Peter L. McCarthy, JD, CLU, ChFC

Passing on the “Good Stuff!” All inheritances aren’t equal. Even two different assets that are worth similar amounts may provide vastly different inheritances because of tax laws and distribution rules.

People who care about their loved ones often want to pass on the assets they own which have the greatest potential for future value. An asset which many financial experts suggest is a great one to inherit is a Roth IRA. Unfortunately, many people don’t have Roth IRAs to pass on to their loved ones.

This article will discuss why a Roth IRA can be an excellent asset to inherit and explain two ways an IRA owner may help his family inherit one.

Many People Have Traditional IRAs

Many working Americans have at least one tax-qualified account in which they are saving funds to help pay retirement expenses. There are a number of different kinds of tax-qualified accounts but, for simplicity, we’ll use the labels “traditional IRA” or “IRA” for all of them except a Roth  IRA.

Generally, traditional IRAs are financially attractive because they offer the opportunity for tax-deferred growth on investment earnings. These accounts give ordinary taxpayers a valuable income tax benefit because contributions come from pre-tax dollars. The ability to defer income taxes on both contributions and earnings helps such an account value grow. Many people are saving substantial sums for retirement this way.

Distributions Are Taxable. Congress created IRAs to be used as retirement savings tools, not wealth transfer tools. Consequently, funds must begin to be distributed from these IRAs no later than the year after the year in which the owner reaches age 701/2. These distributions are fully taxed as ordinary income when they are paid out. When an account owner dies, the balance must continue to be distributed to named beneficiaries.

From a beneficiary’s point of view, an IRA isn’t always an attractive asset to inherit. That’s because an IRA account balance must continue to be distributed whether beneficiaries need the money or not. Further, an IRA doesn’t qualify for a step up in basis at the owner’s death. Thus every dollar distributed is taxed as ordinary income. A beneficiary with a 25 percent marginal income tax bracket who receives a $10,000 distribution will only have $7,500 left to spend after income taxes. Although income tax deferral continues for IRA earnings, the beneficiary will have to pay income taxes on every dollar distributed.

The Roth IRA

In 1998 Congress created the Roth IRA. Although funded with after-tax dollars, Roth IRAs are attractive because they have two important features not available in traditional IRAs: (1) all distributions are federal income tax-free and (2) there are no required minimum distributions during the owner’s lifetime.

When a Roth IRA is properly set up and managed, investment growth isn’t just income tax-deferred, it is income tax-free. Moreover Roth IRA owners decide when to take distributions; they are not required to take any distributions while they are alive. Thus, Roth IRA owners have an opportunity to combine income tax savings with distribution flexibility. Roth IRA owners can leave funds in their account to grow income tax-free until they are needed.

Passing on a Roth IRA. Roth IRAs can be effective wealth transfer tools. After a Roth IRA owner’s death, investment growth on the remaining account balance continues to be income tax-free. Distributions to beneficiaries are not subject to income taxes, but they must begin in the year after the year of the owner’s death and are based on life expectancy of the oldest beneficiary. This combination of features can make a Roth IRA a much more attractive asset for a beneficiary to inherit than a traditional IRA.

Informed heirs usually prefer to inherit Roth IRAs instead of traditional IRAs because they have the potential to produce more after-tax spendable income. If given the choice of inheriting a $500,000 traditional IRA or a $500,000 Roth IRA, many people would choose the Roth IRA. The prospect of income-tax-free distributions is simply more attractive.

When Congress created the Roth IRA, it also created a procedure for converting traditional IRAs into Roth IRAs. Initially some qualifications had to be satisfied before a conversion could take place. Those qualifications ended in 2010. Now the only thing a traditional IRA owner must do in order to convert all or part of the account into a Roth IRA is to recognize the converted amount as taxable income in the year of the conversion and pay income taxes accordingly.

Currently, most Roth IRA conversions take place while the original owner is alive. For best financial results, it is recommended that income taxes be paid from funds outside the Roth IRA. In this way the Roth IRA’s income tax advantages of tax-free growth and tax-free distributions can be maximized.

Although most IRA owners know about the opportunity to convert their traditional IRA to a Roth IRA, many decline to do so because they don’t want to pay additional income taxes or they don’t have sufficient liquid funds outside their IRA to pay the income taxes. They like the idea of turning taxable income into tax-free income, but they don’t want to pay the income tax cost of the conversion. It’s possible that if more IRA owners had extra cash to pay the income taxes, there would be more conversions to Roth IRAs.

Planning for a Roth IRA Conversion at the Owner’s Death. For traditional IRA owners who would like to convert but who don’t have liquid funds to pay the resulting income taxes, full or partial conversion after their deaths as part of their wealth transfer plans may make sense.

Such a conversion could potentially take place after the account owner’s death if three conditions are met:

 1. The owner is married at the time of his death and is survived by his spouse.

 2. The spouse is the IRA’s primary beneficiary.

 3. Money outside the IRA is available to pay income taxes.

When a surviving spouse is primary beneficiary of an IRA, he may elect to roll over the IRA into his own name. After the rollover, the spouse may elect to fully or partially convert the traditional IRA to a Roth IRA.

The costs to convert a traditional IRA into a Roth IRA are the state and federal income taxes on the portion of the traditional IRA the spouse wishes to convert. Often, finding the money to pay these taxes is the key to the conversion.

Alternatives for Paying a Spouse’s Income Tax Costs. A spouse may have several sources of funds available to pay income taxes triggered by the conversion. The money needed could be borrowed or there may be cash in a checking, savings or money market account. Or, a spouse may have inherited other assets from the deceased spouse’s estate that are relatively liquid. Additionally, some assets inherited from the deceased spouse will receive a step up in cost basis. If the spouse is amenable, these assets could be sold soon after the account owner’s death without generating significant capital gains taxes. These are some of the options available if the planning approach relies on the use of existing assets to fund the Roth IRA conversion.

