FOR PRODUCER INFORMATION AND REFERENCE ONLY. NOT FOR USE WITH THE PUBLIC.

Transcription

1 Reference Guide on Advanced Markets Concepts ADVANCED MARKETS (855) , option 2 advancedmarkets@gafg.com AM2000 (04-18) FOR PRODUCER INFORMATION AND REFERENCE ONLY. NOT FOR USE WITH THE PUBLIC. Global Atlantic

2 Topical Index Estate Planning E Business Planning B Retirement Planning R Charitable Giving Through Life Insurance...6 Charitable Remainder Trust... 7 Discounting...9 Dynasty Trusts Estate Planning...11 Gifts and Gifting...14 Grantor Retained Annuity Trust...15 Installment Sale...16 Income in Respect of a Decedent (IRD)...17 Irrevocable Life Insurance Trust...18 Non-Resident Alien...21 Sale to Grantor Trust...24 Self Canceling Installment Note...25 Special Needs...28 Stretch IRA...31 Transfer Taxes Wealth Maximization Buy-Sell Cross Purchase... 3 Buy-Sell Entity Purchase...4 Executive Bonus...12 Executive Bonus Restricted Arrangement...13 Installment Sale...16 Key Person...20 Nonqualified Deferred Compensation...22 Self Canceling Installment Note...25 Simplified Employee Pensions (SEP) Split Dollar Endorsement Split Dollar Employer Loans...30 Charitable Remainder Trust... 7 Executive Bonus...12 IRA Maximization...17 Nonqualified Deferred Compensation...22 Simplified Employee Pensions (SEP) Stretch IRA...31 Traditional IRA, Roth IRA or...32 Look for this symbol to identify consumer-approved pieces that relate to Advanced Markets concepts. To download copies of these materials, visit the Advanced Markets tab of GlobalAtlanticLife.com and choose the sidebar button Advanced Sales Concepts. You may also order printed versions from our forms website. Consumer Approved Materials C Buy-Sell Cross Purchase... 3 Buy-Sell Entity Purchase...4 Estate Planning...11 Executive Bonus...12 Key Person...20 Non-Resident Alien...21 Nonqualified Deferred Compensation...22 Split Dollar Endorsement What Advanced Markets Can Provide You...37 Tax & Retirement Plan Information...41 The following summaries are intended to be a general discussion of the topic presented and are based on our current understanding of applicable tax laws, regulations and rulings. In actual practice, the transactions discussed may be more complex and will require the attention and expertise of professional advisors. In no way should these summaries be construed to constitute tax or legal advice. In order to comply with certain U.S. Treasury regulations, please be advised of the following: Unless expressly stated otherwise, any U.S. Federal tax advice contained in these materials, including attachments, is not intended or written to be used, and cannot be used, by any person for the purpose of avoiding any penalties that may be imposed by the Internal Revenue Service. 1

3 We re excited that you have a copy of our book. Our index sorts topics alphabetically into three categories: Estate Planning, Business Planning and Retirement Planning. If a topic falls under multiple categories, you ll find it listed in each of those categories. Next to each category header, you will find corresponding colored circles that will remind you which topics these would reference. Like the previous editions, you will also find tax rates, tables and retirement planning information inside the back cover. The topics in represent what we see most frequently in the estate, business and retirement areas. However, you ll find our experience sitting across the table from clients in the insurance, legal, accounting and qualified plan worlds gives us unique skills in overcoming obstacles in the planning process. We ll gladly participate in conference calls with client advisors to discuss client objectives and case design solutions. While this piece is not currently approved for use with clients, feel free to distribute it to your clients legal and accounting advisors as a guide to the planning areas with which you can assist. Sincerely, Advanced Markets 2

4 Buy-Sell Cross Purchase B C In a cross purchase plan, company owners agree in advance to buy the interest of a withdrawing/ deceased owner while the withdrawing/deceased owner agrees to sell his or her ownership interests to the remaining owners. A properly structured cross purchase plan makes the entity a better credit risk by increasing the probability of the business continuing past an owner s death. Buy-sell planning is a critical element of any successful business All businesses can benefit from buy-sell planning sole proprietorship, C-Corporation, S-Corporation, Partnerships, LLCs, etc. It provides a definite market for transferring the ownership interest. In a buy-sell cross purchase, the co-owners must purchase the interest. It specifies a set or determinable price. This price may also set the value used for estate tax calculation. It provides some or all of the funds necessary to execute the agreement when properly funded with life insurance. It maintains closeness of the business by restricting and planning who/what can receive the business interests. It provides liquidity to pay estate taxes (due nine months from date of death). How cross purchase works: 1. The owners agree that at an owner s death, disability, or departure, the surviving/remaining owners will purchase the business interest. This is documented in a formal agreement between/among the owners. 2. Each business owner applies for (and is beneficiary of) a life insurance policy on every other owner and will pay the premiums on those policies. 3. At death, each surviving owner receives the policy death proceeds. 4. If departure is for reasons other than death (i.e. disability), the policy s cash values can be accessed to partially or totally fund the purchase. 5. Each surviving owner purchases the agreed business interest from the decedent s estate (e.g. if only one surviving shareholder, he/she purchases all of the business interest from the estate). Why life insurance? Cash value inside a policy grows tax-free. Death proceeds are received income tax-free and received at just the right time to fulfill the agreement. Individually owned policies are generally not subject to the business creditors. Business owners use personal funds to pay premiums on the policy they own. A split-dollar (loan arrangement or employer endorsement) arrangement can be implemented to assist in paying premiums. Possible disproportional premium payments the younger/healthier owners will pay more in premiums to insure the older/less-healthy owners. Policies are potentially subject to the individual s creditors (varies by state law). Administratively complex the more business owners the more policies that must be purchased and maintained. For example, if there are three owners, each owner will own and maintain two policies (six policies total) if there are six owners, each owner will own and maintain five policies (30 policies total). Consumer Approved Materials Consumer Flyer - Partnership Buy-Sell Chart AM3037 Consumer Flyer - Corporation Buy-Sell Chart AM2036 Making the Decision for the Future of your Business AM2057 Consumer Flyer - Protecting the Future of your Business AM2010 Consumer Flyer - Sole Proprietor Buy-Sell Chart AM2038 Estate s non-liquid asset (i.e. the business interest) is sold to the remaining owners at an agreed upon price (little or no gain should be taxable due to step-up in basis at date of death). The business interest passes to those intended to receive that interest. Surviving owners receive basis in the acquired interest equal to the price paid (step-up in basis). 3

5 Buy-Sell Entity Purchase B C In an entity purchase plan (stock redemption plan), the company agrees in advance to buy the interest of a withdrawing/deceased owner while the withdrawing/deceased owner agrees to sell his or her ownership interests to the company. A properly structured entity purchase plan may allow for the business continuing past an owner s death and a source of income for the decedent s family. Buy/sell planning is a critical element of any successful business All businesses can benefit from buy-sell planning sole proprietorship, C-Corporation, S-Corporation, Partnerships, LLCs, etc. It provides a definite market for transferring the ownership interest. In an entity purchase, the company must purchase the interest. It specifies a set or determinable price. This price may also set the value used for estate tax calculation. It provides some or all of the funds necessary to execute the agreement when properly funded with life insurance. It maintains closeness of the business by restricting and planning who/what can receive the business interests. It provides liquidity to pay estate taxes (due nine months from date of death). How entity purchase works with a C-Corporation, Partnership, or LLC: 1. The owners agree that at an owner s death, disability, or departure, the company will purchase the business interest. This is documented in a formal agreement between the company and the owners. 2. The company applies for (and is beneficiary of) a life insurance policy on each owner. The business will pay the premiums and will be the owner and beneficiary of the policy. 3. The company and each insured comply with the notice and consent rules so the death benefit will be received income tax-free. 4. At death, the company receives the policy death proceeds. 5. If departure is for reasons other than death (i.e. disability) the policy s cash values can be accessed to partially or totally fund the purchase. 6. The company purchases (redeems) the agreed business interest from the decedent s estate. A cash basis S-Corporation would vary by: 1. The owners agree that at an owner s death, disability, or departure, the company will purchase the business interest. This is documented in a formal agreement between the company and the owners. 2. The company applies for (and is beneficiary of) a life insurance policy on each owner. The business will pay the premiums and will be the owner and beneficiary of the policy. 3. At death, the corporation redeems the deceased shareholder s interest for a promissory note. This eliminates the deceased shareholder s estate as a shareholder of the S-corporation. 4. The company and each insured comply with the notice and consent rules so the death benefit will be received income tax-free. 5. The corporation then elects a short tax year under Internal Revenue Code (IRC) 1377 (a)(2). 6. The corporation then receives the policy s death benefit after the start of the new tax year. Receipt of policy death benefit increases the basis in current shareholder s stock. Current shareholder includes the surviving shareholders and does not include the deceased shareholder or his/her estate. 7. The corporation pays off the note with the policy death benefit. Continued on page 5 4

6 Buy-Sell Entity Purchase continued from page 4 Why life insurance? Cash value inside a policy grows tax-free (subject to potential AMT if C-Corporation). Death proceeds are received income-tax free (subject to potential AMT if C-Corporation) and received at just the right time to fulfill the agreement. In order for the death proceeds to receive income-tax free treatment, the Pension Protection Act of 2006 requires two items are met: The notice and consent requirements are met; and The insured is an employee or a key person as defined by the tax law,* the proceeds are used to purchase the key employee s interest in the business from one of the persons listed below, or the ultimate payee is: - A member of the insured s family; - The designated beneficiary (other than employer); - A trust established for the benefit of any such person; or - The insured s estate. Policy cash value is potentially subject to corporation s creditors. Premium payments are not a deductible expense. Remaining business owners do not receive a basis increase in their ownership interest. (S-Corporation remaining owners may be able to receive a stepped-up basis with proper redemption planning) Possible dividend treatment in family situations. In a family-owned corporation, the redemption may be treated as a dividend instead of a capital gain. This means that the entire amount received will be taxable, not just the gain. C-Corporations may be subject to Alternative Minimum Tax (AMT) on the policy growth and the death benefit. * See the Key Person Agent Reference Guide AM2022 for the tax law definition of a key person. Form 15996, Notice and Consent for Employer Owned Life Insurance, is required to be completed and included with all new life applications. Estate s non-liquid asset (i.e. the business interest) is sold to the company at an agreed upon price (little or no gain should be taxable due to step-up in basis at date of death.) Company provides premium payments thus avoiding any inequity/unfairness associated with individual premium payments with cross purchase planning. The policy s cash value is an asset on the business balance sheet offsetting the redemption obligation. A minimal amount of administration is required since only one policy per owner needs to be purchased and maintained. The business interest does not pass to any unintended parties. 5

