectancy of 50 to 70 years depending on the facts of the case.  100% of the “inherited Roth IRA” RMDs over that extended period will be INCOME TAX-FREE!!

BSMG can provide competitive annuity products to fund both regular IRAs and converted Roth IRAs.  Moreover, BSMG can provide access to many of the top no lapse UL and no-lapse SUL carriers to efficiently finance the payment of income taxes and/or estate taxes.  The tax-free financial leverage of using life insurance to finance the Roth IRA conversion plan will enhance the net after-tax inheritance for your client’s family.

Russell E. Towers  JD, CLU, ChFC
Vice President – Business & Estate Planning
Brokers’ Service Marketing Group

russ@bsmg.net

The post IRA Conversion Rules: Using Tax-Free Life Insurance to Convert an IRA Into a Tax-Free Roth IRA appeared first on BSMG.

IRS issued Final Regulations in April 2002 on required minimum distributions (RMD) from IRA accounts which are Defined Contribution accounts such as mutual funds, deferred annuities, and bank CDs.  You simply determine the account value from December 31^st of the prior year and divide that amount by the annual attained age factor from the Uniform Lifetime Table (Treasury Regs. 1.401(a)(9)-5)

In June 2004, IRS issued Final Regulations on RMDs from IRAs which are considered to be Defined Benefit accounts.  Included under these Defined Benefit accounts are Single Premium Immediate Annuity (SPIA) IRAs that provide guaranteed settlement options.  For SPIA IRA settlement options starting ON or AFTER the required beginning date of the participant (age 70 ½), Treasury Regs. 1.401(a)(9)-6 provide that RMDs must be paid in periodic payments at least annually for the participant’s life.  As an alternative, the SPIA IRA settlement option payments can be paid over a period certain that is not longer than the participant’s life expectancy factor from the Uniform Lifetime Table for RMDs.

Let’s take a look at some simple case examples of how these defined benefit IRA and defined contribution IRA regulations would work when a client wishes to plan for retirement income:

Case Example #1:

Assume a participant owns an IRA deferred annuity contract and reached the required beginning date for RMD (age 70 1/2).  The IRA owner desires a guaranteed income stream funded by an SPIA rather than a deferred annuity or mutual fund.  What SPIA IRA settlement options are available?

• An annuity settlement option payable for life only.
• A period certain settlement option payment of NOT more than 27 years (the Uniform Lifetime Table factor for attained age 70 is 27.4).
• An annuity settlement option payable for life and guaranteed for a period certain of NOT more than 27 years.

Case Example #2: 

Assume a 77-year-old participant owns an IRA mutual fund account and has been receiving RMDs based on the Uniform Lifetime Table.  The 77-year-old now wishes to transfer the funds to an IRA funded by a guaranteed SPIA.  What SPIA IRA settlement options are available?

• An annuity settlement option payable for life only.
• A period certain settlement option payment of NOT more than 21 years (the Uniform Lifetime Table factor for attained age 77 is 21.2).
• An annuity settlement option payable for life and guaranteed for a period certain of NOT more than 21 years.

Case Example #3:

Assume a 65-year-old participant owns an IRA deferred annuity contract and wanted to transfer the account to an IRA funded by a guaranteed SPIA.  Current age 65 is PRIOR to the required beginning date of 70 ½.  What SPIA IRA settlement options are available?

• An annuity settlement option payable for life only.
• A period certain settlement option payment of NOT more than 32 years (the Uniform Lifetime Table factor for age 70 (27.4 years) PLUS the excess of age 70 over the age at the annuity starting date (age 65) = 5 years.  Thus, 27.4 + 5 = 32.4).
• An annuity settlement option payable for life and guaranteed for a period certain of NOT more than 32 years.

Case Example #4:

Assume a participant owns an IRA deferred annuity contract and reached the required beginning date for RMD (age 70 ½).  However, rather than selecting an annuitized settlement option, the IRA participant wishes to take annual withdrawals from the IRA deferred annuity to satisfy RMD requirements. 

• Determine the December 31^st account value of the IRA deferred annuity contract each year and divide by the attained age Uniform Lifetime Table factor: Age 70 is 27.4, Age 71 is 26.5, Age 72 is 25.6, Age 73 is 24.7, etc.
• Keep in mind that you can always take out more than the RMD from a defined contribution IRA account such as a deferred annuity IRA or mutual fund IRA.          

Often, the retirement needs of an IRA owner will need to be matched to their financial circumstances which can change over time.  BSMG offers SPIA IRAs with guaranteed income and deferred annuity IRAs with income riders from many competitive carriers.   Contact your BSMG Annuity Advisor to discuss case design solutions that can fulfill the retirement needs of your clients.

Russell E. Towers  JD, CLU, ChFC
Vice President – Business & Estate Planning    
Brokers’ Service Marketing Group

russ@bsmg.net  

The post SPIA Settlement Options Can Provide Guaranteed Income appeared first on BSMG.

President Obama has released his “Greenbook” budget proposal for fiscal year 2017.  It renews a number of items from past budget proposals.  The Republican Congress will disagree with many of the proposals based on statements from Republican leaders in both the Senate and the House.  Certain broad subjects may offer a chance for compromise, especially in the area of corporate tax reform.  Others are “dead on arrival” as some Republicans have already stated in the media.  Chances are that tax gridlock will continue in Washington during the election year of 2016 as the Obama budget proposal and the Republican Congress appear to be far apart politically.

Here is a summary of the 2017 budget proposals that would have an effect on income taxes, estate planning, and retirement planning:

Income Taxes and Capital Gains Taxes

• The Administration proposes to reduce to 28% the value of certain deductions for taxpayers in the 33% bracket or higher.  This would affect (1) all itemized deductions (2) any tax exempt bond interest (3) health insurance costs of self-employed individuals (4) employee contributions to defined contribution retirement plans and IRAs.
• An increase in the top long term capital gains and qualified dividends rate from 20% to 24.2%.  Combined with the current 3.8% tax for certain high earners on passive income, this would increase the top effective rate to 28%.
• The proposal seeks to limit the exceptions to the transfer for value rule for transfers of life insurance policies.  This may cause part of the death benefit to be taxable income.  For a transfer to a partner of the insured, a transfer to a partnership in which the insured is a partner, and a transfer to a corporation in which the insured is a shareholder, the exceptions to the transfer for value rule would apply only if the insured is a 20% or more owner in a partnership or a corporation.  LLCs are considered to be partnerships for purposes of the transfer for value rule.
• The budget proposal would impose new reporting requirements for sales of insurance policies to life settlement companies with death benefits of $500,000 or more.  Upon sale, the buyer would be required to report the purchase price, the buyer and seller’s identity, and the insurance carrier and policy number to: (1) the IRS (2) the insurance carrier and (3) the seller.

Estate and Gift Taxes

• The proposal would permanently reinstate the 2009 estate and gift tax exemptions and rates (i.e. 45% estate and gift tax rate, $3.5 million estate tax exemption, and $1 million gift tax exemption).  Portability of the estate tax exemption between spouses would continue.
• Coordinate income and estate tax rules for grantor trusts.  In effect, if a trust was a grantor trust for income tax purposes, the value of the trust assets would be included in the gross estate for estate tax purposes.  Irrevocable life insurance trusts would have to be structured as non-grantor trusts to avoid having the death benefit included in the gross estate.
• Require Grantor Retained Annuity Trusts (GRATs) to have a 10 year minimum term and a minimum remainder value equal to the greater of 25% of the value of the assets placed into the GRAT or $500,000.  This would eliminate the use of short term rolling GRATs and eliminate the use of so-called Walton zero-gift GRATs.
• The proposal would impose a 90 year limit on the GST exemption for so-called generation skipping or dynasty type of trusts.    
• The proposal would allow a gift tax annual exclusion maximum of $50,000 per donor without any present interest requirement.  In effect, this would limit the use of so-called Crummey powers when making gifts to irrevocable trusts.

Impose Capital Gains Tax on Bequests at Death and Gifts in Lifetime of Capital Assets

• The Administration’s proposal would make gifts and bequests of appreciated assets to non-spouses realization events for federal capital gains tax purposes.  Capital gains would be triggered on asset appreciation at the time of gift or estate transfer rather than when the recipient later sells the asset.  The recognized capital gain would be taxed to the donor in lifetime or to the decedent’s estate at death.  The proposal essentially eliminates stepped-up basis at death.  It would also accelerate the payment of capital gains taxes on gifted assets since the taxable event would occur on the date of the gift.
• The proposal would allow a $100,000 per person exclusion of capital gains recognized at death and would be indexed for inflation after 2017.  The exclusion would be “portable” to the decedent’s surviving spouse under the same rules that apply to portability for the current $5,450,000 estate tax exemption.  This effectively makes the capital gain exclusion $200,000 per couple.
• In addition, there would be a $250,000 exclusion for capital gains on a residence which would also be portable to the decedent’s surviving spouse.  This effectively makes the exclusion $500,000 per couple.
• For married couples, no capital gains tax would be due on assets given to a spouse or bequeathed to a spouse until the spouse disposes of the assets or dies.
• Capital gains tax would not apply to bequests and gifts to charitable organizations.

Retirement Planning

• The Administration’s would limit high-dollar retirement plans and IRA contributions and accumulations.  The proposal would limit the combined maximum value of qualified plans, IRAs, 403(b), to about $3.4 million.  This is the current actuarial equivalent to the indexed $210,000 annual defined benefit plan limit.  Once the $3.4 million combined limit is reached, then future contributions would no longer be permitted.
• The proposal would allow all inherited qualified plan and IRA balances for non-spouse beneficiaries to be rolled over within 60 days.  This rollover would be to a non-spousal inherited IRA only if the beneficiary informs the new IRA provider that the IRA is being established as an inherited IRA.  Under current law, non-spouse inherited IRAs can only be accomplished by a direct transfer between providers and not via a rollover.
• The proposal would generally require non-spouse IRA beneficiaries to take all taxable inherited distributions within 5 years.  The non-spouse beneficiary would typically be an adult child.  Certain classes of beneficiaries would be allowed a life expectancy payout (i.e. disabled, chronically ill, a minor child).  The current rule allows a life expectancy payout for any non-spouse beneficiary as long as the first distribution is made by December 31^st of the year following death. 

BSMG will keep you informed of any tax reform legislation which has the possibility of being passed by the Republican Congress in 2016.  Of course, President Obama may veto any Republican crafted tax legislation and the Congress will probably not have the 2/3 required majority to override any veto.  Once the Republican and Democrat presidential candidates are determined after the primaries and caucuses of the 50 states are completed in June, BSMG will provide a side by side comparison of their tax reform proposals.

Russell E. Towers  JD, CLU, ChFC
Vice President – Business & Estate Planning
Brokers’ Service Marketing Group

russ@bsmg.net     

The post Obama Budget Proposal for Fiscal Year 2017 appeared first on BSMG.

A popular new product that has aroused the interest of many estate planners is a Guaranteed No-Lapse Survivorship Universal Life (SUL) Policy with an indemnity joint long term care (LTC) rider.  This type of policy would typically be owned by an irrevocable life insurance trust (ILIT) to provide an income and estate tax-free death benefit at the second death. The indemnity joint LTC rider would be available to provide potential LTC benefit payments to the ILIT to offset lifetime extended care medical costs of a married couple.
The “indemnity” type of rider is crucial for the ultimate life insurance death benefits to be estate tax-free.  Why? Because any rider benefits will be paid only to the ILIT as the policy owner, and NOT used to pay extended care costs directly to the extended care provider.  The payment of LTC benefits are paid only to the ILIT and are NOT required to pay for any specific extended care expenses incurred, this indemnity LTC rider would not create an “incident of ownership” in the UL policy.  Any “incidents of ownership” in a life insurance policy would cause the life insurance death proceeds to be included in the gross estate for estate tax purposes.