Life Insurance Can Help Pay the Income Taxes. Spouses who don’t wish to use liquid assets or sell assets to fund a Roth IRA conversion should consider using life insurance death benefits to pay tax costs. An existing policy insuring the account owner can be used or a new policy can be purchased if the account owner is insurable. Life insurance is an attractive funding tool because the premiums paid are leveraged into larger death benefits that are income tax-free.

If needed, dollars needed to pay policy premiums can even come from distributions from a traditional IRA. If an account owner is over 591/2, IRA distributions do not carry a 10 percent premature distribution penalty; if an account owner is under 591/2, penalty-free distributions to pay premiums can be received under the rules of IRC Section 72(t). After the income taxes on the IRA distribution have been paid, the after-tax portion of the distribution can be used to pay policy premiums.

Step-by-step here’s how a new life insurance policy can fund the conversion from a traditional IRA to a Roth IRA after an account owner’s death:

 1. The IRA owner names the spouse as primary IRA beneficiary.

 2. The IRA owner buys a life insurance policy on his own life and pays the annual premium; the spouse is policy beneficiary.

 3. At the owner’s death, the spouse rolls the IRA over into his own name.

 4. The spouse decides how much of the traditional IRA to convert into a Roth IRA.

 5. The spouse receives the life insurance death benefits.

 6. The spouse uses some or all of the life insurance death benefits to pay the income taxes resulting from the conversion.

 7. The spouse names the children as beneficiaries of the Roth IRA and takes distributions from it as needed during his life.

 8. The Roth IRA beneficiaries receive distributions after the surviving spouse’s death.

The Life Insurance Death Benefits May Be Protected from Estate Taxes. Life insurance death benefits will be included in the estate of the IRA owner; however, to the extent the spouse is policy beneficiary, the death benefits should qualify for an estate tax marital deduction (if the spouse is a U.S. citizen). The net effect is that no estate taxes will be assessed on the death benefits at the owner’s death. Any death benefits remaining at the surviving spouse’s death will be included in the spouse’s taxable estate.

How Does a Surviving Spouse Benefit from Such a Conversion? A surviving spouse may gain several financial benefits from such a conversion. As owner of a Roth IRA, he will likely enhance his financial flexibility in these ways:

 • All Roth IRA distributions a spouse elects to take are income tax-free.

 • No lifetime distributions are required.

 • Any annual account growth is income tax-free.

 • A spouse gets to name new beneficiaries to receive the Roth IRA account balance at his death.

 • All distributions to those beneficiaries are income tax-free.

After the conversion a spouse can mix and match income from other sources with Roth IRA distributions as needed for retirement income.

What Happens If a Spouse Dies Before the IRA Owner? If a spouse dies before the traditional IRA owner, there won’t be any death benefits from the policy insuring the owner to pay income tax costs. Unless the owner remarries, a conversion cannot be made; only the owner can fully or partially convert to a Roth IRA.

There is a way to hedge against the possibility that the spouse dies before the IRA owner. By purchasing two policies—one on the owner and one on the spouse—there will be death benefits to fund a conversion no matter which spouse dies first.

Liquidity Planning to Avoid the Estate Tax

Assuming a spouse lives and completes conversion, a Roth IRA (and any IRAs not converted) are included in his estate for estate tax purposes at death. If the estate is large enough to trigger estate taxes, it is critical that these taxes are not paid from a Roth IRA.

Taking distributions to pay estate taxes will reduce a Roth IRA’s unique ability to build wealth for the family. Every dollar distributed from it to pay estate taxes is a dollar that is no longer able to potentially generate tax-free income each year for the children as beneficiaries.

Estate liquidity planning is the best way to assure that distributions aren’t taken from a Roth IRA to make estate tax and estate settlement payments. Life insurance payable at a surviving spouse’s death is an excellent source of cash to pay estate taxes. A policy on the surviving spouse’s life or a second-to-die policy insuring both spouses will pay death benefits at the second death.

Such a policy may be owned in an irrevocable life insurance trust (ILIT) or be owned by a third party to prevent the proceeds from adding to the estate tax problem. The ILIT or third party can lend the death benefits to the estate or purchase estate assets to provide the executor with the cash needed to pay estate taxes and settlement costs.

A second-to-die policy can be constructed to supply both liquidity to pay income taxes on the conversion to a Roth IRA as well as estate taxes due at the surviving spouse’s death when the estate is passed on to younger family members. A second-to-die policy can have a single life rider insuring the IRA owner and naming the surviving spouse as beneficiary. If the IRA owner dies first, the rider’s death benefits will go to the surviving spouse and can be used to pay income taxes arising from the conversion.

Who Should Consider a “Spousal” Roth IRA Conversion?

Owners of traditional IRAs should meet the following criteria in order to be realistic candidates for a life insurance-funded “spousal” Roth IRA conversion: (1) be married to a spouse who is likely to outlive them, (2) name this spouse as primary IRA beneficiary, (3) be healthy enough to qualify for life insurance coverage, and (4) be unlikely to use up the IRA during life.

Questions to Consider

IRA owners should consider these questions in evaluating a full or partial conversion to a Roth IRA:

 • Do you expect to use up all your IRA money during your lifetime? If not, how much of it would you like to pass along to your spouse or children? What’s your plan for distributing the IRA account?

 • Do you want to leave the money in the IRA and continue tax-deferred growth as long as possible?

 • Who have you named as your IRA beneficiary?

 • If there was a way you could transform your IRA balance from dollars that are fully taxed to dollars that would be completely income tax-free to your family, would you want to know about it?