7 Charitable Giving Through Life Insurance E Charitable giving programs can be funded in a number of ways, but none offer the unique advantages and the flexibility of life insurance. Typically, the amount of a policy s death benefit is many times the total of premiums paid, resulting in leveraged dollars. Rather than making annual donations to help fund charities missions, it s possible to leave amounts large enough to make a serious impact in the planning goals of the client s charity. Benefits of giving to a favorite charity Avoidance of probate delays or red tape. Charity will receive future income from planned gifts, which may help them achieve long-term goals. Publicity from large gifts can help attract other donors. Simple techniques using life insurance in charity giving 1. Gifting insurance policy dividends to a charity. With an older dividend-paying whole life insurance contract, this strategy is easy to implement. All that is necessary is to contact the insurance company and request the policy dividends to be paid in cash, and then donate those dividends to a charity. These cash gifts can be deductible up to 50% of the donor s adjusted gross income. 2. Change the current beneficiary to a charity. This is also easily accomplished. A favorite charity is named as the beneficiary for either all or a portion of the policy proceeds. The ownership of the policy does not change and the beneficiary designation is revocable at any time. There is no income tax deduction for premiums paid on this policy, but it qualifies for a full charitable estate tax deduction for the proceeds. 3. Give an existing policy to a charity. This is for policies that are no longer needed. Perhaps a policy was purchased when the children were small, or before the mortgage was paid in full. Gifting these policies to charity effectively reduces the taxable estate. In addition, an income tax deduction is generally available for the lesser of the cost basis or the fair market value of the contract. Caution needs to be exercised when there is a policy loan on the contract and the tax advisor and the charity should be consulted prior to transferring ownership. 4. Buy a new policy for the charity and make gifts so it can pay the premiums. This can provide a very large gift in proportion to the amount gifted to the charity. The gifts to pay the premiums should provide current tax deductions as long as there are no strings attached to the gifts. Paying the premiums directly to the insurance company can affect how much can be deducted. 5. Buy life insurance to replace the value of an asset donated to charity. Donating highly appreciated assets to charity can provide income and estate tax benefits, but can reduce the amounts left to heirs. To overcome this, the value of the donated assets can be replaced with life insurance so heirs can receive the inheritance income tax-free. If the policy is purchased inside an irrevocable life insurance trust, the death benefit can also be estate tax-free. 6. Buy life insurance to back a pledge or future donation to charity. Pledging a large amount to a charity can mean a lot to both the charity and the donor. An efficient way to ensure payment of a future donation or pledge is by purchasing life insurance and naming that charity as the beneficiary. Life insurance provides a low-cost way to provide a large benefit to charity. As the pledge is paid off, the charity can be left as beneficiary of the entire life policy, or a portion of the proceeds redirected to heirs or another charity. Charitable gifts of life insurance typically avoid or reduce some combination of income, estate, gift, and capital gains taxes. Life insurance is an excellent vehicle to achieve charitable giving goals. It provides the flexibility to donate as little or as much as you desire in a very cost-effective manner. 6

8 Charitable Remainder Trust E R A Charitable Remainder Trust (CRT) is an irrevocable trust designed to turn highly appreciated assets, like stock or real estate, into increased income and reduced current income taxes through a process of tax-efficient asset transfers. When done correctly, these transfers allow clients to minimize estate taxes while leaving substantial gifts to their favorite charities. CRTs may also maximize the estate for heirs. Benefits of a Charitable Remainder Trust Potential immediate (partial) tax deduction, based on the value of the eventual gift to charity. May eliminate capital gains tax for gifts of long-term appreciated securities, real estate and other assets. Accepts many types of assets. Generates income for a beneficiary of the trust. Which type of Charitable Remainder Trust is best for your client? The key questions to ask are: 1. Do you foresee making additional contributions? Yes = Unitrust (CRUT) 2. Are you willing to tolerate fluctuating income? No = Annuity Trust (CRAT) Charitable Remainder Annuity Trust (CRAT) A CRAT requires the trustee to pay a specified annual annuity to the donor or other designated individuals for life or at certain period of time. The annuity must be at least 5% and not be greater than 50% of the value of assets contributed to the trust. The amount projected to go to charity must be at least 10% of the assets value at the time the asset is transferred. Additionally, there must be a 95% probability that the charity will receive the 10% remainder. The CRAT s income beneficiary must receive the required annuity payout each year regardless of the trust s return on its assets. This will sometimes require the use of principal. Donors cannot contribute additional assets to a CRAT. Charitable Remainder Unitrust (CRUT) A CRUT requires the trustee to pay income beneficiaries a specified percentage of the value of the trust assets each year. If the value increases, the payout increases; if the value decreases, the payout will decrease accordingly. As with the CRAT, the specified payout must equal at least 5% and be no greater than 50% of the value of the trust assets. The value of the charitable remainder must be at least 10% of the net fair market value of all assets transferred to the trust. One key advantage of the CRUT is the grantor can add assets to the trust at a future date. How to establish a CRT: 1. Client establishes a CRT. 2. The client names beneficiaries of the trust. The client can be income beneficiary and the charitable institution that will inherit the property at the beneficiary s death will be named or a method to determine the charities provided. 3. Client transfers property to the trust and can receive income in the form of an annuity or unitrust. a. Client can receive a tax deduction equal to the asset s fair market value minus the present value of the payments the income beneficiary is to receive from the trust. b. The interest rate used to determine the present value is the Internal Revenue Code Section 7520 Interest Rate. This rate changes monthly, however the donor has the option to use the current month s rate or one of the previous two month s rates. A higher rate creates a higher income tax deduction. 4. At the client s death or the end of the specified number of years, the assets in the trust are distributed to the charity. (This can also be triggered by the trust assets falling to 10% of the starting value of the gifts made to the trust.) 7

9 When income is distributed, it is taxed to the recipient in the following order: 1. Ordinary Income 2. Capital gain 3. Other income 4. Principal If a client is interested in leaving the remainder interest to a private foundation, the charitable deduction could be limited to the cost of the asset contributed. The type of asset can also change the percentage limitation used in determining the income tax deduction allowed. When assets transferred to the CRT are subject to loans, it could create taxable income for the trust and donor. If an agreement is to sell the asset already in place, the donor would be required to recognize the capital gain and lose one of the key advantages of the CRT. Many times potential donors to a Charitable Remainder Trust are reluctant to give substantial assets away because of their concern for their heirs. One way to overcome this reluctance is to replace the asset with life insurance held in an irrevocable life insurance trust sometimes called a Wealth Replacement Trust. When done correctly, the life insurance can be income and estate tax-free to the heirs. This can increase the net amount passed to heirs after tax. The combination of the tax deductions and cash flow from the CRT are often more than enough to fund the wealth replacement life insurance policy. A Charitable Remainder Trust is a great planning tool if and only if your client has charitable intent. Maybe they are passionate about their church, alma mater, or a cause such as breast cancer research. Charitable intent is necessary because CRT rules require that the present value of the remainder interest be at least 10% of the fair market value of the assets transferred to the trust. Clients should not use this technique just for tax advantages. Tax advantages combined with charitable intent make the CRT a great planning tool. 8

10 Discounting E Discounting allows interests in entities to be transferred at a value that is less than the pro-rata share of the business value. Why? Because the ownership of a minority (i.e. non-controlling) interest in a business does not provide the ability to control the entity or its underlying assets. In addition, there is usually a limited market for interest in closely held businesses. Ownership interests can t easily be transferred. This lack of control and lack of marketability reduce the value of the business interest and reduces transfer (gift, generation-skipping tax and/or estate) taxes. Lack of control discount This discount reflects the inability of a minority owner to control the entity and the assets owned by the entity. Minority owners cannot dictate management decisions regarding the entity s direction; cannot dictate investment decisions regarding the entity s assets; cannot make decisions concerning distributions to owners and are generally at the mercy of those who control the entity. Lack of control discounts are applicable not only to minority interests (less than 51% ownership) but can be applied to non-voting and limited interests in the entity. Typical discounts for lack of control generally range between 20% and 30%. Lack of marketability discount This discount is often applied because of the owner s inability to sell the interest in a readily available market. Most closely held businesses contain specific provisions limiting that transfer of the interests. Each of these provisions, by design, reduces the owner s ability to sell his/ her interest and thereby reduces its value. Several factors can influence the level of discount for lack of marketability. These factors include, but are not limited to, the entity s asset mix (i.e. marketable securities, real property, etc.) and transfer restrictions contained in the entity s legal documents. Typical discounts for lack of marketability also range up to 30%. Valuable assets such as a successful closely held business, real estate, etc., can be transferred to the next generation in a very tax-efficient manner. Parents can gradually give away business units which represent the bulk of the economic ownership of the entity while maintaining control of the business. The discounts related to minority interests, limited interests and/or non-voting interests can be an effective way to transfer significant amounts for a fraction of the overall value. These discounts must be determined by a qualified appraiser in conjunction with an experienced estate-planning attorney. 9