This indemnity LTC rider is contrasted with so-called “reimbursement” LTC riders.  Reimbursement riders pay extended care benefit payments directly to the provider on behalf of the insured.  Most commentators have taken the position that this “reimbursement” type of LTC rider on a life insurance policy owned by an ILIT would be considered an “incident of ownership” that would cause the life insurance death proceeds to be included in the gross estate.

Target Client Profile:

Your clients who are successful business owners, professionals, and wealthy individuals who may have gross estates large enough to be exposed to federal estate taxes, state death taxes, and “income in respect of decedent” (IRD) income taxes on their QRP/IRA assets.

Key Phrases to Use with Your Client:

• An income and estate tax-free death benefit to offset estate and income taxes due at the survivor’s death in a financially efficient manner.
• A special “indemnity” joint long term care rider that provides tax-free restoration of personal funds used to pay extended care expenses
• A guaranteed no-lapse Survivorship Universal Life policy with an extremely competitive Internal Rate of Return (IRR) out to life expectancy and beyond, with an added LTC Rider Benefit 
• The low present value cost provides protection against death and extended care expenses in the same product package

Planning Options Available When “Indemnity” LTC Rider Benefits are Paid to an ILIT

Assuming that a no-lapse SUL policy with an indemnity joint LTC rider is owned by an ILIT, here are some planning options available to the married couple and family to either offset or pay for any extended care medical costs:

Option 1:  Carrier makes income tax-free LTC claim payments to the ILIT. ILIT “keeps cash” in the ILIT to be invested in a side fund.

• ILIT keeps LTC claim payments in the trust and invests in stock, bonds, mutual funds, annuities, etc.
• This trust owned portfolio of financial assets is estate tax-free and will offset extended care LTC costs which are paid out of pocket by the married couple
• The married couple pays any LTC care costs out of pocket from other personal assets.  These payments for LTC medical services will reduce the gross estate for estate tax purposes by the amount of these out of pocket payments.
• At death of the survivor, the net life insurance proceeds paid to the ILIT from the base SUL policy are income and estate tax-free.

Option 2: Carrier makes income tax-free LTC claim payments to the ILIT. ILIT “loans cash” to insured estate owner. 

• ILIT makes a loan to the married couple.  Interest only note payable at current AFR rate is executed between the irrevocable trust and the married couple.
• The married couple uses the cash received from the loan to pay extended care LTC expenses.
• The married couple makes annual interest payments on the note to the ILIT from other personal resources.
• At death, the estate of either spouse pays off the loan principal on the note to the ILIT from other estate assets and takes an estate tax deduction for debts paid from the estate on Line 2 of the Form 706 U.S. Estate Tax return (IRC Section 2053(a)).
• Upon death of the survivor, the net life insurance proceeds paid to the ILIT from the SUL base policy are income and estate tax-free

Option 3: Carrier makes income tax-free LTC claim payments to the ILIT. ILIT “distributes cash” to ILIT beneficiary (adult child).

• ILIT trustee uses discretionary authority granted in a well-drafted trust document to make distributions of trust principal to any one or more of the trust beneficiaries (adult children of insured married couple)
• This cash distribution is a tax-free distribution of trust principal to the adult child.  The income tax-free LTC benefit retains its character when distributed to trust beneficiaries
• The adult child voluntarily (under no obligation) makes an unlimited gift tax exclusion gift of this cash on behalf of either parent to pay the LTC medical expenses of either parent under IRC Section 2503(e).
• At death of the survivor, the net life insurance proceeds paid to the ILIT from the SUL base policy are income and estate tax-free.

The type of joint indemnity LTC rider we are talking about may either be a “qualified” LTC rider under IRC Sec 7702B … or an accelerated death benefit rider for “chronic illness” under IRC Section 101(g).  Both types of indemnity riders pay income tax-free benefit claim payments to the ILIT as the policy owner when triggered.   Any tax-free benefits paid under both types of riders will reduce the life insurance death benefit paid to the ILIT dollar for dollar.

Contact your BSMG Advisor for a discussion on how to structure a no-lapse SUL policy with an “indemnity” joint LTC rider owned by an ILIT.  This protection plan can offset any second death estate costs AND offset lifetime LTC costs for either spouse with income tax-free benefits.

Russell E. Towers   JD, CLU, ChFC
Vice President – Business & Estate Planning
Brokers’ Service Marketing Group

russ@bsmg.net

The post Survivorship Universal Life Policy with Indemnity Joint LTC Rider Owned by an ILIT appeared first on BSMG.

When an individual accumulates and then receives funds distributed from a financial asset to provide retirement income, there are 2 key values: After-Tax Rate of Return (ROR) and the After-Tax Income stream.  Various taxes must be taken into account when saving for retirement and receiving retirement income such as federal and state income taxes, and federal and state capital gains taxes.

In 2016, the top ordinary income tax bracket remains at 39.6% for high earners.  The capital gains rate remains at 15-20% depending on total taxable income.  Plus, the Affordable Care Act continues to levy an additional 3.8% tax on certain “passive unearned income” from investments.  In addition, the Affordable Care Act continues to levy an additional .9% FICA tax on “earned income” for the Hospital Insurance (HI) portion of FICA for these same high earners.

When all the federal and state tax rates are combined, the top marginal tax rate for high income taxpayers could easily approach 45-50% going forward.  When faced with these high combined tax rates, this can make it difficult to accumulate the amount needed to provide sufficient after-tax retirement income for those subject to these high tax rates.

Tax Advantages of Life Insurance

One of the few ways to efficiently accumulate and distribute funds for retirement income is with a cash accumulation life insurance policy such as an Indexed Universal Life (IUL) policy.  That’s because of the multiple tax advantages afforded non-MEC life insurance under the Internal Revenue Code, such as:

1. Cash value accumulates tax deferred
2. Tax free first in-first out (FIFO) withdrawals up to cost basis and then tax free policy loans can be taken from the cash value at retirement
3. Life insurance death benefits are income tax free

The example below compares accumulating and distributing funds from:

(1) A hypothetical financial asset where income taxation on gains are levied throughout both the accumulation and distribution phases versus …..

(2) A competitive cash accumulation IUL policy where there is no income taxation on policy cash value throughout both the accumulation and distribution phases.  A comparison is then made of the hypothetical After-Tax income streams available at retirement.

Facts of a Hypothetical Case

Assume a 50 year old professional will allocate $30,000 per year for 20 years (age 70) into a personally owned non-qualified retirement fund.  The individual has already maxed-out 401(k) qualified plan contributions and needs a supplementary source of retirement funds.  Starting at age 70, withdrawals will be made from this non-qualified retirement fund for 15 years (age 85) to provide retirement income over and above any 401(k) or IRA distributions.

Assume a combined blended ordinary income/capital gains tax rate of 25% is levied on any taxable gains during both the 20 year accumulation phase and the 15 year distribution phase.  Finally, assume a non-guaranteed 6% pre-tax rate of return (ROR) which, in a 25% tax bracket, nets out to an After-Tax ROR of 4.5% during the full 35 year hypothetical projection from age 50 through age 85.

Hypothetical Financial Asset Where Gains are Subject to Annual Taxation During Accumulation and Distribution

• $30,000 annual outlay per year for 20 years ($600,000 cumulative) grows to a non-guaranteed after-tax value of $983,494.  This assumes a pre-tax ROR of 6% and an after-tax ROR of 4.5%.
• This non-guaranteed fund of $983,494 is then distributed annually over the next 15 years from age 70-85 assuming the same 4.5% after-tax ROR.  At 4.5% after-tax ROR, the annual after-tax level income for 15 years is a non-guaranteed $91,577
• With a level after-tax distribution amount of $91,577 for 15 years, the $983,494 fund will be totally depleted and fall to $0 at age 85.

Competitive Indexed UL Policy Where Cash Value Growth is NOT Subject to Annual Taxation and Distributions are Tax Free

• $30,000 annual premium per year for 20 years ($600,000 cumulative) is placed into a personally owned minimum death benefit non-MEC cash accumulation policy with an initial death benefit of $528,791.  At the current assumed crediting rate of 6%, the non-guaranteed cash value will grow to $1,045,631 at age 70 and the non-guaranteed death benefit will grow to $1,574,422 at age 70.  Both cash value and death benefit will then start to decline as withdrawals/loans are made from the policy
• Starting at age 70, a 15 year non-guaranteed tax free FIFO income stream (withdrawals to cost basis and the loans) of $111,384 is distributed annually from the policy cash value.  No more policy distributions are made after age 85
• At the current assumed crediting rate of 6%, the policy will also provide a non-guaranteed tax free death benefit of $100,891 at age 85.
• To achieve these income tax free results, the policy must NEVER be allowed to lapse.  A lapse of a heavily loaned contract in a gain position is a taxable event.  Upon lapse, the recaptured gain would be ordinary income and generate a Form 1099 from the insurance carrier.  Of course, since the policy has lapsed, there is no cash value left to pay the tax on this “phantom income” gain amount.As illustrated from the hypothetical example above, a non-guaranteed Indexed UL policy may provide a higher after-tax income ($111,384) when compared to an alternative non-guaranteed financial asset ($91,577).  And the life insurance policy provides an additional tax free death benefit to the family of the insured that the alternative financial asset does not provide.

Contact your BSMG Life Insurance Advisor for competitive information on insurance carriers offering Indexed UL.

Russell E. Towers  JD, CLU, ChFC
Vice President – Business & Estate Planning
Brokers’ Service Marketing Group
russ@bsmg.net

The post Competitive After-Tax Income for High Bracket Earners with Indexed UL appeared first on BSMG.

Premium financing plans between a financial institution and an Irrevocable Life Insurance Trust (ILIT) can be very complicated and risky arrangements.  Wealthy individuals who are familiar with leveraged financial risk
may desire to borrow money to pay large premiums for insurance owned by an ILIT to offset federal estate taxes.  Often, these individuals can afford to gift premiums outright to the trust but, nevertheless, may choose to finance the premiums.

There are some non-guaranteed financial advantages to a financing large premiums for life insurance owned by an ILIT:

• The client may have to pay lifetime gift taxes on outright gifts to the ILIT because they have used all of their lifetime gift exemptions and annual gift tax exclusions
• Premium financing can provide for the purchase of insurance owned by an ILIT with no current out of pocket cash flow
• Financed life insurance can take advantage of the historically low interest rate environment on borrowed funds
• Valuable liquid asset portfolios or real estate assets can remain intact rather than being liquidated to raise cash to make outright premium gifts to the trust
• Financing may work well with rated insurance case of clients in their 70s and 80s because of shorter time horizons until life expectancy and earlier repayment of the premium loans
• The financing method can work well with either single life policies or survivorship life policies owned by an ILIT

However, there are multiple downside risks that a wealthy client should understand before they seriously consider a premium financing transaction with a bank or financial institution:

• An increasing interest rate environment going forward can make borrowing more expensive
• A relatively small increase in the interest rate charged on renewed premium financing may reduce the anticipated net benefit.  This can happen when the original projection shows a policy crediting rate that exceeds the loan interest rate.
• The bank will require collateral from the estate owner to cover any shortfall between the amount of the outstanding loan principal and the policy cash value
• The interest paid on the cumulative loans to finance premiums is not deductible
• A premium financed plan requires continuous monitoring of the multiple moving parts and requires professional advice from attorneys, CPAs, and financial experts
• The longer the insured lives, the greater the amount of cumulative loan principal and interest.  This will reduce and even possibly eliminate any remaining net death benefit for the ILIT
• Leverage can be positive or negative.  If the policy does not perform as originally projected or interest rates rise on the cumulative premium loans over time, there may be a financial train wreck in the future.
• The insured may live well beyond life expectancy and threaten the financial viability of the arrangement
• The net death benefit could end up being less than the accrued loan.  In this case, the ILIT will not receive any of the death benefit from the policy
• The loan must be repaid.  This repayment will come from the policy death benefit or out of pocket by the borrower from the personal collateral placed at risk
• The lender has the ability to increase interest rates in the future as cumulative short term loans are rolled over.
• There is no guarantee that the bank will renew the loan as each short term financing period expires
• If the lender decides not to make future loans as each short term period expires, the policy may lapse.
• If the net worth of the client falls or the income of the client declines, the bank could decide not to extend the loan.  Or the bank may decide it needs more collateral in order to extend the loan into the next short term period
• Financial institutions typically require the borrower to provide collateral from liquid assets such as securities portfolios

These potential disadvantages of the ILIT premium financing technique may cause even a wealthy person who is familiar with leveraged financial risk to pause and think twice about borrowing to pay insurance premiums.  They may decide to simply make outright premium gifts to the ILIT allocating their lifetime gift exemptions on the Form 709 U.S. Gift Tax return.  Keep in mind that the lifetime gift exemption for an individual in 2016 is $5,450,000 and $10,900,000 for a married couple.  These lifetime gift tax exemption amounts can cover very large cumulative premiums over a period of time, and the lifetime gift exemption is indexed to inflation as well.