 • Does your wealth transfer plan provide your spouse a source of income tax-free dollars that could possibly increase his financial flexibility and security?

A Partial Roth IRA Conversion

Suppose the IRA owner expects to use some, but not all of his IRA before death. What’s a good strategy for a conversion to a Roth IRA?

A possible approach is for an owner to divide the IRA into two separate IRAs. One IRA would have a beginning balance equal to the amount the owner expects to use over the balance of his life; the other IRA would hold the remaining balance. He would take all voluntary and required distributions from the first IRA during the balance of his lifetime. Distributions for life insurance premiums would also come from this first IRA. The second IRA would be left to grow tax-deferred and free of distributions. At the owner’s death, the surviving spouse could convert this balance into a Roth IRA.

If an owner needs more funds to live on than are available in the first IRA, he would have the ability to tap the second IRA as needed for these additional expenses.

Conclusion

Some assets are better to inherit than others. Most spouses and heirs would rather inherit a Roth IRA than a traditional IRA. Traditional IRA owners who don’t want to spend money to convert to a Roth IRA themselves may be able to help their spouses convert to a Roth IRA. Funds to pay income taxes on the conversion can be provided by a life insurance policy insuring the IRA owner.

A surviving spouse can roll over the IRA to his own name, convert it into a Roth IRA and use policy death benefits to pay income taxes. A Roth IRA can provide an IRA owner’s spouse and children with a valuable, multi-generational financial tool. It’s “good stuff” to inherit.

A Roth IRA has the potential to enhance the surviving spouse’s financial security and may ultimately pass on more after-tax wealth to younger family members.

These materials are not intended to and cannot be used to avoid tax penalties. The ING Life Companies and their agents and representatives do not give tax or legal advice. This information is general in nature and not comprehensive, the applicable laws change frequently and the strategies suggested may not be suitable for everyone. Advice should be sought from tax and legal advisors regarding individual situations.

New Wealth Transfer Opportunities. At the end of 2010, the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (TRA 2010 or the Act) became law. Its major purpose was to continue the “Bush tax cuts” through 2012.

In the area of federal transfer taxes, however, TRA 2010 didn’t just extend those tax cuts, it greatly expanded them. As a result, wealthy people have new opportunities to pass on family wealth. The Act temporarily increased both the lifetime gift tax exemption and the generation skipping transfer (GST) tax exemption to $5 million per person. The Act allows married couples to combine their gifting and GST exemptions so that together they may transfer up to $10 million free of federal gift or GST taxes. Because the expanded gifting and GST limits expire on December 31, 2012, many well-to-do parents and grandparents are being advised to make significant gifts before 2013.

Gifting Isn’t for Everyone
Just because someone has the financial ability to make gifts doesn’t necessarily mean they should. Many well-to-do people want to protect their financial security and feel more comfortable waiting to pass on their extra wealth when they die. Gifting away assets could potentially reduce their standard of living and weaken their financial flexibility. Before making large gifts, parents and grandparents need to be comfortable with these facts:

1. Gifts are irrevocable. Once a gift is completed, it can not be recovered. Even if a donor’s circumstances or objectives change, assets given away can’t be retrieved.

2. Control over gifted assets is lost. Once a gift is completed, control over the asset passes to the recipient; thereafter, the parent/grandparent can’t limit, restrict or control how it is used.

3. Gifted assets may be claimed by outsiders. Assets gifted away can potentially be claimed by a donee’s creditors. Or, if there is a divorce, the gifted assets could wind up in the hands of the ex-spouse.

Passing on Wealth without Gifts
Still, most parents/grandparents love their children and grandchildren and want to pass on their wealth to them. Although they have no obligation to leave them an inheritance, many are interested in doing so. Although they may not wish to make large gifts, they may be willing to reposition some of their assets to increase what they pass on to their children/grandchildren as long as: (1) there is no negative impact on their own financial security, (2) the transfer takes place after they die, and (3) they retain control over the assets while they are alive, including the ability to recover their costs and change which family members or charities will receive the funds.

Jim and Nora Jones
Jim and Nora Jones are both 65 years old and in good health, and they just celebrated their 37th wedding anniversary. They have three adult children and seven grandchildren and a combined net worth of $4 million. They would like to pass on as much money as possible to their children and grandchildren, but not in a way that will weaken their own financial security. They are ready and willing to help if their children need financial assistance, but they aren’t interested in making gifts. Instead, they prefer to pass on most of their wealth at death.

Life Insurance May Help. Healthy, well-to-do people like Jim and Nora often use life insurance in their overall wealth transfer strategy. A policy insuring a parent or grandparent will pay death benefits when the insured dies—exactly the time when many parents and grandparents prefer to pass on their assets. Life insurance policies on either or both Jim and Nora have the potential to provide several important advantages, including:

1. Predictable Value. The policy may be structured to pay a known death benefit amount when the insured dies.

2. Death Benefit Values Not Linked to Market Performance. The policy may be structured so that the death benefit is a fixed amount which can be known in advance.

3. Liquidity. The death benefits are paid in cash; generally no transfer costs, commissions or management fees are subtracted from the death benefit.

4. Federal Income Tax-Free Payment. Policy death benefits (including the amount in excess of premiums paid) are generally income tax-free under IRC Section 101.

5. Growth/Leverage. Premiums paid for life insurance death benefit protection can provide significant leverage in the early years and may provide a competitive rate of return through life expectancy. The amount by which the death benefit exceeds the premiums paid is growth that is transferred to the policy beneficiaries free of federal income taxes.

Effective use of life insurance to transfer wealth often requires thoughtful planning. Parents/grandparents may want control over the policy and access to its cash values without having the death benefits taxed in their estates. Including the death benefits in their taxable estates could potentially increase their estate taxes or create an estate tax when none was previously due. Careful planning for policy ownership and payment of premiums may help them pass on more family wealth without making lifetime gifts.