11 Dynasty Trusts E A dynasty trust is a powerful tool that is available to help provide for current and future generations. It is a trust designed to maximize the use of the donor s Generation-Skipping Transfer (GST) tax exemption. This is typically done during life by allocating the GST tax exemption when creating or transferring assets to the trust. When a dynasty trust is properly structured, the assets left in trust are not subject to estate or GST taxes when they pass from one generation to another. Dynasty trust is a sophisticated estate-planning tool Complicated planning issues exist at both the state and federal level. The advantages can provide an effective way to transfer wealth to future generations with minimal tax. If the trust is created with highly appreciating assets, the tax leverage can be significant. If the trust is established in a state that allows trusts to continue for many generations, the dynasty can be created to help provide financial security to future generations. How does a dynasty trust work? 1. Client establishes a dynasty trust that is the owner and beneficiary of a life insurance policy. 2. Client transfers cash or assets to the dynasty trust. (Whether or not these gifts are subject to gift tax depends on your client s annual exclusions and/or lifetime gift tax exemption amounts. In addition, the client will need to allocate some or all of their GST tax exemption to the contributions made to their dynasty trust to avoid the GST tax.) 3. All future growth or death benefit will not be subject to future estate tax. 4. All future distributions of interest and principal are distributed free of the GST tax for the duration of the trust.* The assets are usually exempt from the claims of beneficiary s creditors or ex-spouses because the assets do not actually belong to the beneficiaries. Careful planning is necessary to provide this protection. The client should consider naming a corporate co-trustee because the dynasty trust can continue for many years. * A dynasty trust can be created in any state, however many states subject a trust to the Rule Against Perpetuities. This is a rule that forces a trust to end at some point in time. Many states require a trust to end 21 years after the death of the last beneficiary alive when the trust was created. However, this law is governed at the state level and there are a number of states that have abolished or relaxed this rule. When the Rule Against Perpetuities is abolished, the trust does not need to end until the last living descendent of the trust creator dies. In this situation, there is potential for the trust to never end. Additionally, there are states with relaxed laws that allow a trust to continue anywhere from 150 to 1,000 years. To take advantage of another state s rules, it is important to have at least one trustee with significant powers be based in the desired jurisdiction. Many times this is a bank or trust company. A dynasty trust is a way for clients to provide financial security for their children and future generations. While a dynasty trust can be funded with many types of assets, life insurance is often used in order to maximize the amount of wealth transferred to the trust beneficiaries. 10

12 Estate Planning E C Estate planning is the process of creating a legacy by arranging for the transfer of property at death. Estate planning focuses on creating certainty for the legal transition of property through the orchestrated use of trusts, wills, beneficiary designations and ownership structures. Effective estate planning will typically maximize the value of the estate passed on at death by reducing taxes and other expenses. While there may be a temptation to focus only on the economics of estate planning, ultimately it s about creating a plan that allows an individual to determine who will receive certain property, when they will receive it and how they will receive it. A client s goals should dictate how the plan is implemented. How does estate planning work? The Last Will and Testament is the foundational estate-planning document. Unlike trusts that only govern what they own, a will catches everything that the deceased owned that wasn t already accounted for through another ownership or beneficiary structure. The will is submitted to probate court where an estate is opened and a judge presides over the proceedings, making sure that all property changes hands legally. Courts charge a fee for probate that is typically a small percentage of the overall estate value. While trusts may be designed to last for multiple generations, probate estates are typically closed within a year. In cases where a will is the correct estate-planning document, but ongoing supervision is required, a will may have language that creates a trust known as a Testamentary Trust. When no will has been created or located, then the state where the deceased lived has a default estate plan for their citizens, known as intestacy. Revocable trusts are often created to simplify the estate-planning process by providing how property will transition to others, with the option of having the supervision of a probate court. These trusts may continue for many years after the death of the creator making trusts popular vehicles to provide ongoing protection for minors, individuals with special needs, as well as individuals who may need protection from their own decisions. Irrevocable trusts are commonly designed to reduce estate taxes at death. For wealthy individuals, an irrevocable trust may be created to own a life insurance policy to create liquidity for the estate while not being taxed as an asset of the estate. When done correctly, these proceeds can be used to provide liquidity to pay estate taxes, fund a buy-sell agreement between beneficiaries or equalize the estate. Beneficiary Designations are considered operations of law meaning that at the point a death occurs, the property passes automatically to the beneficiary. For some assets, this creates an ideal outcome; in other cases, the transfer under a beneficiary designation overrides desired trust or will provisions from applying since the beneficiary designation operation of law occurs automatically. Ownership also affects the estate plan. Jointly owned property with rights of survivorship (JTROS) causes the deceased s interest in property to transfer automatically at death to any surviving owners. People who own property as Tenants in Common (TIC) pass their ownership interest according to their will or trust, if any. Estate planning is sometimes mistaken for estate tax-planning. Anyone who owns an asset that will exist after their death will need some form of estate plan either one they design or the state s intestacy laws. Estate tax-planning occurs when an estate is large enough to incur federal estate or state death taxes. Estate tax-planning involves various strategies to reduce the amount tax owed so that a greater percentage of the estate reaches the desired heirs. The probate process provides supervision for the transfer of assets at a cost. While many clients don t like the idea of paying probate fees and incurring the delays the oversight of a probate court can prevent mistakes and mismanagement from occurring that cost the estate valuable time and assets. The probate court typically ensures that the directions in a will are fulfilled. Consumer Approved Materials Consumer Checklist AM2012 Consumer Guide - Federal Estate Tax AM2014 Estate planning is the process of preparing to legally move assets from someone after their death to the people or organizations they care about. This process can be simple or complex depending on the estate and the individual s goals. 11

13 Executive Bonus Plan (Sec. 162 Plan) B R C Executive Bonus Plans can provide key executives significant benefits on a tax-deductible basis for the employer. In an effort to recruit, reward and/or retain top talent, the employer agrees to pay the premiums on a life insurance policy owned by the executive. This amount is includible in the executive s compensation and is generally deductible to the employer (to be deductible the employee s total compensation including the bonus must be reasonable per Internal Revenue Code 162). Executive Bonus Plan is the simplest of the executive benefit plans A way to reward key employees with no discrimination rules. A plan where all contributions can be tax deductible. A plan that is simple to administer and requires no IRS approval to implement or terminate. How the Executive Bonus Plan works 1. The employer agrees to provide the executive with a taxable bonus or a series of taxable bonuses. The employer will include the bonus on the employee s W-2 and can deduct the bonus as compensation and an ordinary business expense. There are three types of executive bonus plans: - Single Bonus The employer pays a bonus equal to the policy premium. The employee is responsible for the income tax on the bonus. This causes the plan to become contributory, due to the employee paying the required income taxes out of pocket. - Double Bonus The employer pays a bonus equal to the premium and the required income tax. For example, if the premium is $10,000, the total bonus would be $10,000 divided by one (the employee s tax bracket). If the employee was assumed to be in the 40% bracket, the total bonus would be $10,000 divided by 0.60, or $16,667. There is no out-of-pocket expense to the employee. - Restricted Bonus Refer to the Restricted Executive Bonus Arrangement page for more information. 2. The executive purchases a life insurance policy as applicant, owner and insured and names the beneficiary. 3. The executive pays the life insurance premiums with the bonus they receive. Alternatively, the Employer can pay the premium directly to the insurance company. 4. The executive can take advantage of the cash value accumulation for personal needs during their lifetime. 5. At the executive s death, the life insurance policy will be paid tax-free to the executive s beneficiaries. Why life insurance? Life insurance policies are extremely flexible in their design. Two primary objectives desired from a life insurance policy are cash accumulation and death benefit. It is possible to fully fund a contract, within the Internal Revenue Code guidelines for Modified Endowment Contracts, to accumulate significant amounts of cash that may be accessed in a tax-favorable manner through tax-free withdrawals and loans. The cash flow can be used for a number of reasons, such as supplemental retirement income, college funding, or emergency situations. The executive owns the life insurance contract, which can be used for survivorship benefits in case of premature death. The cash values can be accessed for emergencies or to help supplement retirement. If the executive should leave, the policy is portable and can be funded with personal dollars. The employer has no ownership rights in the policy on the executive. For a C-Corporation, it may reduce the overall taxes for income to be taxed to the shareholder /executive rather than the corporation. If this is true, an Executive Bonus Plan can be an excellent planning tool. However if the entity is a flow through, such as sole proprietorship, a partnership, an S-Corp., an LLC taxed as a partnership or S-Corp., or an LLP, the Executive Bonus Plan may not provide any income tax savings. Consumer Approved Materials Consumer Flyer - AM2030 An Executive Bonus Plan is a method of rewarding select key employees by paying the premiums on an employee owned life insurance contract. The employee is subject to tax on premiums and the employer s payment can be deductible as employee compensation. 12

14 Restricted Executive Bonus Arrangement B The Restricted Executive Bonus Arrangement (REBA) is an effort to recruit, reward and/or retain top talent. The employer agrees to pay the premiums on a life insurance policy owned by the executive as long as the executive continues working for the employer. The executive also agrees to restrict his or her ability to access the policy s cash value for a period of time. Unlike a standard Executive Bonus Plan, the policy s values are not accessible by the executive for a specified period of time. The premium amount is includible in the executive s compensation and is generally deductible to the employer to the extent that the executive s compensation is reasonable (under IRC 162). REBA can provide golden handcuff incentives for employees to stay This arrangement provides handcuffs not available in a traditional Executive Bonus Plan becauset the executive cannot access policy values for a set period of time without the employer s consent. The employer has no interest in the policy. For the executive, it can provide affordable life insurance protection and potential supplemental retirement income. How a REBA plan works: 1. Similar to an Executive Bonus Plan, the employer agrees to provide the executive with a taxable bonus or a series of taxable bonuses. The employer will include the bonus on the employee s W-2 and can deduct the bonus as compensation and an ordinary business expense. 2. The executive purchases a life insurance policy as applicant, owner and insured and names the beneficiary. 3. The executive and employer will execute a restricted endorsement at the time the policy is purchased and file it with the life insurance company. 4. The executive pays the life insurance premiums with the bonus they receive. Alternatively, the employer can pay the premium directly to the insurance company. 5. At an agreed upon time, the endorsement is lifted and the executive will be able to use the potential cash value in any way desired, including supplementing retirement income. 6. At the executive s death even if the endorsement has not been lifted, the life insurance policy will be paid tax-free to the executive s heirs. The key employee owns the life insurance contract, which can be used for survivorship benefits in case of premature death. The cash values can be accessed for emergencies or to help supplement retirement income once the restrictive endorsement is removed. If the key employee should leave, the policy is portable and can be funded with personal dollars. The employer has no ownership rights in the policy on the executive. Entire premium amount is included in the executive s compensation as opposed to premium sharing arrangement. A REBA rewards an executive but provides some golden handcuffs as an incentive for the executive to stay with the employer. The employee is subject to tax on premiums and the employer s payment can be deductible as employee compensation. At an agreed upon date in the future, the executive will be able to access the potential policy cash value in the life insurance policy. 13