Clearly, the bank wants to make sure that their position as lender is well covered by policy cash values, policy death benefits, and additional collateral for any shortfall in case the loan is terminated while the insured is still alive.  And because the premium financing may last for a long period of time, until the insured dies, the bank will want to renegotiate the terms of the loan every 5-10 years.  Interest rates can change dramatically over an extended period of time as we have witnessed the decline of interest rates over the last 20 years.  What if there is an upward trend of interest rates over the next 20 years?  This potential increasing interest rate environment will make premium financing plans very hard or impossible to sustain over that extended period of time.

BSMG provides access to competitive single life and survivor life products and comprehensive insights into product design, risk appraisal, estate tax and income tax planning. We firmly believe that absolute clarity and a complete understanding by all parties is a prerequisite to reaching any conclusion about the merits and demerits of premium financing.

Russell E. Towers  JD, CLU, ChFC
Vice President – Business & Estate Planning
Brokers’ Service Marketing Group
russ@bsmg.net          

The post Risks of Premium Financed Life Insurance Owned by an ILIT appeared first on BSMG.

It is somewhat common to be dealing with clients who have accumulated significant non-qualified annuity account values.  As a result of tax-deferred Section 1035 exchanges over many years, it is not uncommon for business owners, professionals, and wealthy individuals to have large six-figure or even seven figure account balances.  These accounts carry over the original cost basis through a series of Section 1035 exchanges over many years.

Non-qualified annuities have become valuable financial assets that can be managed and preserved over a long period of time. These annuities may be fixed, indexed, or variable contracts.  This preservation and management can be accomplished for spouses and non-spouses even long after the owner of a non-qualified annuity has died if certain distribution rules are followed.

In most cases, non-qualified annuities can remain tax deferred all the way until the death of the owner.  Income taxes on the gain amount in excess of the cost basis will eventually need to be paid by the beneficiary of the annuity after the annuity owner has died.  This is known as “income in respect of decedent” (IRD). If planned for, this taxable IRD gain amount can be spread over many years after the death of the annuity owner in the form of an “inherited non-qualified annuity”.

Here is a detailed summary of the distribution options available to spouses, non-spouses, and trusts for “inherited non-qualified annuities” under IRC Section 72(s)

A)    Spouse Designated Beneficiary … Inherited Distribution Options

1. The 5 year rule:  Account value must be totally distributed within 5 years of death        (IRC Section 72(s)(1))
2. The life expectancy rule:  Annuitized life expectancy distributions must start no later than 1 year after the death of the holder-owner (IRC Section 72(s)(2))
3. Spouse can continue the existing contract as his/her own and name a new beneficiary.  The surviving spouse can continue tax deferral of gains in excess of the cost basis all the way until death if desired (IRC Section 72(s)(3))

B)     Non-Spouse Designated Beneficiary … Inherited Distribution Options

1. The 5 year rule:  Account value must be totally distributed within 5 years of death       (IRC Section 72(s)(1))
2. The life expectancy rule:  Annuitized life expectancy distributions must start no later than 1 year after the death of the holder-owner (IRC Section 72(s)(2))
3. PLR 200313016 also allows a life expectancy payout for “inherited non-qualified annuities” based on the Single Life Table of Treas. Reg. 1.401(a)(9)-9.  This required annual “inherited” distribution must start no later than 1 year after the death of the holder-owner.  Presumably, this would allow a deferred annuity product with an irrevocable income rider withdrawal option to be utilized.  IRS ruled in PLR 200313016 that this method would satisfy the life expectancy requirement of IRC Section 72(s)(2).

C)    Trust or Estate as Beneficiary … Inherited Distribution Options

1. The 5 year rule:  Account value must be totally distributed within 5 years of death       (IRC Section 72(s)(1))
2. The life expectancy rule:  It is not clear if the Life Expectancy rule can be used where a trust or estate is the beneficiary of a non-qualified annuity.  No Treasury Regulations or IRS rulings exist for non-qualified annuities where a trust or estate is the beneficiary.  A trust or estate is not considered to be an individual “designated beneficiary” under IRC Section 72(s)(4)).  Legally, a trust or estate may be named as beneficiary, but it is not clear whether the life expectancy rule can be used.

Technical Tax Rules for Inherited Non-Qualified Annuities

There are certain technical rules that apply to the post-death distribution methods described above.  Here is a short list of the most important rules for inherited non-qualified annuities:

• Generally, the death of the holder (owner) of a non-qualified annuity terminates the contract and required distributions from the contract must commence under the rules of IRC Section 72(s).  One of the distribution options described above may be chosen with the existing annuity carrier.  An exception is the option for a spouse beneficiary to continue the contract as his/her own under IRC Section 72(s)(3).  The new spousal continuation contract is still eligible for a tax-free Section 1035 exchange to a non-qualified annuity with another carrier.
• For income tax purposes, the distribution option chosen will be governed by either the “LIFO” distribution rules of IRC Section 72(e) or the “exclusion ratio” rules of IRC Section 72(b).
• Where an Irrevocable Trust is the owner of a non-qualified annuity, IRC Section 72(s)(6) states that the “holder” for purposes of post-death distributions of a non-qualified annuity shall be the primary annuitant.  With an Irrevocable Trust as owner, it’s important to determine who will be the annuitant – either the older parent (grantor of the trust) or the younger adult child (beneficiary of the trust).
• There is currently no authority in the Code, Treasury Regulations, or Revenue Rulings for post-death transfers of non-qualified annuity funds from one annuity carrier to another annuity carrier after the holder-owner has died.  However, in PLR 201330016, IRS permitted a post-death exchange of non-qualified annuity funds as long as the transfer was made directly from the old annuity carrier to the new annuity carrier.  The IRS characterized this transaction as a permitted tax-free exchange of annuity contracts within the scope of IRC Section 1035(a)(3). Each annuity carrier involved in the exchange transaction must be consulted to determine their own business practices for this post-death situation.

BSMG can provide access to multiple annuity carriers to fund non-qualified annuities both during lifetime and as an inherited non-qualified annuity post-death.  Contact your BSMG Annuity Advisor to design a post-death annuity distribution plan for your best annuity clients.

Russell E. Towers  JD, CLU, ChFC
Vice President – Business & Estate Planning
Brokers’ Service Marketing Group
russ@bsmg.net        

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It is somewhat common for advisors to be dealing with clients who have accumulated significant mutual fund, IRA or annuity IRA account values.  As a result of rollovers and direct transfers from 401(k) plans, profit sharing plans, defined benefit plans, and 403(b) plans, it is not uncommon for successful business owners, professionals, and wealthy individuals to have large six figure or seven figure IRA balances.

IRAs have become valuable financial assets that can be managed and preserved over a long period of time.  This preservation and management can be accomplished for spouses and non-spouses even long after the IRA owner has died if certain distribution rules are followed.

Here is a detailed summary of the distribution options available to spouses, non-spouses, trusts, and estates for inherited IRAs under IRC Section 401(a)(9) and Treasury Regs. 1.401(a)(9)

Inherited IRA Distribution Options for:

A)    Spouse Designated Beneficiary

1. 5 year rule:  Account values must be totally distributed within 5 years of death
2. Life expectancy rule:
   a. By December 31^st of the year following the owner’s death using the Single Life Table for Required Minimum Distributions (RMD) … OR
   b. By December 31^st of the year the deceased would have attained age 70 ½ using the Single Life RMD Table
3. Spousal rollover to IRA owned by the surviving spouse.  Spouse names a new beneficiary.  Spouse takes RMDs at age 70 ½ using the factor from Uniform Lifetime Table each year

B)    Non-Spouse Designated Beneficiary

1. 5 year rule:  Account values must be totally distributed within 5 years of death
2. Life expectancy rule:  By December 31^st of the year following the owner’s death using the Single Life RMD Table.  Use the life expectancy of the oldest beneficiary.

C)    Trust as Designated Beneficiary

1. 5 year rule:  Account values must be totally distributed within 5 years of death
2. Life expectancy rule:  By December 31^st of the year following the owner’s death using the Single Life RMD Table.  For “common share trusts”, use the trust beneficiary with the shortest life expectancy as the measuring life (i.e. usually the oldest child).  For “separate share trusts”, use the life expectancy of each separate share beneficiary.  See PLR 200537044 for the blueprint of separate share trust inherited distributions
3. Trust will receive RMDs and serve as a conduit to pass RMDs to the trust beneficiaries.  Trustee will issue a Trust K-1 to each trust beneficiary who will place this K-1 amount on Schedule E of their personal Form 1040 U.S. Income Tax return

D)    Estate as Designated Beneficiary

1. If owner died before age 70 ½, then use 5 year rule.  Account values must be totally distributed within 5 years of death
2. If owner died after age 70 ½, then use life expectancy rule based on remaining life expectancy of the deceased IRA owner using the Single Life RMD Table. 

Technical Tax Rules for Inherited IRA Distributions

There are certain technical rules that apply to the distribution methods described above.  Here is a short list of the most important rules for inherited IRAs:

• If an IRA with multiple non-spouse beneficiaries can be divided into separate accounts by September 30^th of the year following the owner’s death, then the life expectancy of each beneficiary may be used for each separate share using the Single Life RMD Table
• When an inherited IRA is received by a beneficiary at the owner’s death, for the life expectancy rule distribution method, determine the Single Life RMD Table factor and subtract 1 each year thereafter.
• Post-death account transfers are permitted from an existing inherited IRA to a new inherited IRA with a different mutual fund custodian or annuity carrier.  The appropriate Single Life RMD Table factor is then carried over and applied to the new inherited IRA for RMD purposes
• Inherited IRAs must be re-titled at the death of the IRA owner.  The individual Social Security number of the beneficiary or the trust Tax ID number must be provided to the IRA custodian or IRA carrier.  The account will always retain legal status as an “inherited IRA” account until it is fully distributed to the beneficiary.  The new title of the inherited account may read as follows:
  a.  John Smith (deceased) IRA for the benefit of (fbo) Karen Smith, daughter
  b.  John Smith (deceased) IRA for the benefit of (fbo) XYZ Bank, Trustee of the John Smith Irrevocable Trust, dated 1/1/2016.

BSMG can provide access to multiple annuity carriers to fund IRAs both during the lifetime of an IRA owner or as an inherited IRA after the IRA owner has died.  Contact your BSMG Annuity Advisor who will consult with BSMG Advanced Sales to design an inherited IRA plan that can be crafted to meet the needs of your best IRA clients.