Let’s assume that Jim and Nora qualify for a $1 million survivorship policy (which would pay death benefits after they have both passed away). The annual premium is $20,000. What options do they have for owning the policy and paying premiums?

Any of three strategies may help them:
         • Standby trust
         • Inter-family loan
         • Private split dollar arrangement

The Standby Trust Strategy
The standby trust strategy is a policy ownership arrangement in which a couple (usually a husband and wife) work together to use a survivorship life insurance policy to transfer funds to younger family members. This strategy gives one spouse control over the policy and the ability to access policy cash values as needed. When this strategy is properly implemented, policy death benefits should be estate tax-free.

Here’s how the standby trust strategy works:

1. The spouse with the shortest life expectancy (Jim) purchases a survivorship life insurance policy insuring both himself and Nora. Death benefits are paid when the survivor (Nora) dies. Jim pays premiums out of personal funds. As the policy owner, he makes the policy management decisions and has the ability to access policy values.

2. Jim creates a credit shelter trust as part of his estate plan. This trust can be created in his will or his revocable trust. Jim names this trust as the policy’s contingent owner and contingent beneficiary. This credit shelter trust “stands by” to receive the policy when Jim dies.

3. Jim’s credit shelter trust becomes the policyowner and beneficiary at his death. The trustee manages the policy according to the terms of the trust. Only the cash value in the policy on the date of death is included in Jim’s taxable estate.

4. When Nora dies, the policy death benefits are paid to the credit shelter trust without becoming part of her taxable estate.

5. The trustee distributes the policy death benefits and other trust assets to the children and grandchildren according to the terms of the trust.

Inter-Family Loans
Another strategy Jim and Nora should consider uses inter-family loans. Inter-family loans can be quite attractive when market interest rates are low. Currently interest rates are at or near historical lows. Table 1 shows how low the IRS short, mid, and long term rates are today compared to rates over the last five years.

In inter-family loans, neither Jim nor Nora owns the policy. Instead it is owned by their children, grandchildren or a trust for their benefit. Jim and Nora supply premium dollars by making loans to the policyowner. There can be one large loan that can be used to pay premiums for several years or there can be a series of smaller annual loans.

The legal formalities of loans need to be followed, and interest on the loan balance must be accounted for annually. Under the terms of the loan, policy cash values are assigned to Jim and/or Nora as security for repayment of the loan balance. An assignment of policy cash values gives Jim and Nora significant control over the policy.

The amount of interest due depends on whether the loan is a term loan (which must be repaid at a specified time) or a demand loan (which can be called for repayment whenever the lender chooses). In term loans the interest payment is a fixed percent for the life of the loan, while in demand loans the interest rate changes from year to year.

The loan arrangement continues until the lender (Jim) demands repayment (a demand loan), the term of the loan ends (a term loan) or the insured parent/grandparent dies. If the insured dies, the policy death benefits are first used to repay the loan balance and then the remaining death benefits are distributed to the policy beneficiaries (usually the children or grandchildren).

Irrevocable Life Insurance Trusts (ILITs). Allowing ownership of the policy to be shared by several children may create problems. To avoid these problems, Jim and Nora can create an irrevocable life insurance trust (ILIT) to own the policy. Their children/grandchildren would be the beneficiaries of the ILIT. Jim and Nora can lend the trustee the funds needed to pay the policy premiums.

Although some costs will be incurred to draft and administer an ILIT, well-to-do people often use them in their estate plans because ILITs give them the potential to:

1. Provide equal treatment to all children. In place of managing separate loans and policies for each child/grandchild, an ILIT allows the parent/grandparent to provide for all of them in one series of loans and use one life insurance policy so the death benefits can be distributed fairly under rules that apply to all.

2. Control the policy and its death benefits indirectly through provisions they included in the trust concerning policy management and distribution of death benefits.

3. Protect the policy and its death benefits from claims by beneficiaries’ creditors and ex-spouses. Such claims should not have access to either the policy or the death benefits in the trust.

4. Prevent policy death benefits in excess of the outstanding loan balance from being subject to either federal income or estate taxes.

Private Split Dollar Arrangements
Suppose neither Jim nor Nora wants to deal with the interest costs that come with inter-family loans. When that is the case, using a private split dollar strategy to pay the life insurance premiums may make sense.

In a private split dollar arrangement, Jim and Nora pay premiums through a split dollar “advance” rather than lending funds to pay premiums. The policy is often owned by an ILIT. The trustee and the parent/grandparent agree in writing to share the life insurance policy.

In return for advancing premium dollars, Jim and Nora will receive a portion of the death benefit equal to the policy’s cash values or the total premiums advanced, whichever is larger. The ILIT receives all the remaining death benefits. If the arrangement ends before both Jim and Nora die, they receive the greater of policy cash values or premiums advanced.

Private split dollar arrangements are not loans, and the ILIT trustee has no obligation to pay interest on the advances. Instead, Jim is deemed to make an annual gift to the ILIT beneficiaries of the term insurance value of the trust’s share of the life insurance protection. This value is known as the “economic benefit value” and can be determined under IRS Table 2001.

The annual gift is the term insurance value of the trust’s share of this year’s life insurance protection. It is not the premiums paid. The gift is “imputed” from the trust’s share of the life insurance protection, and no additional funds are transferred to the trust. Thus, the premium advances are essentially “cashless” gifts.

Jim retains the right to be repaid the greater of the total premiums paid into the policy or the policy cash values when the arrangement ends. When the policy used is a survivorship policy, the economic benefit value is usually relatively small while both Jim and Nora are alive. After one of them dies, the economic benefit value will start to increase substantially.