15 Gifts and Gifting E Gifts are a major tool in estate-planning and can result in significant income and estate tax savings. There are also many non-tax reasons for making gifts. The broad definition of a gift is any transfer, sale or exchange of property from one person to another without full and adequate consideration in money or money s worth. By making a gift, the donor removes all future appreciation on the property from his or her estate. This can substantially reduce the donor s estate. Additionally, someone else s educational or medical expenses can be paid without being subject to gift taxes. Present interest vs. future interest gifts Gifts of present interest qualify for the annual exclusion from the federal gift tax. A present interest gift is one for which the client has the right to currently use, enjoy or possess the property. The client s right must begin at the time the gift is made, not at some future date. Everyone can gift an amount up to the annual exclusion each year to any number of people without any gift tax, if the gift is a present interest. Annual exclusion gifts are an extremely valuable, tax-efficient means of gifting property and can reduce the size of the client s taxable estate. Gifts qualifying for the annual exclusion are often used to pay life insurance premiums. A future interest gift occurs when the recipient s use, possession or enjoyment of the property starts at a future date. For example, a gift in trust is a gift of future interest unless the beneficiary is given a right to immediately require the distribution from the trust of his/her proportionate share of the gift. A future interest gift does not qualify for the annual exclusion. The IRS requires the trustee give the beneficiary notice of their right to withdraw the gifted funds for a period of time (usually 30 days) using a Crummey Notice. Once the period for withdrawal has lapsed, the trustee can use the funds to pay premiums or use for other purposes. Split gifts A married couple can in effect, combine their gifts to provide an additional level of gift tax leverage. It doesn t matter which spouse owns the property if they both elect to treat the transfer as a split gift. If the couple elects gift splitting, it applies to all gifts either one makes during a year, other than to each other. The Internal Revenue Service requires that the couple file a gift tax return when split gifts are made even though no gift tax is owed. The gift tax return, Form 709, must be filed on or before April 15 of the year following the year the gift is made. Outright gifts to a spouse qualify for the gift tax marital deduction. Gifts to a trust for a spouse must meet certain requirements to qualify for the marital deduction. In addition to gifts qualifying for the gift tax annual exclusion, marital deduction or charitable deduction, a donor may make additional gifts up to the amount of the lifetime exemption (this is known as the applicable exclusion amount or unified credit). Any unused lifetime exemption is available at death. Outright gifts to a charity qualify for the gift tax charitable donation. Gifts to a trust for a charity must meet certain requirements to qualify for the charitable deduction. Gifting and life insurance can be a powerful combination. If life insurance is owned by an Irrevocable Life Insurance Trust (ILIT), the trust will generally receive the policy death benefit free of estate and income tax. Clients can use their annual exclusion amounts to gift money to an ILIT, and then the trustee can use those gift dollars to purchase life insurance. The death benefit can be substantially more than the original gift. When the recipient sells the property received as a gift, any gain is based on the donor s basis, not the property s value at the time of the gift. The gain on inherited property is generally based on its value at the date of death. This can result in higher income taxes for gifted property than inherited property. If the premium is larger than the available annual exclusions, or if the annual exclusions are being used with other planning, then the client should consider implementing a premium-sharing arrangement (endorsement split-dollar, employer loans, private loans) or a premium-financing arrangement. Premium-sharing arrangements are essentially a process of renting the death benefit (endorsement arrangements) or borrowing to pay premiums (loan arrangements). The effect is to reduce the annual gift tax cost from the entire premium cost for the year to either: (1) the economic benefit (endorsement arrangement) or (2) the interest (loan arrangement) cost of the arrangement. It is important to have an exit strategy for any premium-sharing arrangement. Such strategies can include: using policy values; Grantor Retained Annuity Trust; sale to grantor trust; charitable remainder trust; etc. Gifts are an effective estate tax-planning tool. Gifts qualifying for the annual exclusion are totally removed from the donor s estate. The appreciation on property gifted is excluded from the donor s estate. They should be considered in any estate plan designed to minimize estate taxes. 14

16 Grantor Retained Annuity Trust E A Grantor Retained Annuity Trust (GRAT) is often used when transferring highly appreciating or income producing assets to subsequent generations. It is also effective in planning to terminate premium financing of life insurance, private financing of life insurance, and economic benefit split dollar arrangements. The trust pays a fixed annuity to the grantor for a defined period. How a GRAT works: 1. The client (grantor) creates an irrevocable trust. 2. The client transfers or gifts highly appreciating or income producing assets to the trust, and retains the right to an annuity payment for a specified term (or for the shorter of a specified term or life). a. The gift tax value is determined by subtracting the present value (PV) of the annuity interest retained by the grantor from the assets value at the date of the gift. b. A GRAT is intended to be a qualified interest so that the valuation rules of 2702 do not apply. If these rules apply, the gift tax value would be the full value of the transferred assets. c. The gift does not qualify for the annual exclusion amount to shield any gift tax consequences associated with a GRAT because the beneficiary has a future not present right to the asset. d. A GRAT can be designed so its gift tax value is very small or zero. 3. The assets remaining in the trust automatically go to the beneficiary after the annuity period is finished. The assets remaining will consist of the assets originally transferred to the trust plus the appreciation on those assets plus the income produced by those assets minus the annuity paid to the grantor. In its simplest form, a GRAT is a short-term trust (as short as two years) Removing asset(s) from the grantor s estate. If the grantor survives the term of the trust, the asset(s) are no longer part of the grantor s estate because the grantor no longer holds any right or interest in the asset(s). Savings on federal gift taxation. It produces a savings on federal gift taxation compared to an outright gift of the property. If the grantor does not survive the term of the GRAT, the GRAT assets (or at least a portion of the assets) will be included in his/her estate for estate tax purposes. A life insurance policy may be good additional planning tool to cover the estate tax caused by inclusion. A grantor retained annuity trust can be a powerful estate-planning tool, particularly when it comes to passing a family business or other valuable assets. 15

17 Installment Sale E B An installment sale allows the seller to defer part of the capital gain to future taxation years. Installment notes require the buyer to make regular payments (installments) on a periodic basis. Interest must be charged if installment payments are to be made in subsequent taxable years. How an installment sale works: 1. Client sells asset to buyer. The note bears an interest rate at least equal to the applicable federal rate based on the term of the note plus a risk premium. 2. Buyer receives the asset(s) and agrees to make installment payments to seller. 3. Seller receives payments and reports gain spread over the term of the note. 4. If seller dies before the final payment, the note may or may not become immediately due, depending on the contractual language. 5. If buyer dies before the final payment, the buyer s estate must continue making payments until note is satisfied. A life insurance policy on the buyer can cover the risk of non-payment if the buyer dies. Life insurance may also be used to fund an accelerated buyout at the death of the seller. The seller will recognize gain over the term of years unless the seller elects to recognize all of the gain in the year of the sale. The installment sale rules are very complex. An installment note is a type of promissory note setting out the principal and interest payments of the installment sale, as well as the schedule for payments. The note must bear an adequate rate of interest based on the note s duration using the applicable federal rate (short-term, mid-term, or long-term). Installment sales allow sellers to defer taxation on sales when the payments received in two or more years. 16

18 Income in Respect of a Decedent (IRD) E R IRD can be a significant estate planning issue, especially if you have large balances in an IRA or other retirement account or inherit such assets. What is IRD and how does it affect IRAs and other qualified plans? IRD is income that the deceased was entitled to, but had not yet received, at the time of his or her death. It s included in the deceased s estate for estate tax purposes, but not reported on his or her final income tax return, which includes only income received before death. The tax code provides for it to be taxed when it s distributed to the deceased s beneficiaries. Also, IRD retains the character it would have had in the deceased s hands, but is taxed at the beneficiary s tax rate. For example, an IRA would be taxed as ordinary income to the beneficiary, but at the beneficiary s tax rate. IRAs do not receive a stepped up basis and the balance is included in the value of the deceased estate. For large estates, the lethal combination of estate and income taxes (and, in some cases, generation-skipping transfer tax) can quickly shrink an inheritance down to a fraction of its original value. Planning considerations for IRA recipients If someone inherits IRD property, they may be able to minimize the tax impact by taking advantage of the IRD income tax deduction. The IRS code allows them to offset a portion of their IRD with any estate taxes paid by the deceased s estate that are attributable to IRD assets. They can deduct this amount on Schedule A of their federal income tax return as a miscellaneous itemized deduction. But unlike other deductions in that category, the IRD deduction isn t subject to the 2%-of-adjusted-gross-income floor. Planning considerations for the estate IRD can dramatically alter the consequences of the estate plan. Suppose the client plans to divide their assets equally among their three children and a charitable organization: One child receives $1 million in real estate, one receives $1 million in publicly traded stocks, one receives $1 million in an IRA and the charity receives $1 million in cash. On closer examination, it turns out that the children aren t treated equally after all. The real estate and stock are entitled to a stepped-up basis. This means that, when the children sell them, their taxable gain will be based on the assets value when they inherited them not on what the original basis was. So if they sell the assets as soon as they inherit them, they ll generally owe no tax on the sale. And even if they sell them later and recognize some gain, it may be taxed at the beneficial long-term capital gains rate perhaps only at 15%. The IRA balance, on the other hand is IRD- subject to income tax at rates as high as 39.6%. They can avoid short-changing the third child by leaving him or her the cash and donating the IRA to charity. As an exempt entity, the charity isn t subject to tax on IRD. Another strategy for dealing with IRD is dividing IRD assets equally among your beneficiaries. Or defer the tax by leaving IRD assets to the spouse. IRD assets are treated differently than other assets for estate planning purposes. To avoid unpleasant tax surprises, be sure to work with an estate planning attorney and CPA to identify IRD assets, assess the tax implications and develop a strategy for eliminating or minimizing IRD. 17