Russell E. Towers  JD, CLU, ChFC
Vice President – Business & Estate Planning
Brokers’ Service Marketing Group
russ@bsmg.net

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IRC Section 162 Executive Bonus Plans funded with cash accumulation life insurance policies have provided a time-tested non-qualified benefit for many years. The employer simply makes a tax deductible bonus to the shareholder-employee or non-owner key employee who then reports the full bonus as W-2 earned income.

The bonus is used to pay an annual premium for a personally owned insurance policy. Future FIFO withdrawals up to cost basis and policy loans can be made tax free. The employer may even pay an “extra bonus” so that the shareholder-employee or non-owner key employee has enough cash to pay both the tax on the gross bonus plus the full policy premium. The shareholder-employee could be the owner of shares in a C Corp, S Corp, or LLC.

A new type of Section 162 Bonus Plan is available for business owners and professionals. It’s called a Flex Pay “Linked-Benefit” Executive Bonus Plan. Maybe the most practical “linked benefit” type of life insurance product is a “flex pay” type of product that provides basic life insurance protection along with valuable long term care (LTC) rider benefits. The premium payment schedule for a guaranteed paid-up contract is typically 5 to 10 years. Any LTC benefit claim payments are received tax free and will simply reduce the death benefit down to a minimum residual amount. Charges against cash value for the cost of the LTC rider are simply a tax free reduction to the cost basis of the policy.

The annual premiums for this executive benefit is generally deductible to the employer as a compensation expense under IRC Section 162 and is currently taxable to the shareholder-employee or non-owner key employee as W-2 earned income.

FACTS OF A HYPOTHETICAL CASE

• A shareholder-employee, a 50 year old male, is the majority owner of a successful S Corp, and is in good health.
• This shareholder-employee would like to use current business cash flow to fund personal protection for potential long term care (LTC) expenses
• The business owner has a combined personal tax bracket of 33% for income tax purposes
• He asks for a recommendation to design a plan that would provide LTC insurance benefits if he has LTC claims as he gets older
• He also would like to be able to withdraw funds from this plan while he is still working for other personal emergencies that may arise and would like his family to get some benefit at his death if no LTC claims are ever made during his lifetime
• The business is currently profitable and is expected to grow over the next few years as the general economy recovers

RECOMMENDED PLAN DESIGN

• Purchase a 10-Pay “Linked-Benefit” Flex Pay life insurance product owned personally by the business owner. Lifetime benefits are guaranteed with only 10 premium payments.
• An application is taken with a short form medical questionnaire
• The company will pay annual premiums of $10,000 each year for 10 years via a Section 162 Executive Bonus to the shareholder-employee
• The business will deduct the annual bonuses as a Section 162 compensation expense and the business owner will report W-2 earned income each year equal to the total bonus amount
• In a 33% personal tax bracket, the firm could pay an “extra bonus” so that the shareholder-employee has a so-called “zero net after-tax outlay” from a cash flow point of view. (Extra bonus is $5,000. Total taxable bonus each year is $10,000 plus $5,000 = $15,000).
• $15,000 x 33% = $5,000 for income tax plus $10,000 is left after-tax to pay the annual premium of $10,000
• The Section 162 bonus is considered to be “earned income” for FICA withholding purposes (OASDI limit for FICA withholding is $118,500 of earned income in 2016. HI component of FICA is levied against unlimited earned income)
• As annual premiums are paid, a graduated vested Return of Premium (ROP) benefit accrues for a complete surrender of the contract.

SUMMARY OF 10 PAY “LINKED-BENEFIT” GUARANTEED PLAN BENEFITS

__________________________________________________________________________________________________________________________________

Total Premium = $100,000

As you can see from the chart above, a very substantial Life-LTC “Linked Benefit” program has been funded by business cash flow. The client has locked-in a tax-free death benefit for his family of at least $173,779 if no LTC claims are ever made during lifetime. The client can get back the full $100,000 premium outlay in cash by a simple surrender request after the contract has been in force for 10 years. And, most importantly, the client has $7,241 of monthly LTC protection ($86,890 annual LTC protection) available over a minimum 6 year duration period with a cumulative total benefit of $521,337. The current annual cost of different types of extended care generally ranges from about $6,000 per month ($72,000 annual) to about $10,000 per month ($120,000 annual) depending on the state where care is delivered. These costs continue to rise significantly from year to year.

The personal net after-tax cash flow outlay to the business owner is zero ($0) because the bonus was “grossed up” to $15,000 so that he had enough to pay both the tax on the gross bonus (33%) PLUS the annual $10,000 premiums for the Flex Pay “Linked-Benefit” contract. Contact your BSMG Advisor today to discuss how business cash flow from C Corps, S Corps, and LLCs can be used to fund personal LTC protection needs of shareholder-employees or non-owner key employees.

Note 1: A “linked benefit” life insurance/LTC contract is defined as life insurance under the Internal Revenue Code. These “linked benefit” type of life insurance products are NOT to be confused with “stand-alone” LTC contracts which have no life insurance component in their basic design.

Note 2: Business cash flow to fund premiums for personal protection needs could be in the form of:

(1) “Earned income” Section 162 bonuses from any type of business entity as described above
(2) K-1 passive income “pass-through” profit for owners of S Corps or LLCs
(3) Non-deductible “qualified dividends” for owners of C Corps that are taxed personally at only 15%-20%
(4) Tax free “accumulated adjustment account” (AAA) distributions of previously taxed profit for owners of S Corps ….. or tax free “capital account” distributions of previously taxed profit for owners of LLCs.

Contact your BSMG Advisor for a discussion of the differences between “linked benefit”, “stand alone” LTC, and universal life /LTC rider types of products available on the market today or check our our video blog.

Russell E. Towers JD, CLU, ChFC
Vice President – Business & Estate Planning
Brokers’ Service Marketing Group
russ@bsmg.net

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IRC Section 1035 provides exchanges into life insurance or annuity contracts with Long Term Care (LTC) riders to be income tax free and treated as LTC contracts under IRC Section 7702B(e). The tax free exchange provisions in Section 1035 positively impact so-called linked benefit life insurance-LTC products and linked benefit annuity-LTC products.

These products fall into 2 major categories which provide flexibility for case design:

1. Single deposit or flex-pay life insurance products with a LTC rider.
Life insurance death benefits are income tax free. Lifetime LTC rider benefits paid on these contracts are also income tax free (IRC Section 7702B (e)), but will reduce the net life insurance death benefit to the minimum residual amount.

2. Single deposit non-qualified deferred annuity products with a LTC rider.
The full deferred annuity account value will first be reduced to zero to pay LTC benefit claims before the remaining tax free LTC rider benefit claims are paid. Lifetime LTC rider benefits will be income tax free (IRC Section 7702B (e)). Lifetime cash withdrawals from the deferred annuity will still be treated as LIFO income on gain in excess of cost basis. Death benefits will still be treated as taxable LIFO income in respect of decedent (IRD) on gain in excess of cost basis.

Key Section 1035 exchange provisions that make these opportunities possible:
I. Life insurance exchanges into a life insurance contract with a LTC rider is defined as a life insurance to life insurance exchange for Section 1035 purposes (IRC Section 1035(b)(3))…

Meaning that existing life insurance cash values can be exchanged, tax free, into a linked benefit life insurance-LTC contract (single deposit or annual flex pay). Only complete life insurance to life insurance exchanges are permitted, i.e. the old contract must cease to exist. For flex-pay exchanges, a trail of annual premiums may be paid out of pocket by the policy owner in addition to the lump sum exchange amount from the old life insurance contract.

The possibility of a one for two Section 1035 life insurance to life insurance exchange also exists. In this case, a traditional UL policy without a LTC rider could be one of the new contracts and the other new contract could be a linked benefit life insurance-LTC contract (single deposit). Carryover cost basis on the exchange to the two new contracts will be allocated proportionally.

II. Annuity exchanges into an annuity contract with a LTC rider is defined as an annuity to annuity exchange for Section 1035 purposes (IRC Section 1035(b)(2))…

This means that existing deferred annuity account values can be exchanged tax free into a linked benefit deferred annuity-LTC contract (single deposit).  Since this type of exchange is considered to be an annuity to annuity exchange, partial exchanges from one annuity contract to another annuity contract are permitted under the guidance of Rev. Rul. 2003-76 and Rev. Proc. 2011-38. Carryover cost basis will be allocated proportionally between the old and new contracts.

Cost basis tracking will be important for both life insurance-LTC and annuity-LTC linked benefit products.

The Code provides rules for using cash value or account value of linked benefit products to pay the monthly charges (costs) for the LTC rider. These charges will be excluded from gross income and will reduce the cost basis of the insurance-LTC contract or annuity-LTC contract. However, the contract cost basis cannot fall below zero (IRC Section 72(e)(11)(A)(B)).

1035 Exchange Options for Standalone LTC and Guaranteed UL with LTC Rider

III. Another significant issue concerning LTC Section 1035 exchanges is that the IRS has issued additional tax guidance for partial exchanges involving annuities and stand-alone individual LTC products.

In Notice 2011-68, the IRS allowed a series of annual partial tax free exchanges from a deferred annuity contract to fund annual premiums for a stand-alone LTC contract. This method can work well administratively when both the deferred annuity contract and the stand-alone LTC contract are issued by the same carrier.

IV. Lastly, Annual Premium or Limited Pay Guaranteed Universal Life (GUL) insurance products with a qualified LTC rider are available for Section 1035 exchanges.
Life insurance death benefits are income tax free. Lifetime LTC benefits paid on these contracts are also income tax free (IRC Section 7702B(e)) and reduce the death benefit dollar for dollar. This tax free Section 1035 exchange option is available for both GUL with LTC rider and Survivorship GUL with a joint LTC rider.

BSMG life insurance, annuity, and LTC advisors can provide access to a wide variety of linked-benefit LTC, standalone LTC, and GUL-LTC type of products from our competitive carriers. Contact us today for a policy review of your client’s insurance or annuity contracts to see if a product with an LTC type of rider may provide a more flexible and more efficient combination of protection benefits.

Russell E. Towers JD, CLU, ChFC
Vice President – Business & Estate Planning
Brokers’ Service Marketing Group
russ@bsmg.net

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Successful business owners and professionals often have maxed out the tax deductible and elective deferral contributions to their qualified retirement plans, such as profit sharing, 401k, or Simplified Employee Pension (SEP) type plans. Often, this prompts questions to their financial professional on whether there are plans that could provide additional supplemental retirement income.  Is there a simple plan that can be offered selectively to S Corp, C Corp, or LLC shareholder-employees that can provide a special benefit plan just for the business owners on a tax-favored basis?

Yes. A non-qualified benefit that can be offered selectively, may provide a valuable retirement supplement to the business owner.  For instance, the business owner may have reached the 2016 limit of $18,000 for contributions to the company 401k plan.  Participants age 50 and over can increase their contribution limit to $24,000 by taking advantage of the $6,000 catch-up provision.  What else can be done for this business owner without including employees in the plan? 

The plan that could be attractive is known as a Section 162 Executive Bonus Plan which can be selectively provided to the business owner.  The financial product that may provide the best accumulation vehicle for a supplementary retirement benefit is a specially designed life insurance product that takes advantage of the tax-favored benefits of life insurance found in the Internal Revenue Code (IRC).