Private split dollar arrangements can be more complex than loan arrangements. The agreement itself should be drafted by a qualified attorney, and annual administration may be necessary. The economic benefit value increases each year as the insured ages. This means that the size of the imputed annual gift increases annually as well.

If there comes a time when Jim no longer wishes to continue the split dollar arrangement, he can have the option to convert it to an inter-family loan arrangement. In that case the split dollar premium advances he has made to date and future premiums will be treated as loans.

Conclusion
TRA 2010’s increase in the gift tax and GST tax exemptions gives wealthy parents/grandparents a great opportunity to transfer significant wealth to their children and grandchildren before 2013. Those who would like to transfer some wealth but who don’t wish to make gifts should consider using a standby trust strategy, inter-family loans, or private split dollar arrangements as alternatives. These strategies use life insurance ownership and premium paying strategies to increase what’s passed on to children/grandchildren. They avoid or minimize gifts while giving the policyowner the ability to recover some or all of his money if his circumstances or objectives change.

The ING Life Companies and their agents and representatives do not give tax or legal advice. This information is general in nature and not comprehensive, the applicable laws change frequently, and the strategies suggested may not be suitable for everyone. Each taxpayer should seek advice from an independent tax advisor.

Choosing a structure for a buy/sell arrangement can be difficult. The difficulty is knowing what type of buy/sell structure will produce the best results when the triggering event is unknown and will likely take place many years in the future.

A buy/sell format that may seem to be a good choice for a business today may not make sense 5, 10 or 20 years down the road. Change is a regular occurrence in business, and it is likely that situations will change after a buy/sell agreement is finalized but before a triggering event occurs.

Possible Changes Include:
Industry shifts
Economics of a business
Owners’ health
Makeup of owners’ families
Tax laws
Local business climate
Business technology
Owners’ finances
Owners’ personal objectives
Insurance companies and products

So that business owners can respond to unexpected future changes, including some provisions in the buy/sell agreement that give it flexibility is probably wise. By their nature, most entity purchase and cross-purchase agreements are fixed and may not be able to accommodate many changes.

What are some ways flexibility can be incorporated into a buy/sell agreement? This article will discuss two potential strategies: (1) creating flexibility in the identity of the buyer(s) and (2) creating flexibility in the ownership of life insurance policies purchased to fund the agreement.

Creating Flexibility
Among The Purchasers
One of the most important tasks of a buy/sell agreement is to create a binding obligation to purchase the departing owner’s interest. Meeting this objective, however, doesn’t mean there can’t be some flexibility in the identity of the purchaser or that there can’t be several purchasers. The objective of the agreement is to make sure the departing owner’s entire interest is purchased and that ownership remains within a specific group of individuals.

Using preliminary purchase options is a strategy with the potential to add ownership flexibility while still assuring that the entire interest for sale will be purchased and that ownership will remain within the group. A buy/sell arrangement that uses purchase options before a mandatory purchase is often called a “wait-and-see buy/sell.”

The Wait-and-See Buy/Sell. This arrangement allows the owners to wait until the first death or another triggering event to decide whether the business, the remaining owners, or a combination of the two will purchase the interest for sale. This flexibility is useful because it allows the remaining owners to postpone deciding what the future ownership makeup will be until a triggering event actually occurs. Wait-and-see arrangements allow the purchasers to be the entity, the remaining owners—or both.

How It Works. In a typical wait-and-see arrangement, the business has the first option to purchase all or part of the interest for sale at the price or formula set in the agreement. If the business does not fully exercise the option and purchase the entire available interest within a specified time, the surviving owners are next in line to purchase the interest remaining for sale. Each remaining owner may have the option to purchase his pro rata share of the remaining interest. If the remaining owners do not fully purchase the remaining interest, then the business entity is required to purchase the remainder.

A wait-and-see arrangement adds flexibility because if a cross-purchase plan is more advantageous than an entity purchase at the time of the triggering event, the business does not have to exercise its first option to purchase. The remaining owners will then exercise their individual options. On the other hand, if the owners believe an entity purchase plan is more advantageous, they can elect that the business purchase the entire interest available for sale.

Life insurance policies funding a wait-and-see arrangement are usually owned by the individual owners just as in the cross-purchase funding format. If one owner dies, and the remaining owners decide to complete the purchase in a cross-purchase format, they will receive the death benefits and may use them to fund the purchase of their shares of the interest. If they decide to use the entity purchase format instead, they will receive the policy death benefits and then they can lend these death benefits to the business entity. When the loan is paid up, it is likely that only the interest paid on the loan will be considered taxable income to the owners.

The Own-Your-Own Policy Buy/Sell
Nearly all buy/sell agreements that use life insurance have one thing in common: The insured business partners do not own the life insurance policies that insure their own lives. In an entity purchase arrangement the business owns the policies. In a cross-purchase arrangement the other owners or another entity (e.g., a trust or a general partnership) own the policies.

The fact that owners don’t own their own policies has the potential to create a variety of problems, including:

• An owner is precluded from making decisions about the policy insuring his life.

• If an owner leaves the business before death, he may not be able to acquire ownership of his policy or use the death benefits for personal financial objectives.

• If an owner’s health deteriorates, he may become uninsurable and unable to purchase other life insurance coverage; thus, he may need the buy/sell coverage for his family.

• Even if a departing owner is insurable, the cost of purchasing new coverage could be prohibitive because of age, health or other conditions.

Many buy/sells are triggered when an owner retires, becomes disabled or voluntarily leaves for other reasons. In those cases the policy death benefit can’t be used to purchase the departing owner’s interest because the insured owner hasn’t died. Nevertheless, the departing owner’s policy is a potentially valuable asset which could be quite useful in his wealth transfer and personal financial planning. When policies are individually owned, each partner controls his death benefit after leaving the business and can change the beneficiary designation to meet his personal objectives.