19 Irrevocable Life Insurance Trust E An irrevocable life insurance trust (ILIT) is used to remove the death benefit from the insured s estate for estate tax purposes. The grantor completely gives up all rights in the property transferred to the trust and retains no rights to revoke, terminate or modify the trust in any material way. How ILITs are used Help meet the liquidity needs of the grantor s estate. Avoid estate taxation of the death proceeds. Help provide for the income needs of survivors after liquidity requirements have been satisfied. Shelter property from creditors at death. Funding alternatives An irrevocable life insurance trust may be either funded or unfunded. In a funded life insurance trust, the grantor transfers property to the trust from which the premium payments may be made. The property may be in the form of cash, securities or some other asset. The trust income is generally taxed to the grantor. In an unfunded life insurance trust, the trustee has no other property in the trust and depends on annual cash gifts from the grantor to pay premiums on the policy. The unfunded trust is more commonly used, and we will focus on it in the remainder of this material. How an irrevocable life insurance trust works: 1. The grantor transfers a life insurance policy to the trust or the trustee applies for a new policy. - The beneficiaries of the trust are often family members. - If the transfer of the policy occurs less than three years before the grantor s death, the death benefit will be subject to estate tax. 2. The grantor transfers cash annually to the trust which can be sheltered from the gift tax by the gift tax annual exclusion, through the beneficiary s Crummey power. Any gift that does not qualify for the annual exclusion reduces the lifetime exemption available or is subject to gift tax. 3. The trustee makes premium payments. 4. At the grantor s death, the trust receives the death benefit from the policy. 5. The trust gives the trustee the power to make loans to the grantor s estate, or to purchase assets from the estate, to provide the estate with funds to help pay estate settlement costs. The trustee does not make the payments directly. Continued on page 19 18

20 Irrevocable Life Insurance Trust continued from page 18 The gift tax associated with transferring a policy is based upon (1) total premiums paid on a newly issued policy; (2) cost of a comparable policy with insured s attained age on a paid up or single premium policy; or (3) the interpolated terminal reserve plus unearned premium on a previously issued policy still in premium paying status. Transferring cash to an irrevocable trust is considered a future interest gift. Therefore the annual exclusion is not available because the trust s beneficiaries cannot currently access and use the gift. However, the gift can be made a present interest gift by giving some or all of the trust s beneficiaries a temporary right (a Crummey power ) to withdraw some or the entire gift. To do so, the trustee notifies the beneficiary of the temporary right to withdrawal funds from the trust (a Crummey Notice ). If the beneficiary does not exercise this right within the stated period (usually days) then the right lapses and the gift is considered a present interest gift. Once the withdrawal right lapses, the trustee can use the gifted funds to pay premiums. At the insured s death, the trust should receive death benefit proceeds income-tax-free and estate-tax-free. These proceeds can be used to provide liquidity to pay estate taxes (by making loans to the decedent s estate or purchasing assets from the decedent s estate). If the insured has an incident of ownership in the life insurance policy at death (or within three years prior to death) the death benefit value is brought into the insured s gross estate (the trust beneficiaries will receive the actual proceeds but the amount of those proceeds will be included in the insured s gross estate value). Paying premiums is not an incident of ownership. However, there are gift taxes associated with paying premiums on a life insurance policy that is not owned by the premium payor. For existing policies, the client can gift enough money to the trust so the trustee can buy the policy from the grantor for its fair market value. This avoids the three-year rule. If the insured is treated as the owner of the trust for income tax purposes, it qualifies for an exception to the transfer for value rule. Care must be taken to ensure that the sale is for the policy s fair market value. The grantor/insured creates an irrevocable trust to own any life insurance policies on his/her life so the death benefit is not subject to estate taxes. Gifts to the trust by the grantor are used to pay the premiums. 19

21 Key Person B C Every business operating today has key people that help it remain successful and profitable. Although most businesses insure their property and profits, few think to insure their most precious assets the men and women whose experience, talent and judgment contribute substantially to the financial success of the business. Loss of a key person can adversely affect the business earning potential and will cause expenses related to finding his/her replacement. Key person insurance can provide a business with financial security Typical losses associated with losing a key person include: - Loss of management experience and leadership; - Loss and disruption in production; - Loss of credit rating for business; and - Loss of capital that is now required to find a replacement. Closely held businesses are particularly at risk since there are typically one or two people whose skill and contacts make the business profitable. How key person insurance works: 1. The business purchases a key person life insurance policy on the key employee. The business is owner and beneficiary of the policy. There is no special key person policy. The business should choose the policy that best fits its needs. 2. The business makes non-deductible premium payments and retains all ownership rights. Cash values inside the policy grow tax-free. 3. If key person dies, the business will receive income tax-free death proceeds if the two requirements of the Pension Protection Act of 2006 are met: a. The notice and consent requirements are met; and b. The insured is an employee or a key person as defined by the tax law,* the proceeds are used to purchase the key employee s interest in the business from one of the persons listed below, or the ultimate payee is: i A member of the insured s family; ii. The designated beneficiary (other than employer); iii. A trust established for the benefit of any such person; or iv. The insured s estate. Business receives needed funds at key person s death. These funds can be used to offset production declines, bolster the business credit rating, and find the key person s replacement. The business can access the policy s cash value if necessary. When properly structured, the death proceeds will be received income tax-free. Consumer Approved Materials Consumer Flyer AM2023 *See the Key Person Agent Reference Guide AM2022 for the tax law definition of a key person. Form 15996, Notice and Consent for Employer Owned Life Insurance, is required to be completed and included with all new life applications. All businesses have key people who keep things running successfully through their ideas, know-how, experience, and leadership. A business can range anywhere from a local convenience store to a large manufacturing plant, but regardless of size, it has key people who contribute to its success. The only difference is that a larger business may have more of them. 20

22 Non-Resident Alien E C Individuals who are residents of the United States but not citizens are subject to the same estate and gift tax rules as U.S. citizens. Based upon the value of assets, beneficiaries could be faced with the impact of the federal estate tax as well as state inheritance or estate taxes. Who is subject to the U.S. gift and estate tax system? The U.S. tax system recognizes three classifications of taxpayers: Citizens: A citizen is born or naturalized in the U.S. and is subject to its jurisdiction. The estate tax is applied to all assets owned, wherever that property is situated in the world. (IRC 2001) Resident Aliens: A non-citizen who intends to domicile in the U.S. is deemed a resident alien, Estate and gift taxation is the same as for U. S. citizens (IRC 2001) Non-resident Aliens: A non-citizen who does not intend to establish domicile in the U.S. is referred to as a non-resident alien. The estate and gift tax is imposed on assets located in the United States. (IRC 2103) How to help resident aliens plan for the future: 1. Work with an attorney experienced in estate-planning for resident aliens. A needs analysis can illustrate any shortfall that maybe needed. 2. If there is an estate tax problem or gifting issue, a qualified domestic trust (QDOT) or life insurance in a Spousal Access Irrevocable Life Insurance Trust can help. a. Distributions from the ILIT would not be subject to gift or estate tax limitations even though the non-citizen resident is the primary beneficiary of the trust. b. A life insurance policy might fit the need for any shortfall shown in a needs analysis. A QDOT is used in lieu of the marital deduction so the non-citizen spouse can inherit, free from estate tax. The property is left to the trust, instead of directly to the spouse. The spouse is the beneficiary of the trust; there can t be any other beneficiaries while the spouse is alive. Full estate taxes are due at the non-citizen spouse s subsequent death. Clients with a non-citizen spouse cannot make unlimited gifts to the spouse without tax during life or death. Upon death of the U.S. citizen spouse, they may face estate taxes. During life, they may face gift taxes if money is transferred from a U.S. citizen to a non-citizen. If the spouse becomes a U.S. citizen by the time the estate s federal estate tax return is due, he or she will qualify for the unlimited marital deduction and no QDOT is needed. (The return is generally due nine months after death, but the IRS may grant a six-month extension.) Consumer Approved Materials Consumer Guide AM2027 A family that includes a non-citizen spouse will need to carefully review any assets and liabilities with the focus on the U.S. citizen spouse. If estate taxes and gift taxes are an issue, life insurance can fit the need but might be best placed in an ILIT. 21

23 Nonqualified Deferred Compensation B R C A well-designed nonqualified deferred compensation plan can provide attractive supplemental retirement benefits to executives who have maxed out their qualified plan contributions. It can be a much needed incentive for employers to attract and retain these individuals. Unlike qualified plans, the nonqualified plan can be custom-designed to fill the unique needs of different executives and employers. The benefits of a nonqualified deferred compensation arrangement The agreement can be designed to meet the executive s individual needs and provide select group of executives with supplemental retirement benefits with minimal ERISA reporting requirements. Cash value accumulates on an income tax-deferred basis. The agreement can be self-completing in the event of the executive s death. The executive can compensate for the limited benefits available to highly compensated employees under qualified plans. Employer controls the plan. Benefits paid to executive are tax-deductible to the employer and taxable to the executive. Types of nonqualified retirement plans 1. Supplemental Executive Retirement Plan (SERP) generally provides defined benefit payments for executives over a period of five to twenty years. 2. Deferred Income Plan (Deferred Compensation) allows executives to defer income without the contribution limits of IRAs or 401(k) plans (k) Look-Alike Plan (Deferred Compensation) offers a savings and employer-match strategy similar to a qualified 401(k) plan without contribution limitations. 4. Split SERP Plan with Endorsement Split Dollar combines two nonqualified executive benefits. It provides a pre-retirement income tax-free benefit to the executive s beneficiaries, if the executive dies before retiring or retirement income is distributed to the executive during retirement. Funding arrangements Plans can either be classified as a funded or unfunded arrangement. An unfunded plan has no specific reserve set aside to fund the plan. It is an unsecured promise, and the assets targeted to fund the plan are general assets of the business and subject to creditors. A funded plan has a specific reserve. For these plans, the executive s deferral of taxation is more complicated because the plan must provide the executive s benefits are subject to a substantial risk of forfeiture. It is important to remember that in an unfunded plan the assets set aside are a general asset of the business, subject to creditors. For this reason, most plans are considered unfunded arrangements. Because of its unique characteristics, life insurance is the most commonly used asset to informally fund an unfunded deferred compensation plan. The cash values grow tax deferred, tax-free death benefits create an immediate fund to pay survivor benefits to heirs, and cash values can be accessed tax-free to pay retirement benefits via withdrawals and policy loans if the policy is not a Modified Endowment Contract. It is important to note that if life insurance is used to informally fund the plan, the employer must comply with the notice and consent requirements of IRC 101(j). If it does not, the employer would be subject to income tax on the amount of the death benefit that exceeds the premiums it paid. Remember, the life insurance policy is not the plan; it s a general asset of the business. Consumer Approved Materials Deferred Compensation Consumer Guide AM