IRC Tax Benefits Available to Life Insurance

The IRC offers a number of income tax benefits to life insurance that are not available to other financial products like stocks, bonds, bank accounts, U.S. government securities, and non-qualified annuities.  These other financial products will have income or capital gains taxation on yields or gains as the asset grows in value or as gain amounts are withdrawn.  The taxation of gain amounts will diminish the after-tax amounts available to provide future retirement income.  Here are some life insurance tax advantages that are not available to these other financial assets:

• Death benefits of life insurance are income tax-free under IRC Section 101(a)(1).  The death benefit will self-complete the retirement plan for the family if the business owner dies prior to retirement.
• The annual cash value growth of any type of permanent life insurance product grows tax deferred.  This is the same tax deferral available to non-qualified annuities and stocks or equity mutual funds.
• Most importantly, life insurance withdrawals of the cash value up to cost basis can be made tax free on a first-in / first-out (FIFO) basis under IRC Section 72(e)(5)(A) and (C).
• Loans from life insurance cash value can also be made tax-free under IRC Section 72(e)(5)(A).

To obtain the tax-free withdrawal and loans from a life insurance policy, the policy must NOT be classified as a Modified Endowment Contract (MEC), where too much premium is paid into a life insurance policy for a given face amount.  A MEC can result by a failure to meet the so-called 7-pay test of IRC Section 7702A.  IRC Section 72(e)(10) states that both withdrawals and loans from a MEC in a gain position will be taxed on a last-in / first-out (LIFO) basis.  In other words, gain amounts come out first as taxable income in the same way as a withdrawal of LIFO gain amounts from non-qualified annuities are taxed.

So, based on the IRC income tax rules for life insurance listed above, how might we design a selective Section 162 Executive Bonus plan funded with life insurance?  How can we efficiently accumulate the most cash value for a given amount of life insurance death benefit while still maintaining the tax-favored non-MEC status of the policy?  Let’s take a look at the following case study of a successful small business owner who has maxed out contributions to the company 401k plan.

Case Study of S Corp Owner-Employee with Maxed-Out 401k Plan Contributions

Mr. Wilson is a successful 100% shareholder-employee of an S Corp and is currently 50 years old and is in a 40% federal and state income tax bracket.  His company provides a 401k plan to its employees.  He plans on making the maximum $24,000 contribution to his 401k plan account in 2016 which includes a catch-up amount for the first time.  He asks if there is anything else he can do for his own retirement that will provide good tax benefits while accumulating a supplementary retirement account.  The company can afford to allocate $80,000 of cash flow to a selective benefit just for this purpose.  Here is a plan design that may interest him:

IRC Section 162 Bonus Plan Funded by Minimum Death Benefit Non-MEC Life Insurance

His S Corp pays a tax-deductible bonus of $80,000 to the S Corp owner (Mr. Wilson).  In a 40% tax bracket, the S Corp owner uses $32,000 for income taxes and allocates $48,000 per year into a personally owned Indexed Universal Life (IUL) policy from a competitive carrier.  His net after-tax outlay is $0 because the extra taxable bonus provides enough cash flow to pay both the personal income taxes and the annual premium outlay.

• The IUL policy is assumed to provide a hypothetical non-guaranteed indexed crediting rate of 6%.  The upper cap rate for this indexed product is 12%. This typical indexed life product has minimal downside risk of 0% subject to the annual cost of insurance charges.
• The minimum non-MEC death benefit for age 50 with preferred underwriting is $882,000.  The non-guaranteed death benefit grows to $1,268,000 by age 65 and then slowly starts to decline as tax-free distributions are made from the cash value.  By life expectancy (age 83 for current age 50), the non-guaranteed death benefit has declined to $768,000.  The Internal Rate of Return (IRR) on that age 83 death benefit is still a non-guaranteed 5.44%.  In a 35% tax bracket, the pre-tax equivalent IRR at life expectancy age 83 is 8.37%.
• The $48,000 annual premium is paid for just 7 years (age 57) so that the policy passes the 7-pay test to achieve non-MEC status under IRC Section 7702A.
• No additional premiums are paid from years 8-15 (age 65) to preserve non-MEC status.
• At age 65, the hypothetical non-guaranteed tax-free income stream of about $40,000 from the non-MEC will be paid from years 16-30 (age 80) to provide supplementary retirement income.  First, tax-free withdrawals of cash value up to the cost basis will be distributed.  When the cost basis has been adjusted down to $0, then a switch to tax-free policy loans will be requested.  Policy loan interest will be capitalized and added to the loan principal.
• In a 35% assumed tax bracket, the $40,000 of non-guaranteed tax-free FIFO policy distributions are equivalent to $61,538 of taxable income.
• The cost-of-insurance (COI) charges are minimized by the minimum death benefit non-MEC design.   This allows for a maximum non-MEC outlay into the policy to accrue cash value as soon as possible in the first 7 years.
• Depending on future business and personal circumstances, another 7-pay minimum death benefit non-MEC could be underwritten at age 57 to further supplement retirement income.
• Depending on future retirement and estate planning circumstances, the accumulated cash value of the indexed UL policy could be part of a future tax-free Section 1035 exchange to a no-lapse UL policy to provide a much larger tax-free death benefit.  This may be the case if future circumstances determine that any supplementary retirement income is not needed because other income sources are available.  Of course, new medical underwriting would be needed to complete the Section 1035 exchange.

Indexed Universal Life Policy Must Be Monitored Closely and Kept In Force

Keep in mind that the 6% assumed rate of return on the indexed accounts is not guaranteed.  The policy must be kept in force all the way until a tax-free death benefit is paid.  If the policy lapses due to poor performance or excess withdrawals or loans while the insured is still alive, a significant taxable event will take place.  A lapse of a heavily loaned policy in a gain position will generate a taxable Form 1099-R from the insurance carrier.

Since the adjusted cost basis will have been reduced to $0 in our plan design, the outstanding cumulative loan plus unpaid interest will be taxable income to the policy owner upon a lapse.  So, the policy must be closely monitored to make sure it never lapses.  Certain carriers have so-called over-loan protection riders to make sure a lapse will not occur and preserve some smaller amount of income tax-free death benefit.  If this over-loan protection rider is triggered in the future, no more withdrawals or policy loans will be allowed.

Contact your BSMG Life Advisor to discuss the Section 162 Executive Bonus plan funded by a 7-pay minimum death benefit non-MEC.  BSMG provides IUL policies with over-loan protection riders for your business owner and professional clients seeking a non-qualified supplementary retirement benefit.

Russell E. Towers  JD, CLU, ChFC

Vice President – Business & Estate Planning

Brokers’ Service Marketing Group

russ@bsmg.net

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Since June 20th, 1988, life insurance policies that do not meet the guidelines of the “7 Pay Test” of IRC Section 7702A are classified as Modified Endowment Contracts (MEC).  As such, any lifetime withdrawals or loans from the cash value of a MEC in a gain position will result in LIFO (last in-first out) taxable income to the extent of the gain (IRC Section 72(e)(10)).

This LIFO method is similar to the way withdrawals from deferred annuities in a gain position are taxed.  Alternatively, withdrawals up to cost basis and/or loans from the cash value of a non-MEC FIFO (first in-first out) life insurance policy are income tax-free.

Given the LIFO taxation of MECs and FIFO taxation of non-MECs, are there situations where a MEC could be recommended to finance estate tax planning, non-qualified executive benefit plans, or the tax-efficient asset management desires of wealthy clients?

Yes, and we have outlined 5 different situations where a MEC can provide tax-free leverage to efficiently finance certain advanced planning objectives:

1)     Life Insurance Owned by an ILIT Funded by a Lump Sum Gift of any Amount Up to the Current Lifetime Gift Exemption of $5,450,000 for an Individual, or $10,900,000 for a Married Couple

• A single-pay MEC premium of up to $5.45 million / $10.90 million would buy a very large no-lapse Universal Life (UL) or no-lapse Survivorship Universal Life (SUL) policy owned by the ILIT.  For instance, a $5,450,000 single pay premium for a competitive no-lapse SUL on a Male 70 preferred / Female 70 preferred will purchase a guaranteed death benefit of $16,243,000.  The internal rate of return (IRR) at joint life expectancy (20 years) is a very competitive 5.61% in this continuing low-interest economic environment.  Assuming a 35% combined income tax bracket, the pre-tax equivalent IRR is 8.63%.

• This concept also works well for a Dynasty Generation Skipping type of ILIT where the estate owner can allocate $5,450,000 of generation-skipping exemption to the lump sum gift.  The filing of the 709 U.S. Gift Tax return form would concurrently allocate both the regular lifetime gift exemption and the generation-skipping exemption. Dynasty type of ILITs work well in states that have extended the rule against perpetuities far into the future and also have no state income taxes on trust income (i.e. Alaska, Delaware, Nevada, South Dakota).

• The cash value of the no-lapse SUL MEC will never get into a gain position so there is never any potential of lifetime LIFO taxation.  Also, the death benefit from the single pay MEC is also income tax-free and estate tax-free.

2)     Life Insurance Owned by an ILIT Funded by a Lump Sum “Private Split Dollar Economic Benefit” Transferred of Cash from the Estate Owners to the ILIT

• A single pay MEC premium to purchase a no-lapse UL or SUL policy will provide an income and estate tax-free death benefit.  The policy may have growing cash value for a period of time before the cash value starts to trend downward and eventually falls to zero.

• The private split dollar interest of the estate owners will typically be defined in the written agreement as the GREATER of the cash value or the cumulative premiums paid.  For a typical no-lapse UL or SUL policy design, the interest of the estate owners will be the lump sum premium paid.  At death, this lump sum amount will be returned to the estate of the deceased and included in the gross estate at a 40% estate tax rate.  The remaining net death benefit paid to the ILIT will be estate tax-free.

• During the lifetime of the insured(s),  the only reportable gift for gift tax purposes are the low Table 2001 economic benefit rates for single life policies and the super-low joint life Table 2001 economic benefit rates for survivorship policies.

• This very low reportable value for gift tax purposes is ideal for estate owners who have used most of their $5.45 million / $10.90 million lifetime gift exemptions on prior gifts and don’t want to make any taxable gifts resulting in lifetime gift taxes at a 40% rate.

• Keep in mind that the current lifetime gift exemption of $5,450,000 is indexed each year and has been growing by a rate of 1-2% since 2012 when indexing became permanent.

• See Treas. Regs. 1.61-22(d) for detailed tax rules for split dollar economic benefit regime plans.

3)     Life Insurance Owned by an ILIT Funded by a Lump Sum “Private Split Dollar Loan” Transfer of Cash from the Estate Owners to the ILIT   

• A single pay MEC premium for a no-lapse UL or SUL policy will provide an income and estate tax-free death benefit.  The estate owners execute a written private split dollar loan agreement locking in the current long term AFR rate as the interest rate for the lump sum loan.  The current long term AFR rate is 1.90% and will be considered an imputed gift to the trust each year.

• For example, if a $5,450,000 private loan is made to the ILIT, the annual imputed interest gift to the trust annually will be $5,450,000 x 1.90% = $103,550.  This imputed gift of $103,550 each year should be easily covered by annual gift tax exclusions and/or annual indexing of the lifetime gift exemption.  So, in most cases there should be little or no cumulative taxable gifts which would result in any lifetime gift taxes.

• At death, the $5,450,000 loan principal will be repaid to the estate from the total tax-free death benefit paid to the ILIT.  This amount will be included in the gross estate for estate tax purposes as a loan receivable and subject to estate taxes at a 40% rate.  The net death benefit remaining in the ILIT will be estate tax-free.

• See Treas. Regs. 1.7872-15(e) for detailed tax rules for split dollar loan plans.

4)    Corporate-Owned Life Insurance (COLI) to Fund a Cost-Recovery for a     “Non-Qualified Salary Continuation” Agreement for a C Corp Executive

• A single pay MEC premium will generally provide an income tax-free death benefit to the corporation to provide cost-recovery for the employer’s costs of providing the lifetime salary continuation benefit.  Rather than buying a cash accumulation type of non-MEC policy and making tax-free withdrawals and loans from the policy to pay the salary continuation benefits, the company buys a lower cost single pay no-lapse MEC.