Potential Advantages. There are a number of potential advantages when partners own their individual buy/sell life insurance policies, including:

• One Policy Per Owner—There is no need for multiple policies on each owner.

• Personal Ownership and Control­—Each partner owns and makes the decisions concerning his policy (although each owner must manage the policy to satisfy any standards or requirements set in the buy/sell agreement).

• Personal Death Benefit Coverage—If an owner wants more death benefits than the amount needed under the buy/sell agreement, he may wish to combine the coverage required under the buy/sell agreement with the coverage for his personal protection and wealth transfer planning.

• Personal Responsibility—Each owner is responsible for his own premiums. Younger or healthier owners aren’t forced to pay premiums on older or less healthy owners.

• Personal Premium Level—Owners decide how much premium to pay; they may choose to pay more than the minimum in order to increase cash values potentially available for supplemental retirement income.

• Policy Is Portable­­—Every owner who leaves the business before death takes the policy with him; there is no need to attempt to reacquire the policy from another owner or from the business.

• Personal and Wealth Transfer Plan­ning—After an owner leaves, he has the option to reposition the death benefits to meet personal needs without going back through underwriting to purchase new coverage; thus, problems with increased premiums and decreased insurability can potentially be avoided.

Two Reasons Personal Ownership Is Rarely Used. In spite of the potential advantages, personal ownership of death benefits to fund buy/sell agreements is a strategy that is seldom used. This is true for two primary reasons:

1. Someone else (either another owner, entity or the business itself) has the legal obligation to purchase the interest. Because potential purchasers need to make sure they have sufficient funds to satisfy their purchase obligations under the agreement, it may not make sense for them to own and control the policies.

2. The transfer for value rule of IRC Section 101. One of the advantages of using life insurance as part of the buy/sell funding is that policy death benefits are generally federal income tax-free to the policy beneficiary when the insured owner dies. This valuable income tax benefit may be lost if the business owners own their own policies because they may violate the “transfer for value rule.”

A transfer for value occurs when the owner of a life insurance policy transfers an interest in the policy to someone else and receives something of value in return. Under IRC Section 101 “value” isn’t limited to just cash or tangible assets; “value” can also include an enforceable promise which could potentially benefit the recipient (such as a promise to purchase the owner’s interest).

Violating the transfer for value rule results in taxable income to the policy beneficiaries to the extent of the difference between the policy death benefit and the total of the consideration paid plus all premiums paid after the transfer.

Here’s an example to illustrate the point. A and B are each 50 percent owners of a business. Each purchases a $1 million life insurance policy on his own life and names the other as a beneficiary (normally neither A nor B would name each other as a policy beneficiary). Reciprocal promises to name each other as beneficiaries can be implied from their respective actions (or from the terms of the agreement). These reciprocal promises are the “value” that triggers the transfer for value rule. Thus, if Partner A dies, part or all of the $1 million death benefit Partner B receives as the beneficiary of A’s policy may be taxable income to B.

The Partnership Exception. Fortunately, it is possible to avoid the harsh income tax consequences of the transfer for value rule. In IRC Section 101(a)(2) Congress created a number of exceptions to the rule; if one of those exceptions applies, then it is possible the policy beneficiary may still receive the life insurance death benefits free of federal income taxes.

The exception most likely to apply to buy/sell arrangements is the partnership exception. This exception shields transfers for value from federal income taxes if the transfer is to a partner of the insured or to a partnership in which the insured is a partner.

The ability to use the partnership exception to avoid the transfer for value rule may create an opportunity for a new type of life insurance funded buy/sell arrangements­:the Own Your Own Policy Buy/Sell. In this approach each owner owns his policy and assigns or endorses part of the death benefit to the other owners so they will have the funds to meet their purchase obligations under the agreement. If these owners are in a partner/partnership relationship, income taxation of the death benefits under the transfer for value rule should be avoided.

• How the Own Your Own Policy Buy/Sell Works. Assuming there is valid partnership in place or the business is organized as a limited liability company (LLC), limited liability partnership (LLP), or a general partnership, these steps may be taken:

1. The owners enter into a cross-purchase arrangement; each owner agrees to purchase his pro rata share of the other’s death.

2. Each owner purchases and pays the policy premiums on his own life with a face amount at least as large as the value of his interest in the business. An option B death benefit approach—where the death benefit payable is the face amount plus premiums paid—may be appropriate because the insured’s estate will recover premiums paid into the policy.

3. Each owner assigns or endorses part of his policy’s death benefit to the other owners according to their pro rata shares of the business; the necessary forms are filed with the insurance company.

4. At an insured owner’s death, the benefits are paid according to the assignment/endorsement and the policy beneficiary designation; each surviving owner uses his share of the death benefit to purchase part of the deceased’s share of the business from his estate, as required by the agreement.

5. If an owner retires or otherwise leaves the business before death, the remaining owners may use the cash values in their policies and/or other personal assets to purchase their respective shares of the departing owner’s interest.

6. The owners complete all paperwork necessary to release the assignment/endorsement they hold against the departing owner’s policy and the departing owner releases his assignments/endorsements against their policies.

• Incentive to Use Cash Value Insurance. Many business owners consider the need for buy/sell life insurance to be temporary. That’s because they often expect to sell their interests when they retire (usually between ages 60 and 70). As a result, they often use term life insurance to fund their obligation to purchase upon another owner’s death.