24 Nonqualified Deferred Compensation continued from page 22 The amounts in an unfunded arrangement are generally includible in the participant s gross income for the year they are actually or constructively received. A funded plan must make sure there is a risk of forfeiture or the plan becomes taxable immediately. In addition to adhering to the 409A rules, nonqualified deferred compensation plans must meet three conditions in order to avoid immediate taxation: 1. The income deferral was agreed upon before compensation was earned; 2. The deferred amounts were not unconditionally placed in escrow or trust; and 3. The employer s promise to pay was merely a contractual obligation and was unsecured. IRC 409A may be a little intimidating to some employers, however with the help of trusted advisors, it should not present any hurdles to accomplishing the objectives of most small employers whose stock is not traded publicly. If the objective is to tie the key employee to the owner s business, nothing in the marketplace can accomplish this as effectively as nonqualified deferred compensation. The future payments are the carrot, and the plan and the conditions of the plan are golden handcuffs keeping the key employee as a valuable member of the operating team. A deferred compensation plan creates a deferred liability of the business, and most will choose to set aside funds to meet these obligations. The business should hold all rights to the fund and should not grant any vesting rights in any of the assets to the participants before benefits are paid. The American Jobs Creation Act of 2004 enacted Section 409A of the Internal Revenue Code. This code section significantly changed nonqualified deferred compensation rules. If a plan fails to meet the rules, compensation deferred under the plan becomes immediately taxable, and penalties and interest apply. All plans had to comply with the final regulations under IRC 409A as of January 1, Therefore, it is crucial for business owners to work with knowledgeable advisors. In addition to complying with these regulations, the following design considerations should be considered: - Eligibility of key employees, while considering that the plan must restrict benefits to upper management and highly compensated employees; - The conditions that would cause future benefits to be forfeited; - Incentives that the benefits are based upon; and - Vesting of benefits A business structured as a C-Corporation can design a nonqualified deferred compensation plan to allow the owners to defer compensation to a later date, when more advantageous. If a business is structured as a partnership, an LLC taxed as a partnership, or a corporation or LLC taxed as an S-Corporation, an owner-employee or controlling shareholder generally will not benefit from a nonqualified deferred compensation plan. IRC 101(j) requirements of notice and consent paperwork must be completed. (Form 15996) A nonqualified retirement plan is an agreement between an employer and select executives to pay a future benefit for services performed today. Via the agreement, the employer makes an unsecured and unfunded promise to pay the executive at some future date. It can provide significant incentives to covered executives while providing golden handcuffs that can tie the executive to the employer. 23

25 Sale to Grantor Trust E Grantor Trusts, revocable or irrevocable, are trusts in which income is attributed to the grantor instead of the trust. Irrevocable grantor trusts are often used when transferring highly-appreciating or incomeproducing assets to keep them out of the grantor s estate. For the purposes of this planning technique, the kind of irrevocable trust used is known as an Intentionally Defective Irrevocable Trust (IDIT). The defect in the trust is an intentional provision that causes income to flow back to the trust s grantor qualifying the trust for grantor income tax treatment while also removing the assets for estate tax purposes. By paying the taxes on the trust income, the grantor allows the trust assets to grow without being reduced by taxes. How a sale to a Grantor Trust works: 1. The trust is drafted so that the grantor is considered the trust owner for income tax purposes, but not for gift and estate tax purposes. 2. The grantor will make a gift of cash and/or assets to the trust. (The IDIT must be seeded or otherwise made a viable borrower adequate seeding may be between 10% and 20% of the value of property sold.) This is done using annual gift exclusions or the client s gift tax exemption. 3. After the gift, the client sells assets to the trust and receives an installment note payable over a specified period of time. The note must bear an adequate rate of interest based on the note s duration based on the applicable federal rate (short-term, mid-term, or long-term). 4. The assets sold to the IDIT will hopefully provide sufficient income to cover the debt service. Any excess income can be added to trust principal or expended for other uses (i.e. paying premiums). 5. The assets remaining in the trust can remain in the trust or go to the beneficiary after the note is repaid. Sales to Grantor Trusts are effective estate planning techniques No capital gain is recognized by the seller upon transfer of the assets; The IDIT assumes the seller s basis in the property sold; The income or gain generated inside the IDIT is taxable to the client (lender) even though it is not distributed to the client (lender); and The interest received on the note is neither taxable nor deductible. A sale to a Grantor Trust is also effective in planning to terminate premium financing of life insurance; private financing of life insurance, and economic benefit split dollar arrangements. There are gift tax concerns if the IDIT must be seeded by gifting funds. However, these can be made subject to the grantor s annual exclusions. The sale could be structured to cancel any outstanding balance of the note at the seller s death by using a Self-Canceling Installment Note (SCIN). The adequate rate of interest or face amount must be adjusted to include a premium reflecting the risk that the seller dies before receiving full payment. If the seller does not survive the term of the IDIT, the remaining balance on the note is included in his/her estate for estate tax purposes. There are no gift tax concerns regarding the sale as long as the note bears an adequate rate of interest. The IDIT may provide for distributions to the grantor to pay the taxes on the trust s income. By paying the taxes on the trust s income the grantor allows the trust s assets to grow. Payment of the taxes is not considered a gift to the trust. A sale to a Grantor Trust may allow you to achieve significant tax benefits while funding an irrevocable trust during lifetime. it allows you to transfer assets outside your taxable estate at a discounted value and then use the trust income to fund a needed life insurance policy. 24

26 Self-Canceling Installment Note E B Self-Canceling Installment note (SCIN) is an effective method to transfer assets to subsequent generations with minimal gift and/or estate tax costs. A SCIN is often used when transferring highlyappreciating or income-producing assets to subsequent generations. How a self cancelling installment loan works: 1. An asset is sold to buyer for a note. The note bears a rate equal to the applicable federal rate based on the term of the note. A risk premium is added either to the interest rate or the sales price to compensate the seller for the risk that the full sales price may not be paid. 2. Seller receives payments and reports gain spread over the term of the note. 3. If seller dies before the final payment, the note is canceled. 4. If buyer dies before the final payment, the buyer s estate must continue making payments until note is satisfied. (A life insurance policy on the buyer can cover the risk of non-payment.) The client sells the asset(s) to a trust or individual in exchange for an installment note payable over a specified period of time. The seller will generally recognize gain over the term of years. The installment sale rules are very complex. The assets sold will hopefully provide sufficient income for the buyer to cover the required payments. The note term must be less than the life expectancy of the seller and will contain a self-canceling clause in the event of seller s death. The note must bear an adequate rate of interest based on the note s duration using the applicable federal rate (short-term, mid-term, or long-term). The SCIN interest rate must contain a risk premium to compensate in the event of an early death or the face amount must include a risk premium, or a combination. If the risk premium is not sufficient, then the transaction will be treated as a part-sale, part-gift transfer. SCINs can be an effective way to transfer assets to subsequent generations at little to no gift and/or estate tax costs. 25

27 Simplified Employee Pensions (SEPs) B R Simplified employee pension IRAs (commonly referred to as SEPs) allow employers to establish and fund the plan after the employer s tax year ends. They are the only employer-sponsored retirement plan that does not have to be established prior to the end of the tax year. Like profit-sharing plans, only employers contribute to a SEP. A SEP is simple; plan administrators, plan trusts and trustees are not needed. An IRA is used to hold the employer contributions and the employee controls the IRA from day one. SEPs are also subject to simpler employee eligibility requirements, vesting rules, and non-discrimination rules than profit-sharing plans. SEP contributions do not have to be made every year, giving the employer flexibility not seen in other employer-sponsored retirement plans. SEP Requirements Any employer can establish a SEP, including self-employed persons, sole proprietors, partnerships, and LLCs. Self-employed individuals are treated as employees for retirement plan purposes, including SEPs. A SEP must cover all employees who meet the following requirements: 1. At least age 21; 2. Performed services for the employer during at least three of the five immediately preceding years; and 3. Received a minimum amount of compensation from the employer for the current year. Employers can provide more liberal eligibility requirements; for example, covering all employees who worked for the company for at least one year. Determining SEP Contributions The maximum amount an employer can contribute to an employee s SEP is the lesser of: 25% of compensation (special rules apply to calculate compensation for the business owner, a tax professional will need to perform the calculation), or A specific dollar amount (dollar limit changes annually). Establishing a SEP As its name indicates, setting up a SEP is simple. The employer must establish it by the due date for making contributions to the SEP. Three requirements must be met: 1. The employer executes a written agreement spelling out the terms of the SEP plan. 2. Each employee must receive certain information about the SEP. 3. Each employee sets up an IRA to receive employer contributions. If the employee refuses or cannot be located, the employer can set up the account for the benefit of the employee. Setting up the SEP by using IRS Form 5305-SEP and following the instructions meets the requirements to establish a SEP and satisfies the first two requirements. The third requirement is done by each employee establishing a SEP IRA account. Benefits of a SEP Business owners often are looking for ways to save income taxes and don t realize how a SEP can help save income taxes. They may think establishing SEPs does not benefit them because they must make SEP contributions for all eligible employees. However, the income tax savings from the total SEP contributions can equal or exceed those contributions. For example, assume a professional structured her practice as an S-Corporation and has two support staff. Her income is $300,000. Combined, her support staff earned $100,000. The maximum she can contribute to the SEP is $79,000 ($54,000 for her due to IRS limits and a total of $25,000 for her staff s SEPs). In her 35% tax bracket, the $79,000 of SEP contributions produces an income tax savings of $27,650, $2,650 more than the amount contributed to SEPs for the two employees. The $79,000 contribution produces a $54,000 SEP benefit for the client and a $27,650 income tax savings. 26

28 Simplified Employee Pensions (SEPs) continued from page 26 The employer has discretion on how much and when to contribute to a SEP. Employees control the SEP account from day one and are able to withdraw SEP contributions without any employer restriction but are still subject to normal IRA distribution rules.. A special adjustment is required for self-employed persons, including partners and LLC members, to determine their maximum SEP contribution. SEPs must comply with non-discrimination rules by covering all eligible employees and contributing the same percentage of compensation for all eligible employees. Businesses that are under common control or businesses that are part of an affiliated service group are treated as a single employer, meaning all businesses under common control must have a SEP if one business does. This prevents employers from setting up a separate organization to provide retirement benefits for just the owners without covering the rank and file. Establishing a SEP can help business owners save for retirement, reduce their income taxes, provide flexibility on when to make contributions, and provide retirement savings for employees. A SEP is the only employer sponsored retirement plan that can be established and funded after the tax year ends. 27