• Instead the company will pay the tax deductible salary continuation benefits to the executive at retirement from the future operating revenue of the firm.  A single pay no-lapse MEC allows the company to recover its costs of providing the deferred retirement benefit to the executive.  These costs will equal the lump sum single premium paid plus the cumulative net after-tax cost of the annual tax-deductible salary continuation benefit payments.  These salary continuation benefits are taxable to the executive when received.

• The cost recovery death benefit paid to a C Corp may be subject to the corporate alternative minimum tax (CAMT) in the year of death.  However, the corporation will receive a dollar for dollar corporate tax credit on their Form 1120 in the subsequent tax year for any CAMT actually paid.  Thus the only financial cost is a minimal time value of money cost between the time any CAMT is paid and the time when the corporation receives the tax credit in the following tax year.

5)     “Private Placement Insurance” for Ultra-Affluent Clients Desiring to Make Their Asset Portfolio More Income Tax Efficient

• When ultra-affluent clients, including those with a Family Office wealth management structure, desire to make their asset portfolio more income tax efficient, then the cash-rich private placement MEC may serve to balance their portfolio.

• These types of clients may have assets which produce significant interest, dividends, capital gains, rental income, and K-1 pass-through income of S Corps, LLCs, or partnerships.  A Private Placement type of insurance policy that’s a MEC can give them tax-deferred growth.  Many of these mega-rich may not be too concerned about future LIFO taxable withdrawals or loans from a cash-rich MEC.  They may even decide to simply hold the MEC until death which would result in an income tax-free death benefit.

• In addition, the life insurance wrapper that holds the underlying private placement assets can be tailored to suit the risk profile of the client.  Private Placement insurance plans often require a minimum cumulative premium commitment upwards of $5,000,000 for wealthy individuals known as a qualified purchaser.

• Private Placement life insurance must be filed with and approved by state insurance departments and comply with the IRC Section 7702 definition of life insurance.  The policy is typically designed with a minimum death benefit to accelerate tax-deferred cash value growth.  The policy may even be owned personally by the client as part of the client’s overall asset portfolio.  Premium payments options for qualified purchasers include a single pay of $5,000,000 (MEC) or a 5-Pay of $1,000,000 per year (non-MEC) for those clients who want to preserve the option of tax-free lifetime withdrawals and/or loans from the cash value.

Contact your BSMG Life Advisor when considering lump sum premium advances to fund any of the MEC planning concepts described in this article.  BSMG has access to competitive carriers that still provide lump sum premium payment designs.

Russell E. Towers  JD, CLU, ChFC                                                                                          

Vice President – Business & Estate Planning  

Brokers’ Service Marketing Group      

russ@bsmg.net     

The post When To Recommend a Modified Endowment Contract (MEC) appeared first on BSMG.

Successful C Corp, S Corp, and LLC business owners often want to use the cash flow from their business to pay life insurance premiums.  These premiums may be for either employer owned polices or for personally owned policies depending on the specific insurance protection needed.

Tracking the income tax effect of your business’s cash flow is an important part of understanding how business dollars can be used to pay annual insurance premiums.  The summary below highlights important income tax and FICA tax considerations that producers should understand when selling business or personal insurance to business owner clients.

C CORPORATION (C Corp): SEPARATE TAX ENTITY (Form 1120)

• For policies owned by the C Corp or QPSC:  The premium is a non-deductible expense to the corporation (IRC Section 264).  Since the premium is non-deductible, the annual premium amount will be part of the C Corp profit each year.  This U.S. Form 1120 profit (net income) will be taxed to the C Corp as a separate tax entity at C Corp tax rates.  These rates range from a low of 15% to a high of 39% depending on the amount of taxable profit (net income).

• Cash flow #1 for policies owned personally by the C Corp owner-employee:  If current business cash flow is used to pay premiums, the amount is deductible to the corporation as bonus compensation paid (IRC Section 162).  This amount is taxable to the C Corp owner-employee personally as W-2 compensation received.  Bonus comp is considered “earned income” and therefore, all the usual FICA taxes (OASDI and HI) must be withheld at both the personal level and the matching corporate level.

• Cash flow #2 for policies owned personally by the C Corp owner:  The C Corp owner can make dividend withdrawals from the balance sheet Retained Earnings to pay premiums.  This withdrawal is considered to be a dividend distribution which is not deductible to the C Corp.  The dividend is taxable to the C Corp owner as dividend income.  For tax year 2016, this dividend distribution is taxed at a rate of 15%-20% depending on the total taxable income of the business owner.

S CORPORATION (S Corp): PASS-THROUGH TAX ENTITY (Form 1120S)

• For policies owned by the S Corp:  The premium is a non-deductible expense to the corporation (IRC Section 264).  Since the premium is non-deductible, the annual premium amount will be part of the S Corp profit each year.  This U.S. Form 1120S profit (net income) will be “passed-through” as K-1 income to the S Corp owner personally on Schedule E of the Form 1040 U.S. Income Tax Return.

• Cash flow #1 for policies owned personally by the S Corp owner-employee:  If current business cash flow is used to pay premiums, the amount is deductible to the corporation as bonus compensation paid (IRC Section 162).  This amount is taxable income to the S Corp owner-employee personally as W-2 compensation received.  Bonus comp is considered “earned income” and therefore, all the usual FICA taxes (OASDI and HI) must be withheld at both the personal level and the matching corporate level.

• Cash flow #2 for policies owned personally by the S Corp owner:  The S Corp owner can use some end of year distributed K-1 pass-through profit to pay premiums.  As stated just above, this K-1 profit is taxable to the S Corp owner personally.  However, this S Corp profit is generally considered to be unearned passive income and therefore, is NOT subject to the FICA taxes levied on earned income.

• Cash flow #3 for policies owned personally by the S Corp owner:  The S Corp may have a previously taxed profit account, known as the Accumulated Adjustments Account (AAA) for tax accounting purposes.  This AAA is the cumulative amount of any previously taxed S Corp K-1 profits from prior years that have been left in the S Corp.  A tax-free withdrawal can be made from this previously taxed AAA to pay for personally owned insurance of the S Corp owner.  The AAA will be adjusted downward by the amount of the withdrawal.  There are no FICA taxes on AAA withdrawals which have been previously taxed as unearned income.

 
LIMITED LIABILITY COMPANY (LLC): PASS-THROUGH TAX ENTITY (Form 1065)

• For polices owned by the LLC: The premium is a non-deductible expense to the LLC (IRC Section 264).  Since the premium is non-deductible, the annual premium amount will be part of the LLC profit each year.  This U.S. Form 1065 profit (net income) will be passed-through as K-1 income to the LLC owners personally on Schedule E of the Form 1040 U.S. Income Tax return.  LLCs are generally treated as partnerships for income tax purposes.

• Cash flow #1 for policies owned personally by the LLC owners:  If current business cash flow is used to pay premiums, the amount is deductible to the LLC as guaranteed payment compensation.  This amount is taxable income to the LLC owners personally as compensation received.  Guaranteed payment comp is considered earned income and therefore, subject to self-employment FICA taxes. Keep in mind the OASDI earned income limit for self-employment FICA purposes.

• Cash flow #2 for policies owned personally by the LLC owners:  The LLC owners can use some of the distributed K-1 pass-through profit to pay premiums.  As stated just above, this K-1 profit is taxable to the LLC owners personally.  However, LLC profit is generally considered to be unearned passive income and therefore, is not subject to FICA taxes levied on earned income.

• Cash flow #3 for policies owned personally by the LLC owners:  The LLC may have a previously taxed profit account, known as the Capital Account for tax accounting purposes.  This Capital Account is the cumulative amount of any previously taxed LLC K-1 profit from prior years that have been left in the LLC.  A tax-free withdrawal can be made from this previously taxed Capital Account to pay for personally owned insurance of the LLC owners.  The Capital Account will be adjusted downward by the amount of the tax-free withdrawal.  There are no self-employment FICA taxes on Capital Account withdrawals which have been previously taxed.

As a general rule, it is important to ask business owner clients for permission to see their business tax returns so that sources of business cash flow can be identified to pay for insurance premiums.  These tax returns are: (1) the Form 1120 U.S. Corporation Income Tax Return for C Corps (2) the Form 1120S U.S. Income Tax Return for an S Corporation and (3) the Form 1065 U.S. Return of Partnership Income for LLCs.  These returns can reveal potential tax accounting sources of cash flow described above to fund annual premiums for business or personal life insurance.

Russell E. Towers  JD, CLU, ChFC
Vice President – Business & Estate Planning
Brokers’ Service Marketing Group
russ@bsmg.net

The post Tracking Business Cash Flow to Pay Life Insurance Premiums For C Corp, S Corp, and LLC Owners appeared first on BSMG.

Many closely held businesses operate as S Corporation “pass-through” entities for federal income tax purposes. Some S Corps started out as C Corporations and converted to an S Corp a number of years ago. Often, questions arise on the income taxation of distributions of cash or assets from S Corps to the shareholders of those S Corps personally. These S Corp shareholders often will need to use these S Corp distributions to fund personal financial objectives … like personally owned or trust owned life insurance to finance their personal protection, retirement income, or estate planning objectives.

A specific sequence and protocol must be followed under IRC Section 1368 when S Corp cash and/or assets are actually distributed to S Corp shareholders. Each “tier” of distribution must be reduced to zero before moving into the next tier of distribution. Here is the sequence of taxation that must be followed when these distributions take place. For simplicity, assume the S Corp shareholder owns 100% of the shares of the company. S Corps are “pass-through” tax entities where K-1 net profits are taxed to the S Corp shareholder personally on Schedule E of their Form 1040 U.S. Income Tax return.

Note: The S Corp distribution tiers described in this article are above and beyond any salary or bonus earned income paid to the S Corp shareholder as an employee.  Salary and bonuses are considered to be earned income subject to all FICA taxes for OASDI and HI.  S Corp tier distributions are not considered to be earned income and are not subject to FICA taxes.

S CORP DISTRIBUTION SEQUENCE WHEN ASSETS and/or CASH ARE TRANSFERRED TO THE S CORP SHAREHOLDER PERSONALLY (IRC Section 1368)

Tier 1
All S Corp Net Profit (business income minus business expenses) for the current tax year is passed-through as K-1 ordinary income to the S Corp shareholder. For tax year 2016 and beyond, ordinary income may be taxed at a top federal rate of 39.6% for high income S Corp owners.  Plus, an additional 3.8% tax on passive interest and rental income as a result of the Affordable Care Act (ObamaCare) is still in effect for certain high earners.  The combined marginal tax rate on ordinary income for high income S Corp owners could be as high as 43.4%.

Tier 2
All S Corp Accumulated Adjustments Account (AAA) is distributed tax free to the S Corp shareholder. This AAA account is a tax accounting entry for all previously taxed K-1 income that has been left in the S Corp and was not distributed to the shareholder in prior tax years. Some professionals refer to this AAA account for S Corps as previously taxed profits or previously taxed income. This AAA tier of distribution is important to verify because it can provide a tax free technique to fund personal insurance needs. The most recent Form 1120S U.S. Income Tax Return for an S Corp would be a good source to verify the AAA account.

Tier 3
All locked-in retained earnings from S Corps that previously had C Corp status are

distributed as a non-deductible dividend distribution to the S Corp shareholder. For tax year 2016 and beyond, qualified dividends are taxed at only a 15-20% federal rate.  Plus, an additional 3.8% tax on passive dividend income as a result of the Affordable Care Act (ObamaCare) is still in effect for certain high income earners.  The combined marginal tax rate on dividend income for high income S Corp owners could be as high as 23.8%.

To accelerate taxable dividend distributions from Tier 3 up to Tier 2, a tier switch under IRC Section  1368(e)(3) can be elected. Accordingly, S Corp owners can take advantage of this tier switch to unlock retained earnings from prior C Corp status and be taxed currently.