The Own Your Own Policy Buy/Sell structure creates incentives to use cash value insurance for the buy/sell funding. Because the policy death benefit can meet other personal and wealth transfer objectives after an owner leaves a business, his policy will need to be in force for the balance of his life. Cash value insurance may also be attractive because of its potential to provide some degree of supplemental retirement income. The fact that a policy has a variety of potential uses after an owner leaves a business increases the odds of selling cash value policies.

Managing the Policy. A business owner may be able to combine both his business and personal life insurance planning in one personally owned policy. The total death benefit could include components for buy/sell funding, spousal support, mortgage and personal debt repayment and estate liquidity. Of course, the personal portion of the death benefit would be included in his taxable estate. If this is a problem, then it may be possible for him to establish an irrevocable life insurance trust (ILIT), which would own the policy. The portion of the death benefit needed to fund a buy/sell arrangement could be handled by naming the other owners as beneficiaries of the ILIT to the extent of ownership in the business. The ILIT could be drafted so that their status as beneficiaries would end if they die before the owner or if the owner leaves the business prior to death.

An insured is responsible for paying policy premiums. He can use personal funds or enter into a premium sharing arrangement with the business or an outside entity. If it makes financial sense, the business may be able to supply some of the premium dollars through a 162 bonus plan, an economic benefit split dollar arrangement, or a split dollar loan. It is also possible that some assets from the business could be distributed to the owners as dividends or (depending on the business’ tax structure) return of basis.

Savvy business owners will want to make sure the death benefits they need from another owner’s policy will be paid to them so they can meet their purchase obligations upon another owner’s death. Thus, their status as beneficiaries, entitled to receive a portion of the death benefit, must be secured through a written assignment, an endorsement of death benefits, or an irrevocable beneficiary designation. They should consult with their tax and legal advisors to determine which option is best suited to their needs.

• Potential Tax Consequences of the OYOP Buy/Sell. The year-to-year income tax treatment of an OYOP buy/sell arrangement is not known with certainty. The transfer for value issue should arise only when an insured owner dies, not while he is alive. It does not create year-to-year income tax consequences during an insured’s lifetime. Also, it is possible to “cure” a transfer for value before the insured’s death by transferring the policy back to the insured.

Are there any year-to-year tax consequences when a policy owner names a business partner as a temporary beneficiary of all or part of the death benefit of his policy in return for a business partner doing the same for him? The answer to this question is not known with certainty.

• Potential Disadvantages. Possible disadvantages of an OYOP buy/sell arrangement include:

1. A procedure for monitoring the policies should be implemented and performed annually.

2. The death benefit assignments/endorsements should be filed with the insurance company.

3. Economic benefit calculations will need to be performed annually if the split dollar rules apply.

4. Taxable gifts could either use up a portion of the business owner’s $13,000 per donee gift tax annual exemption or part of the $1 million lifetime gift tax exemption and may also reduce the amount of the estate tax unified credit available at death. As a result the amount of property an owner may be able to transfer federal estate tax-free at death may be reduced.

• Widespread Potential for Use. The OYOP buy/sell concept could potentially be used by a large number of businesses. That’s because many existing businesses are organized as LLCs, LLPs and general partnerships. The LLC form of business is a legal structure that is often adopted by new businesses. Owners of C corporations and Subchapter S corporations sometimes have assets that are used in the business but are owned outside the corporation in a partnership.

If there is no existing partnership in place, C corporation and Subchapter S corporation owners may choose to create one by contributing personal assets and/or taking distributions from the corporation and contributing the after-tax portion of some of those distributions into a new partnership.

Flexibility in business succession planning and funding can be very important to the future of a business, its owners and their families. A buy/sell arrangement which can’t adjust to changing business and personal circumstances may fail to accomplish what it was designed to achieve. The wait-and-see format provides potential options for how a business is owned after an owner leaves. The own your own policy approach is a funding strategy which may increase flexibility for the life insurance policies funding the agreement.

Consider presenting these ideas to the business owners you encounter and the attorneys and CPAs who advise them.

These materials are not intended to and cannot be used to avoid tax penalties. This information is general in nature and not comprehensive, the applicable laws change frequently, and the strategies suggested may not be suitable for everyone. Each taxpayer should seek advice from an independent tax advisor.

Pilates sessions are famous for increasing physical strength and flexibility. The gift tax provisions of the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (TRA 2010) have this effect on life insurance premium financing. As a result, premium financing cases have the potential to be easier than ever in 2011 and 2012. This article discusses how the act adds new temporary flexibility to premium financing arrangements.

What Is Premium Financing?
Premium financing is a wealth transfer/estate liquidity strategy that has the potential to help wealthy people meet their estate liquidity needs and transfer more wealth to their children and grandchildren. This strategy is best suited to people who are quite wealthy and who do not wish to use their own funds to pay policy premiums. (See the Profile of a Suitable Premium Financing Prospect)

Profile of a Suitable Premium Financing Prospect

Premium financing is not for everyone; it is a complex transaction which carries a variety of risks.

A suitable premium financing prospect should meet these criteria:

•  Has a need for life insurance death protection
•  Has a net worth in excess of $5 million
•  Has liquid assets to pledge as security for the premium loans
•  Meets company underwriting guidelines
•  Satisfies the lender’s minimum requirements
•  Has access to knowledgeable tax and legal advisors

In a premium financing arrangement, a wealthy person creates an irrevocable life insurance trust (ILIT) which purchases a large life insurance policy insuring his life. The ILIT trustee borrows money to pay the policy premiums from a bank or other commercial lender. The policy is collaterally assigned to the lender as security for repayment of the loan. As part of the lending arrangement, the insured may be required to pledge additional collateral that is acceptable to the lender to fully secure the loan. If the loan is still outstanding at the insured’s death, the death benefit proceeds repay the outstanding loan balance and the remaining death benefits are paid to the ILIT so they can be distributed as directed by the trust agreement.