29 Special Needs E Individuals who are referred to as special needs fall into a wide spectrum of people with physical, mental and emotional disabilities. Because the spectrum of needs is so diverse, planning for the future can be a unique endeavor. For caregivers, providing for a child s life-long needs can be a daunting task. Fortunately, combining a life insurance policy with special needs planning can create additional sources of cash while the parents are living, as well as a substantial lump sum payment at the parents death. Special needs planning can provide an individual with financial security Financial resources to protect the individual for the rest of his or her life, Protecting eligibility for government (and potentially, private) benefits, Identifying the succession of future caregivers, and Creating a plan that will provide for other family members. How to plan for the future of a dependent with special needs: 1. Look at the future in regards to future medical, educational and housing needs for the person with special needs. 2. Work with an attorney with experience in special needs planning to create a plan and potentially set up a special needs trust and other supporting legal documents. The special needs trust may be funded or unfunded. a. Special needs trusts can ensure that any distribution from the trust does not disqualify the dependent from receiving on-going government support like Medicaid and SSI. b. Special needs trust can also provide on-going support for dependents that will not need, or qualify for, government benefits. 3. A life insurance policy might fit the need for any shortfall shown in a needs analysis. Then, the trust can apply for insurance usually on the primary caregivers often the parents. 4. At the death of the beneficiary with special needs, the remainder of the special needs trust can be paid to other beneficiaries, such as siblings. 5. Review beneficiary designations for any asset including those of other friends and family members. This is important because all designations should be to the special needs trust and not the dependent. This includes bequests in a will. 6. A letter of intent may be written to outline the individual s situation, needs and desires as well as the parent s thoughts and wishes for a dependent in the event of temporary or permanent absence of a primary caregiver. Gifts and inheritances should be planned for in advance and directed to a special needs trust to avoid a loss of access to government benefits based on income and assets. A direct gift or inheritance could cause the individual to lose critically important benefits. Life insurance provides liquidity to help equalize an inheritance for the benefit of all heirs. Since no one knows when they will die or become disabled, it s important to plan for a dependent with special needs. Coordination is key between family members, a special needs attorney and financial planners. 28

30 Split Dollar Employer Endorsements B C Many employers are seeking ways to reward and retain their top employees. Providing a meaningful life insurance benefit can mean the difference between keeping the key employee s loyalty or losing him or her to the competition. Endorsement split-dollar may be the strategy to achieve this objective while maintaining a cost-neutral position for the employer. Employer endorsement arrangement are often used for: Providing a golden handcuff if the executive leaves, the employer can terminate the endorsement. Providing needed life insurance coverage to an executive at a reasonable cost. Reducing transfer tax costs associated with funding the irrevocable life insurance trust (ILIT). Providing a benefit that is cost-neutral to the employer. Costs are recovered through death proceeds. How to structure an endorsement split dollar arrangement 1. The employer and the employee enter into an endorsement split dollar agreement. 2. The employer applies for an employer-owned life insurance policy on the employee. The Notice and Consent for Employer-Owned Life Insurance (Form 15996) is submitted with the application. 3. The employer endorses a portion of the death benefit to the employee or the employee s life insurance trust. 4. The employer pays the premiums and the employee pays income tax on the economic benefit. a. The economic benefit refers to the term cost of the death benefit and is calculated annually based on the employee s age. b. The economic benefit is determined by an IRS table (currently Table 2001) that gives a cost per thousand for the death benefit provided based on the insured s age during the year. c. The cost per thousand for a joint/survivor arrangement (Second to die policy) is typically very low. 5. If the employee dies prior to retirement, the employer and employee s beneficiaries will each receive their portion of the death benefit proceeds. 6. When the employee retires, the endorsement terminates and the employer retains ownership of the policy. The policy s cash values may be accessed to pay supplemental retirement income to the employee. Endorsement Split-Dollar is a welfare benefit plan for ERISA purposes and requirements. An Endorsement arrangement is not appropriate for public company executives due to Sarbanes-Oxley implications. IRC 101(j) requirements of notice and consent paperwork should be completed. (Form 15996) Consumer Approved Materials SI/GI Split SERP Consumer Guide AM2062 Today s competitive business environment requires employers to utilize creative means in keeping key performers. Since the employee s cost of an endorsement split dollar plan is only the income tax based on the economic benefit of the death benefit provided, the plan offers the employee a low-cost death benefit protection. 29

31 Split Dollar Employer Loans B There are many benefits to using a split dollar arrangement for an employee-owned life insurance policy depending on the need for life insurance. Sometimes employers are seeking ways to retain and reward their top employees and other times they are looking to merely reward them. In split dollar planning, a loan arrangement may be established for (1) retaining/handcuffing the employee to the employer; (2) rewarding the employee for services provided; or (3) both with appropriate planning. Split dollar loan arrangements can be beneficial: The employer can structure the loan to primarily tie/handcuff the employee to the employer. The promised benefit should be available as long as the employee does not leave prior to the agreed upon time. However, if the employee terminates his/her employment prior to the agreed upon time, the benefit may be forfeited. This is typically accomplished with a Demand Loan. Alternatively, the employer can structure the loan to primarily reduce the overall cost(s) associated with the employee purchasing life insurance coverage. This can be especially useful when the policy is purchased in the employee s irrevocable life insurance trust. By using a Term Loan, the interest rate risk associated with borrowing money can be mitigated. Types of split dollar loans: 1. Demand Loans A demand loan can be called, in whole or in part, at any time by the lender. This gives the employer (lender) the ability to require repayment of the benefit (i.e. loan balance) if the employee (borrower) does not fulfill his or her requirements under the agreement. This can be an effective handcuff designed to retain the top employee while at the same time rewarding him or her for their services and loyalty. The minimum required interest rate on a demand loan is adjusted each July by the IRS resulting in a certain amount of interest rate risk since the rate adjusts each year. If the employee does not pay the minimum rate of interest each year to the employer, the amount will be imputed as follows: (1) an amount equal to the adequate rate of interest for the year imputed as compensation to the employee; then (2) that same amount imputed as required interest paid by the employee to employer. The imputed transfers typically result in a compensation deduction and interest income for the employer, and compensation income for the employee. 2. Term Loans A term loan is a commitment by the employer (lender) to advance money for a certain period of time (the loan cannot be called like a demand loan). The minimum required interest rate is (1) fixed for the entire duration of the loan; (2) determined when the loan is made; and (3) varies depending upon the term/length of the loan. If the term is for 3 years or less the short-term applicable federal rate ( AFR ) is used; if the term is more than 3 years but not more than 9 years the mid-term AFR is used; and if the term is more than 9 years the long-term AFR is used. The employer loan must provide for payment for adequate interest (or it will be imputed) and contemplate repayment of the loan proceeds. Typical loan repayment strategies include: (1) using policy cash values; (2) Grantor Retained Annuity Trusts; (3) side fund with earnings in excess of rate on borrowed funds; and/or (4) policy death benefit. The life insurance policy is collaterally assigned to the employer as security for the loan. Split dollar loan arrangements between employers and employees can be very effective in helping employees purchase life insurance to meet their retirement and estate-planning goals. A demand loan structure can help employees take advantage of lower interest rates (employees need to be comfortable with volatility in interest rates) while giving the employer handcuff leverage over the employee. Employees who want their arrangements to have predictable costs and results may choose a term loan structure that has stability but higher interest costs. Both split dollar loan arrangement structures will allow employees to use business dollars to pay life insurance premiums to enhance their financial security. 30

32 Stretch IRA E R One of the primary benefits of an Individual Retirement Account (IRA) is the ability to defer taxes. The longer the deferral, the faster, typically, the IRA will grow. The stretch IRA concept is a wealth transfer technique that may allow the benefits of an IRA to stretch across several generations. The IRS wants its fair share Unfortunately, the Treasury Department eventually asks for its share of that growth, starting on the required beginning date. The required beginning date for IRA owners is April 1 following the year the owner reaches age 70½ (i.e. If an IRA owner reaches age 70½ in June, the required beginning date is April 1 of the following year). The required beginning date for beneficiaries of IRAs is December 31 following the year of death; however in cases in which the IRA owner has not taken a Required Minimum Distribution (RMD) for the year of death, the beneficiary must take this distribution by December 31 of the year of death. The failure to make these distributions will result in a 50% tax penalty. How Stretch IRA Works: When people refer to a stretch IRA, it means only the RMD is taken each year by the account owner and their designated beneficiaries, thereby extending the period for maximum deferral. When someone is taking only RMDs, it is most often a situation when the person has other sources for current income so they do not need the RMDs for living expenses. To maximize the deferral period, the following guidelines should be followed. Each situation is different and should reflect variables such as age, marital status, age of spouse, number of children and grandchildren, and financial status. Generally the IRA owner should: 1. Name the spouse as primary beneficiary. 2. Name the children and/or grandchildren as contingent beneficiaries. 3. Ultimately divide the accounts into separate accounts or separate shares before the IRA reaches the contingent beneficiaries. Naming the spouse as primary beneficiary allows for the most flexibility when deferring taxes. Upon the death of the owner, the spouse has the option to: 1. Keep the account in the deceased person s name as an inherited IRA and defer RMDs until the deceased spouse would have been 70½. This also allows the spouse to take distributions before age 59½ without being subject to the 10% penalty. 2. Complete a spousal rollover and assume the account as if it were his or her own. This would allow the spouse to defer RMDs until the spouse is age 70½. Distributions to the spouse from this IRA before he or she is 59½ are subject to a 10% penalty unless an exception applies. The spousal rollover is available at any time. This allows the spouse to name beneficiaries entitled to receive distributions from the account after the spouse s death over their own life expectancies if the proper requirements are met. 3. Disclaim the property as if the spouse was never a beneficiary. This would make the contingent beneficiaries the primary beneficiaries. To avoid gift tax consequences, the disclaimer must comply with federal and state law requirements. If the IRA is divided into separate accounts for each beneficiary by December 31 of the year after the IRA owner s death, each beneficiary can use his or her life expectancy to compute RMDs. If this deadline is missed, the oldest beneficiary s life expectancy must be used. If a trust is named as the beneficiary, special rules apply. To ensure equal distribution among the beneficiaries, each account should have the same investments and the RMD for each IRA should be taken from that IRA. To guarantee that the separation will happen, many IRA owners will divide the IRA into separate accounts for each beneficiary prior to death. If estate taxes are payable on the IRA, there is a partial income tax deduction under IRC section 691(c) for the federal estate taxes paid on the IRA. Special care needs to be taken when counseling inherited IRA owners. Many times the estate tax return is prepared by advisors of the owner and not the advisors of the beneficiaries. so beneficiaries may not know about the federal estate taxes paid on the IRA. Estate taxes: If estate taxes are due and the estate needs IRA monies to pay these taxes, there might not be anything left to stretch. Tax laws may change: Life insurance can provide funds to pay the estate taxes and maximize the benefits of the stretch. Tax rates in the future could be significantly higher. Poor returns on the IRA: Investment losses could completely wipe out the potential value of future IRA distributions. Lump sum distributions: Beneficiaries have the right to withdraw more than the Required Minimum Distribution. If this is a concern the account owner should discuss with advisors establishing a trust should be discussed with their advisors. A properly designed trust can guarantee that only the Required Minimum Distribution is withdrawn each year from the inherited IRA. A stretch IRA can provide many benefits for a beneficiary. It may provide lifetime income to the beneficiaries. By withdrawing smaller amounts over time, there is a potential to pay lower taxes due to lower tax brackets. Lastly, the continued tax-deferred growth can increase the wealth passed to heirs. 31