Tier 4
All Cost Basis which the S Corp shareholder has in the shares of the company is distributed tax free to the S Corp shareholder. This cost basis is the original capital with which the shareholder started the corporation PLUS any paid-in capital the shareholder added to the company over the years the company has been in operation. 

Tier 5
Finally, any additional asset value beyond Tier 4 cost basis is distributed as Capital Gain to the S Corp shareholder. For tax year 2016 and beyond, capital gains are taxed at a 15-20% federal rate.  Plus, an additional 3.8% tax on passive capital gain income as a result of the Affordable Care Act (ObamaCare) is still in effect for certain high earners.  The combined marginal tax rate on capital gain income for high income S Corp owners could be as high as 23.8%.

Example of S Corp Tier 1 and Tier 2 Distributions to Fund Life Insurance

Assume a 100% S Corp owner is 60 years old and is in the highest personal income tax bracket for 2016 (39.6%).  The S Corp has $400,000 of Tier 1 pass-through K-1 profit in the current year and $500,000 of Tier 2 previously taxed Accumulated Adjustment Account (AAA). The client wishes to make a tax free withdrawal from the AAA account to pay the taxes on the K-1 profit and use the full $400,000 of K-1 profit to fund personal financial needs using tax-favored financial products.

• Tier 1 K-1 Profit (Ordinary Income) … $400,000 x 39.6% = $158,400 tax.
• Tier 2 AAA … $500,000 – $158,400 withdrawal for tax = $341,600 remaining AAA

The $400,000 K-1 profit distribution can be placed in a personal side fund where annual withdrawals could be made to fund annual premiums for a non-MEC personally owned life insurance policy.  The policy could be no-lapse guaranteed UL policy, a current assumption UL policy, an indexed UL policy or a whole life policy depending on the retirement needs and risk tolerance of the S Corp owner.

Or the $400,000 K-1 profit distribution could be gifted using $400,000 of lifetime gift exemption to a no-lapse UL or no-lapse SUL policy owned by an Irrevocable Life Insurance Trust (ILIT) if estate tax free death benefits are required based on the facts of the case.

Contact your BSMG Advisor for a discussion of the life insurance funding possibilities for your S Corp clients.  Your Advisor will work with BSMG’s tax accounting and advanced planning specialists to design the most efficient insurance funding for your S Corp business owner clients.

Russell E. Towers   JD, CLU, ChFC
Vice President – Business & Estate Planning
russ@bsmg.net

The post Distributions from S Corps Can Fund Life Insurance Premiums appeared first on BSMG.

People purchase life insurance for a variety of reasons.  The income tax protection offered by life insurance on cash value accrual, withdrawals, and death benefits are well-known features.  An often overlooked feature of life insurance is the protection many states provide for life insurance against the claims of judgment creditors.  Every state has a creditor protection statute which addresses the issue of whether death proceeds and cash values are fully or partially exempt from the claims of creditors.

In cases where this issue arises, only the client’s legal counsel can provide advice based on the specific facts of the client’s situation.  However, it is often the life insurance producer who first brings this creditor protection issue to the client and legal advisor.

TYPICAL ASSET PROTECTION TECHNIQUES

Certain assets are protected under a variety of state and federal laws:

• The Internal Revenue Code and ERISA require qualified plans and IRAs to contain an anti-alienation statement which provides that a participant’s account cannot be assigned, alienated, or attached by legal process
• Titling a home (deed) in the sole name of a spouse of a professional prevents a judgment creditor (i.e. malpractice litigation) from forcing the sale of the house.  In a limited number of states, the same result may be accomplished by filing a homestead declaration
• Gifting assets to adult children or an irrevocable trust will remove the assets from the reach of judgment creditors.  However, attention should be given to the Fraudulent Transfer Acts in each state (Statute of Frauds), which generally prevents transfer of assets after legal process has been served.  Generally, real estate and non-qualified investments owned in the sole name of the debtor are assets that are most at risk of being reached by the claims of judgment creditors.

LIFE INSURANCE AS AN EXEMPT ASSET PROTECTED FROM CREDITORS

The typical life insurance exemptions only apply to personally owned or trust owned policies.  There is no exemption when life insurance policies are owned by business entity such as corporations, LLCs, and partnerships.  This distinction is important when the question is whether to own the life insurance inside or outside the business entity.

Also, if the life insurance is subject to a collateral assignment to secure a loan, the creditor already has a security interest in the contract, and any state creditor exemption statute will be of little or no benefit.

All states have some form of creditor protection for life insurance.  Many states fully protect life insurance death benefits and cash values from being reached by judgment creditors.  However, a small number of states only offer partial creditor protection up to certain specified dollar amounts.  State statutes are subject to legislative revision making it all the more important for a client to seek advice from legal counsel for the specific creditor protection rules in the state where they reside.

LIFE INSURANCE AND BANKRUPTCY

In the bankruptcy context, life insurance may be removed and exempted from the federal bankruptcy estate by the debtor and partially protected from bankruptcy creditors.  The federal Bankruptcy Code protects the actual insurance element of life insurance policies owned by a debtor (USC Section 522(d)(7)).

However, the federal Bankruptcy Code only protects up to a specified amount ($12,250 in 2016) of the debtor’s aggregate interest in any accrued dividends, interest, or loan values (net cash values) of policies owned by the debtor (USC Section 522(d)(8))

Some states allow a bankrupt debtor to choose between the federal bankruptcy exemptions or the state exemptions available in the non-bankruptcy context.  Other states do not allow a bankrupt debtor a choice of the federal bankruptcy exemptions and only allow the state’s exemptions in the non-bankruptcy context.  Often, these state exemptions will provide more liberal protection guidelines anyway than the limited federal bankruptcy exemption ($12,250 in 2016) for policy dividends, interest, or cash values.  Again, it is important for a client to consult legal counsel to determine whether his or her state of residence allows a choice between the federal bankruptcy exemptions and the state exemptions available in the non-bankruptcy context.

LIFE INSURANCE IS A SPECIAL ASSET WHICH ENJOYS PROTECTED STATUS UNDER LAW

One again, life insurance demonstrates that it is unique property to own when compared to other forms of property ownership.  A brief summary of life insurance advantages include the following:

• Cash value grows tax deferred
• Withdrawals up to cost basis and loans against cash value are tax-free (non-MEC)
• Death benefit is tax-free
• Death benefit can be arranged to be estate tax-free
• A high pre-tax equivalent internal rate of return on the death benefit
• Guaranteed lapse protection on certain type of policies
• Significant statutory creditor and bankruptcy exemptions available in most states.

For clients with personal, business, and professional situations which require a degree of asset protection planning, permanent cash value life insurance should be seriously considered.

BSMG Advanced Sales can provide the life insurance producer with specific citations of the creditor protection statutes of all 50 states.  This information can help you to focus your client on the statutes of their state in preparation for a more in-depth discussion with their legal advisor. This discussion can explore the merits of using cash value life insurance as part of their protection, cash accumulation, and asset protection strategy.

Russell E, Towers  JD, CLU, ChFC
Vice President – Business & Estate Planning
Brokers’ Service Marketing Group
russ@bsmg.net                                                                

The post Life Insurance Provides Creditor, Bankruptcy, and Tax Protection appeared first on BSMG.

With the recovery of the equities markets after the economic downturn of 2008-2009, it is common for successful business owners, professionals, and other individuals to have more than $1,000,000 in their IRA account. Many of these IRA owners have multiple sources of income as they approach their retirement years. These sources could include continued earned income from a profession, Social Security retirement benefits, K-1 “pass-through” income from ownership of S Corp or LLC entities, rental income from real estate, and other interest, dividends, or capital gains from non-qualified financial assets.

These IRA owners understand that Required Minimum Distributions (RMDs) must be taken from their IRA starting when they turn 70 ½. The question that typically arises in their financial planning is what to do with the after-tax amounts from their RMDs? For IRA owners with multiple sources of income, these after-tax RMDs are usually allocated as some form of inheritance to their heirs. Should these after-tax amounts simply be re-invested in their non-guaranteed financial asset portfolio or is there a more tax efficient way to re-allocate these funds that could provide a larger inheritance to their family?

The concept that can provide a larger after-tax inheritance is commonly known as the “Inherited IRA Legacy Plan” where after-tax RMDs are allocated to an annual premium for a no-lapse UL or no-lapse SUL life insurance product. The actuarial leveraging and income tax free life insurance death benefit can provide a larger inheritance by life expectancy and beyond than simply re-investing the after-tax RMDs in an asset portfolio with taxable yields. This is especially true in the continuing low-interest economic environment for fixed financial assets.

A Basic Blueprint for the “Inherited IRA” Using Life Insurance

Here are the steps of the “inherited IRA” transaction to provide a leveraged tax free fund for heirs in the form of life insurance:

First, create an income stream from the IRA by taking distributions from the IRA. An IRA owner doesn’t need to wait until age 70 ½ to take distributions from an IRA. Some IRA owners may wish to wait until 70 ½ while others may find it beneficial to start distributions prior to 70 ½. Starting prior to 70 ½ may work when coupled with a life insurance program because of the usual higher premium “cost of waiting”. Also, the onset of certain medical conditions as we get older that may result in less favorable underwriting may be a good reason to consider starting IRA distributions prior to 70 ½.

The income stream from the IRA is taxable, but the after-tax dollars can be used for a premium on either personally owned life insurance or insurance owned by an irrevocable life insurance trust (ILIT). The decision on personal ownership or ILIT ownership will depend on factors such as the size of the IRA gross estate in relation to the $5.34 million (single) and $10.68 million (married) federal estate tax exemption. Also, the simple size of the death benefit may dictate ownership by an ILIT whether or not the IRA owner has an estate large enough to worry about federal estate taxes. Certainly, many IRA owners may be exposed to state death taxes because of the lower state death tax exemptions of many states that still levy state death taxes.

Who shall be named as the beneficiary of the life insurance? Shall it be the children of the IRA owner outright or an ILIT for their benefit? Or shall it be an ILIT for the benefit of the grandchildren of the IRA owner?

Who shall be named as the beneficiary of the IRA? Shall it be the children of the IRA owner outright or a trust for their benefit so the “inherited IRA” can be paid over the children’s life expectancy? Or shall it be a trust for the benefit of the grandchildren so the “inherited IRA” can be paid over the longer life expectancy of the grandchildren?
Case Study of “Inherited IRA” Using After-Tax IRA Distributions for Life Insurance versus Using After-Tax Distributions for Alternative Fixed Financial Asset

Case Study of “Inherited IRA” Using After-Tax IRA Distributions for Life Insurance versus Using After-Tax Distributions for Alternative Fixed Financial Asset

Facts of Case Study:

Client and spouse are 71 and 70 respectively and have a current gross estate of $5,000,000. The client owns an IRA worth $1,000,000 and must start taking RMDs. They have other sources of retirement income including Social Security benefits, income from rental properties, and interest, dividends, and capital gains from their non-qualified asset portfolio. They ask you, their financial professional, to make a study of what to do with the after-tax RMDs that must start to be distributed from the IRA. Their combined federal and state income tax bracket is estimated at 35%. They feel that an after-tax return on their non-qualified asset portfolio is 5% going forward.

SCENARIO #1

Place After-Tax RMDs in an Asset Allocation Portfolio at 5% After-Tax Rate of Return (ROR)

• The factor from the Uniform Distribution Table for a 71 year old is 26.5. This means the RMD on the $1,000,000 IRA account will be $37,736. In a 35% tax bracket, the after-tax amount is $24,528.
• This after-tax amount of $24,528 will be re-allocated each year into the non-qualified asset portfolio with an assumed after-tax ROR of 5%.
• The joint life expectancy of a male 71 / female 70 from the government joint life expectancy table is about 20 years.
• An annual deposit of $24,528 into a non-guaranteed financial asset for 20 years at 5% after-tax ROR would provide a fund value of $851,594. This is the hypothetical non-guaranteed amount that would be inherited by the heirs of the client and spouse.