33 Traditional IRA, Roth IRA or... R What is the best accumulation vehicle to help supplement your clients retirement? It depends on their current income, it depends on their current marginal tax bracket; it depends on how they feel about their future marginal tax bracket. Lower tax bracket - A traditional IRA might be the right fit If they are convinced they will be in a lower bracket at retirement, a Traditional IRA can be great. Defer tax in a higher bracket, pay tax in a lower bracket. No brainer right? Not so fast. What if they don t qualify because they are covered under a qualified plan and they make too much money? Being also in a lower bracket at retirement might not be a given. Many times people lose deductions at retirement. No more dependents, no mortgage interest deductions, lower charitable contributions, no business expenses. In addition they may be assuming Congress won t raise taxes in the future. This could be wishful thinking. Higher tax bracket - A Roth IRA might be the answer So if they don t qualify for a Traditional IRA or if they think they might be in the same marginal bracket or higher, how about a Roth IRA? Roth IRAs seem great; pay tax now, the money grows tax free, and never pay tax again. But what if they don t qualify because they make too much money or they want to contribute more than is allowed? Are there alternatives? YES! Roth 401(k) and/or life insurance Roth 401(k) If the 401(k) plan permits, participants in qualified plans can make after-tax contributions to a Roth 401(k) account. Roth accounts inside qualified plans require separate accounting. This could increase administrative cost so a plan may not include a Roth account. If it is available, a Roth contribution to a qualified plan works just like a Roth IRA except: 1. There are no income qualifications 2. They are subject to required minimum distributions and 3. The amounts contributed are the same deferral limits as non-roth 401 (k) contributions. Life Insurance A properly funded life insurance policy can be a great accumulation vehicle because it is taxed just like a Roth IRA, but has several advantages. A properly funded life insurance policy in this situation means a policy that is maximum funded and is not a Modified Endowment Contract. It is also critical that the contract stay in force until death in order to avoid taxation of any gain borrowed or withdraw during life. Creates an immediate estate. If the insured dies prematurely, the plan will be self-completing. The beneficiaries receive an income tax-free death benefit not just the contributions and any earnings. No compensation requirements or fixed contribution limitations. Earnings can be accessed prior to age 59½ without tax penalty. Can produce significant internal rate of return on the accumulated cash values in the future and on death benefit in the early years. 32

34 Traditional IRA, Roth IRA or... continued from page 26 Side-by-side comparison Below is a comparison of key features of a Traditional IRA, Roth IRA and a life insurance policy. In this example, the life insurance policy is not a Modified Endowment Contract (MEC) and stays in force until death of the insured. Feature Traditional IRA Roth IRA Life Insurance Non-Deductible Contribution No Yes Yes Tax-Deferred Growth Yes Yes Yes Defer Distributions until Death No Yes Yes Income Tax-Free to Beneficiaries No Yes* Yes Compensation Requirements Yes Yes No Income Limitations Yes Yes No Unlimited Contribution No No Yes** Early Withdrawals of Gain Without Penalty No No Yes Immediate Estate Creation upon Premature Death No No Yes * If time period requirement is met. ** Subject to Insurability and Financial underwriting guidelines. At the end of the day, what is best for your client depends on many factors including their specific situation and feelings. Whether clients feel like they need to reduce their income taxes now, save on taxes in their retirement or need life insurance, life insurance can provide for the client s family and provide flexible, tax- efficient retirement income. No matter what option is chosen, indexed annuities and life insurance are great choices to help accumulate money on a tax-favorable basis for retirement. 33

35 Transfer Taxes, an Introduction E The federal transfer tax system is comprised of three taxes: estate tax, the gift tax and the generation skipping transfer (GST) Tax. Unlike the income tax system, where a tax is imposed on the increase in wealth, the transfer tax system imposes a tax on the transfer of wealth from one individual to another. It is entirely possible that an asset may be subject to federal income taxes in addition to a transfer tax, depending on the type of transaction. Under tax law, the federal government exempts a certain dollar amount from transfer taxes known as the Applicable Exclusion Amount for gift and estate taxes and the GST Exemption Amount for the generation skipping transfer tax. How the federal estate tax works: The federal estate tax applies to assets transferred at death. (Reporting occurs on IRS Form 706.) Determining what property is calculated in the gross estate. For U.S. citizens or residents, this includes worldwide assets owned at death. - Ownership for this purpose is very broad and may even include property that had been given away prior to death, such as life insurance policies that were transferred within the last three years. - The marital deduction and charitable deduction eliminates any estate tax on these transfers. Also, no estate tax is applied to any administrative expenses, funeral expenses, debt or cost for administering the estate. After deductions, the remainder of the estate is subject to estate tax. A surviving spouse may use any of a deceased spouse s unused applicable exclusion amount. An estate tax return must be filed to take advantage of this provision, often called portability. Once the estate tax has been calculated, any portion of the client s remaining exclusion amount not used to shelter lifetime gifts from Gift Tax can be used against estate tax. So, if the client has not made any taxable gifts during their lifetime, their total applicable exclusion amount remains available for exemption. Example: A widower dies, leaving $15 million to his children. He had not made any taxable gifts. Under the law in place at the time of his death, he had a $11.18M applicable exclusion amount available and a 40% top tax rate. In this example, no federal estate tax is due on the first $11.18 million passing to his children; estate tax will be due on the remaining $3.82 million at the 40% tax rate. Any portion of his spouse s applicable exclusion amount that is available would reduce the taxable amount. How the Gift Tax works: The gift tax applies to assets transferred during life. (Reporting occurs on IRS Form 709.) Current law provides that an annual gift can be made to an individual where no gift tax is due (the gift tax annual exclusion ), with all gifts to that individual in excess of the annual amount being subject to gift taxation. Additionally, someone else s educational or medical expenses can be paid without being subject to gift taxes. Any appreciation after a gift is made is not included in the donor s estate in determining the estate tax. The gift tax does not apply to certain transfers to a U.S. citizen spouse or to transfers to qualifying charities. Any portion of a gift that does not qualify for an exclusion or deduction is a taxable gift subject to gift tax. - U.S. citizens have an applicable exclusion amount which they can use during their lifetime in cumulative taxable gifts before any gift tax is actually paid. But note this is linked to the estate tax so any amount applied to the gift tax reduces the amount available for the estate tax. Example: A woman gives an annuity to her son by changing ownership to him. Her basis in the annuity is $50,000; the fair market value of the annuity is $200,000. In the year of the transfer, the gift tax annual exclusion amount is $15,000; the applicable exemption amount for gifts is $11.18 million. This transaction means a taxable gift of $185,000 has been made to the son ($200,000 annuity less $15,000 annual exclusion) and must be reported on IRS Form 709. Assuming she s made no other taxable gifts in her life, she has $10,995,000 of exclusion amount left. In this example, there is also an income tax consequence she must recognize the $150,000 gain as ordinary income from the transfer of the annuity. If she is under age 59 ½, the gain will be subject to a 10% penalty unless an exception applies. 34

36 Transfer Taxes, an Introduction continued from page 34 How the generation skipping tax works: The generation skipping transfer tax applies to transactions when assets are passed in a way that skips a generation. The generation skipping transfer tax may be levied on a transaction that is also taxed as an estate bequest or gift. The GST tax was designed to catch a portion of the taxes that would have been paid if the asset had been passed one generation at a time, rather than skipping levels and reducing transfers. Like the estate and gift taxes, the GST also has an exemption amount where transactions for less than the amount are not taxed. Unlike the gift and estate tax exemptions which are automatically applied to transfers as they occur, the donor or the executor can determine how to apply the GST exemption. Example: A man names five grandchildren as the beneficiaries of an irrevocable trust. Without notifying them or their parents (all living), he transfers a life insurance policy with a $14 million fair market value to the trust. In the year of this transaction, the gift tax applicable exclusion amount and the GST exemption amount are both $11.18 million. He has not used any of his applicable exclusion amount or his GST exemption. This gift exhausts his $11.18 million gift tax applicable exemption amount. He must file a gift tax return and pay gift tax on $2.82 million of the gift. In addition, the GST tax will apply to the gift. His $11.18 million GST exemption will be automatically allocated to the gift unless he elects otherwise when he files his gift tax return. Many states impose their own transfer taxes. These taxes are generally imposed at lower rates than the federal transfer tax rates. Any amounts paid to the state for transfer taxes are allowed as deductions in determining the federal tax. Transfer of life insurance policies to remove the excess of the death benefit over the value at the date of gift from the estate is common and often very tax efficient. Transfers of annuities are typically considerably less tax efficient. The basis used to determine gain varies depending on whether the property is received by gift or inheritance. Although gifts and transfers at death are part of a unified system, one may produce better results than the other, depending on the situation. The estate tax is often described as a voluntary tax. There are numerous ways to minimize transfer taxes if the transfer tax system is understood and the advice of competent professionals is sought before substantial gifts are made and as part of the estate-planning process. 35