SCENARIO #2

Place After-Tax RMDs in a No-Lapse Survivorship Universal Life (SUL) Policy for Male Age 71 (Standard NS) and Female Age 70 (Standard NS)

• The factor from the Uniform Distribution Table for a 71 year old is 26.5. This means the RMD on the $1,000,000 IRA account will be $37,736. In a 35% tax bracket, the after-tax amount is $24,528.
• This after-tax amount of $24,528 will be re-allocated each year into a premium for a no-lapse SUL insurance policy issued by a competitive carrier.
• An annual premium of $24,528 will purchase a guaranteed SUL death benefit of $1,172,609 right from the beginning. This is the tax free amount the heirs would receive at the death of the survivor of the client and spouse. The IRR at year 20 joint life expectancy is 7.72%. In a 35% tax bracket, the pre-tax equivalent IRR is 11.88%.
• Instead, if very good health was able to provide a Male 71 Preferred NS and a Female 70 Preferred NS medical underwriting result, the $24,528 annual premium would purchase a guaranteed SUL death benefit of $1,351,838. The IRR at year 20 joint life expectancy is 8.90%. In a 35% tax bracket, the pre-tax equivalent IRR is 13.69%.

Summary of Benefits for “Inherited IRA” Plan with Life Insurance

The benefits of channeling after-tax IRA distributions into guaranteed no-lapse life insurance are significant. When compared to the taxable yields of alternative fixed financial assets (Money markets, bank CDs, bond funds, U.S. government securities), in the continuing low interest environment, the net results are truly outstanding.

1. The net inheritance to the heirs of the IRA- SUL life insurance plan shown above is hypothetically improved by about $321,000 at joint life expectancy (20 years) with “standard” medical underwriting when compared to alternative financial assets. The net inheritance to the heirs of the IRA-SUL life insurance plan is hypothetically improved by about $500,000 at joint life expectancy (20 years) with”preferred” medical underwriting when compared to alternative fixed financial assets.
2. the SUL life insurance provides a guaranteed no-lapse benefit versus a non-guaranteed accumulation value of the alternative fixed financial asset. The non-guaranteed “cross-over” point where the non-guaranteed financial asset hypothetically exceeds the guaranteed “standard underwriting” SUL insurance death benefit does not occur until year 25 when the younger insured, if still alive, is age 95. The non-guaranteed “cross-over” point where the non-guaranteed financial asset hypothetically exceeds the guaranteed “preferred underwriting” SUL insurance death benefit does not occur until year 27 when the younger insured, if still alive, is age 97.
3. The SUL life insurance could be owned by an ILIT so that the death benefit is estate tax free for state death tax purposes. The $5,000,000 taxable estate in our case study above would generate almost $400,000 of state death taxes in state which still uses the tax table from IRC Section 2011. Part of the SUL death benefit could be used to offset these state death taxes with the rest of the death benefit managed by the trustee for the benefit of trust beneficiaries.
4. The remaining IRA value at the death of the client is paid outright to children or to a separate trust for the benefit of children or grandchildren as an “inherited IRA”. The RMDs using the Single Life Table can be “stretched” over the remaining life expectancy of the children or grandchildren depending on the dispositive provisions of the trust document. Using this “inherited IRA” stretch method, the income taxes to the heirs are spread out and paid annually over many years into the future rather than paid in a lump sum and taxed all in one tax year.

Contact your BSMG Advisor if you have a client that has significant IRA values they never expect to use during their lifetime. Your BSMG Advisor can work with BSMG Advanced Sales to craft a plan to enhance the legacy of your client’s IRA using guaranteed no-lapse life insurance.

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Restricted Executive Bonus plans funded with life insurance offer a hybrid arrangement that bridges the gap between a deferred compensation plan and a regular executive bonus plan.  These plans are a great benefit for a company to offer to non-owner key executives to retain and reward them for their valuable services.

A)    An employer may like the benefit control afforded by a Deferred Comp plan with a company owned life insurance policy to informally fund the agreement and a vesting schedule in the deferred comp agreement.  But, the employer may object to the non-deductibility of deferred amounts and premium payments for tax accounting purpose.  Also, the employer may object to the booking of the deferred comp liability on the company balance sheet for GAAP and FASB purposes.

B)    Conversely, a regular Executive Bonus plan provides a current deduction to the company (IRC Section 162) and current taxation to the executive.  However, the corporation has no control over the bonus once it has been paid to the executive in the form of a premium for personally owned insurance policy.  Also, the executive can leave the company for other employment at any time with no loss of the benefits (i.e. policy cash value) on bonuses already received.

C)    The Restricted Executive Bonus plan gives the corporation a current deduction PLUS control of the benefit provided in the form of forfeiture language in a restricted bonus legal agreement.  If the executive leaves the company for other employment prior to the full vesting according to the written agreement, the executive may lose some of the benefits (i.e. cash value) provided in the insurance policy

PLAN DESIGN FEATURES AND INCOME TAXATION

• A written agreement is executed where the employer agrees to pay an annual bonus subject to partial forfeiture of cumulative bonuses if the employee terminates during the vesting period (i.e. 5-10 years).  A forfeiture during the vesting period would require the executive to reimburse some amount of the cumulative bonuses back to the corporation. The corporation would have to declare any reimbursements as taxable corporate income
• The bonuses are used to pay premiums for a personally owned cash accumulation type of insurance policy. The policy could be current assumption UL, indexed UL, or whole life depending on preference of the employee and employer.  Premiums are paid from the issue age to the age of retirement only
• The company may provide an extra bonus for the taxes due so that the after-tax amount is equal to the annual premium (40% tax bracket …. $20,000 bonus ….nets $12,000 premium after taxes)
• The insurance proposal can show a tax free solve income stream from policy cash values via withdrawals to cost basis, then switching to policy loans (FIFO).  For example, the tax free policy income stream may be shown from retirement age 65 to age 85.
• The death benefit remains income tax free to the personal beneficiary of the insured executive.
• The restricted bonus plan is especially attractive in an S Corp case.  Since an S Corp is a pass-through entity to the S Corp owner for tax purposes, the non-deductible deferrals of a deferred comp plan would flow through as part of the K-1 pass-through profit to the S Corp owner personally on Schedule E of his Form 1040 U.S. Income Tax return.  In essence, the S Corp owner would be using his own personal after-tax dollars to fund the deferred comp benefit of his non-owner key executive.  The restricted bonus plan avoids this K-1 accounting problem.
• The bonuses are currently deductible to the corporation and currently taxable to the executive as earned income compensation.  Since the benefits of a restricted bonus plan are subject to a risk of forfeiture if the executive terminates employment during the vesting period, the executive can make an IRC Section 83(b) election to have the bonuses taxed currently despite the risk of forfeiture.

Contact your BSMG Life Advisor to discuss whether a Restricted Executive Bonus plan can work for your business owner client’s key executives.  BSMG has access to a wide array of cash accumulation type of life insurance products from competitive carriers.

Russell E. Towers  JD, CLU, ChFC
Vice President – Business & Estate Planning
Brokers’ Service Marketing Group
russ@bsmg.net

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IRC Section 1035 provides exchanges into life insurance or annuity contracts with Long Term Care (LTC) riders to be income tax free and treated as LTC contracts under IRC Section 7702B(e). The tax free exchange provisions in Section 1035 positively impact so-called linked benefit life insurance-LTC products and linked benefit annuity-LTC products.

These products fall into 2 major categories which provide flexibility for case design:

1. Single deposit or flex-pay life insurance products with a LTC rider.
Life insurance death benefits are income tax free. Lifetime LTC rider benefits paid on these contracts are also income tax free (IRC Section 7702B (e)), but will reduce the net life insurance death benefit to the minimum residual amount.

2. Single deposit non-qualified deferred annuity products with a LTC rider.
The full deferred annuity account value will first be reduced to zero to pay LTC benefit claims before the remaining tax free LTC rider benefit claims are paid. Lifetime LTC rider benefits will be income tax free (IRC Section 7702B (e)). Lifetime cash withdrawals from the deferred annuity will still be treated as LIFO income on gain in excess of cost basis. Death benefits will still be treated as taxable LIFO income in respect of decedent (IRD) on gain in excess of cost basis.

Key Section 1035 exchange provisions that make these opportunities possible:
I. Life insurance exchanges into a life insurance contract with a LTC rider is defined as a life insurance to life insurance exchange for Section 1035 purposes (IRC Section 1035(b)(3))…

Meaning that existing life insurance cash values can be exchanged, tax free, into a linked benefit life insurance-LTC contract (single deposit or annual flex pay). Only complete life insurance to life insurance exchanges are permitted, i.e. the old contract must cease to exist. For flex-pay exchanges, a trail of annual premiums may be paid out of pocket by the policy owner in addition to the lump sum exchange amount from the old life insurance contract.

The possibility of a one for two Section 1035 life insurance to life insurance exchange also exists. In this case, a traditional UL policy without a LTC rider could be one of the new contracts and the other new contract could be a linked benefit life insurance-LTC contract (single deposit). Carryover cost basis on the exchange to the two new contracts will be allocated proportionally.

II. Annuity exchanges into an annuity contract with a LTC rider is defined as an annuity to annuity exchange for Section 1035 purposes (IRC Section 1035(b)(2))…

This means that existing deferred annuity account values can be exchanged tax free into a linked benefit deferred annuity-LTC contract (single deposit).  Since this type of exchange is considered to be an annuity to annuity exchange, partial exchanges from one annuity contract to another annuity contract are permitted under the guidance of Rev. Rul. 2003-76 and Rev. Proc. 2011-38. Carryover cost basis will be allocated proportionally between the old and new contracts.

Cost basis tracking will be important for both life insurance-LTC and annuity-LTC linked benefit products.

The Code provides rules for using cash value or account value of linked benefit products to pay the monthly charges (costs) for the LTC rider. These charges will be excluded from gross income and will reduce the cost basis of the insurance-LTC contract or annuity-LTC contract. However, the contract cost basis cannot fall below zero (IRC Section 72(e)(11)(A)(B)).

1035 Exchange Options for Standalone LTC and Guaranteed UL with LTC Rider

III. Another significant issue concerning LTC Section 1035 exchanges is that the IRS has issued additional tax guidance for partial exchanges involving annuities and stand-alone individual LTC products.

In Notice 2011-68, the IRS allowed a series of annual partial tax free exchanges from a deferred annuity contract to fund annual premiums for a stand-alone LTC contract. This method can work well administratively when both the deferred annuity contract and the stand-alone LTC contract are issued by the same carrier.

IV. Lastly, Annual Premium or Limited Pay Guaranteed Universal Life (GUL) insurance products with a qualified LTC rider are available for Section 1035 exchanges.
Life insurance death benefits are income tax free. Lifetime LTC benefits paid on these contracts are also income tax free (IRC Section 7702B(e)) and reduce the death benefit dollar for dollar. This tax free Section 1035 exchange option is available for both GUL with LTC rider and Survivorship GUL with a joint LTC rider.

BSMG life insurance, annuity, and LTC advisors can provide access to a wide variety of linked-benefit LTC, standalone LTC, and GUL-LTC type of products from our competitive carriers. Contact us today for a policy review of your client’s insurance or annuity contracts to see if a product with an LTC type of rider may provide a more flexible and more efficient combination of protection benefits.

Russell E. Towers JD, CLU, ChFC
Vice President – Business & Estate Planning
Brokers’ Service Marketing Group
russ@bsmg.net

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