Why Do Wealthy People
Use Premium Financing?
Most suitable premium financing prospects have enough assets to pay their own premiums. Why do they choose to borrow the premium dollars from a commercial entity if they can afford to pay them themselves? There are a number of good reasons why some wealthy people decide to use outside funds to pay their life insurance premiums, including:

1. They may be asset-rich but cash poor. That is, their assets may be tied up in a variety of fixed or illiquid investments and cannot be easily converted into cash.

2. Converting assets into cash may trigger a variety of taxes, costs and fees such as: capital gains taxes, management fees and sales commissions. The extra costs, taxes and complexity of selling assets to create cash for premium dollars can make premium financing easier and more efficient than personally paying the premiums.

3. They may wish to save their cash and liquid assets for other purposes or to keep them available to deal with possible future crises and financial emergencies.

4. They may like the idea of using money other than their own to pay life insurance premiums because they can maintain control of their assets rather than spending them and losing any growth or earnings potential.

5. Borrowing premium dollars may be inexpensive relative to other available options in today’s low interest rate environment.

6. Until TRA 2010, gifting limits may not have been high enough to allow direct gifting to be an effective alternative option for paying policy premiums.

7. Commercial loans generally do not create a gift by the client to his trust; consequently, considerable gift tax savings may potentially be realized.

Favorable New Gift Tax
Rules for 2011 and 2012
TRA 2010 significantly expands the tax free gifting limits in 2011 and 2012. Effective January 1, 2011, the act increased the lifetime gift tax exemption from $1 million to $5 million per donor for two calendar years. The generation skipping transfer (GST) tax exemption limit also increased from $1 million to $5 million. Gifts and GST transfers exceeding these limits are potentially subject to gift and GST taxes at a maximum rate of only 35 percent. The increases in these limits have the potential to make premium financing arrangements much more flexible through 2012.

The expansion of the gift and GST limits offers wealthy individuals and married couples a wonderful opportunity to efficiently transfer more of their wealth to their children and grandchildren by making lifetime gifts before January 1, 2013. Individuals have an increase of $4 million in gifting capacity over what they could give in previous years. Married couples have an increased gifting capacity of $8 million. Individuals who haven’t yet used any of their lifetime gift tax exemption could give up to $5 million, while married couples could give away up to $10 million if neither spouse has previously used any lifetime gifting exemption.

Life Insurance Sales Opportunities
for Wealthy Clients
Parents and grandparents who are in good health and who can afford to make lifetime gifts have been given what may be a once-in-a-lifetime opportunity over the next two years. The increase in both the gift tax and GST exemptions to $5 million creates unique potential to pass on large amounts of wealth to younger generations. Gifts to GST trusts have the potential to accumulate and distribute family wealth outside the federal transfer tax system for several generations (the exact length of time depends on a variety of factors, including state law). When life insurance is used as a trust asset, it may be possible to leverage those gifts into additional wealth for the trust beneficiaries.

New Premium Financing Arrangements
New premium financing arrangements could be quite attractive to wealthy individuals and families. The ability to combine their expanded gifting and GST exemptions with funds their ILIT trustees may borrow from commercial lenders could significantly increase the amount of wealth they could potentially transfer outside the transfer tax system. At the same time, their premium financing arrangements could possibly be more flexible and efficient.

A hypothetical case may help make this clear. Let’s assume James Smith (age 65) needs $15 million of life insurance coverage to meet his estate liquidity needs. He has never used any of his gift tax lifetime exemptions, and he wants to establish a premium financing arrangement to cover the $900,000 annual premium cost. He creates an ILIT to own the life insurance policy. These are some of the flexible design alternatives potentially available to him:

1. Gift $1 million in cash to the trust in 2011 so the trustee has funds to pay the annual interest due on the outstanding loan balance.

2. Gift $3 million in additional cash to the trust in 2011 to reduce the total amount of premiums that need to be borrowed and the amount of required outside collateral he will have to put up to finalize the loan.

3. Gift an additional $2 million to the trust in 2012 which the trustee may use to pay down the outstanding loan balance; this may also reduce or eliminate the need for outside collateral.

4. Gift $1 million in income-producing property to the trust in 2011; the trustee may use the income to pay interest and/or possibly pay off part of the outstanding loan balance.

5. In either 2011 or 2012 create a 10-year grantor retained annuity trust (GRAT) funded with $10 million in assets. The ILIT would be the remainder beneficiary of the GRAT and, after 10 years, the GRAT would end and the ILIT would receive the GRAT’s remaining assets, which the trustee could use to pay down or pay off the outstanding loan balance. If the Section 7520 rate is 3 percent, the gift tax value of a 10 year, $10 million GRAT paying out 6 percent annually to the grantor is $4,881,800.

Existing Premium
Financing Arrangements
TRA 2010’s increased gifting limits give new flexibility to premium financing arrangements already in place. Wealthy clients have new potential opportunities to change or enhance premium financing arrangements they implemented years ago. To envision some of the possibilities, let’s assume that James Smith’s financing arrangement for his $15 million policy was put in place five years ago and that the current loan balance is $4.5 million. These are some of the new options he has for managing the arrangement:

1. Gift $4.5 million in cash to the trust in 2011 so the trustee can retire the outstanding loan balance.

2. Gift $1 million in cash to the trust in 2011 so the trustee has funds to pay the annual loan interest.

3. Gift $2 million in cash to the trust in either 2011 or 2012 so the trustee can pay back part of the loan balance (with a possible reduction in the amount of required outside collateral). The trustee may also retain part of the gift to pay annual interest costs on the reduced loan balance.

4. Gift up to $5 million in income-producing property to the trust before the end of 2012; the trustee may use the income to pay interest on the outstanding loan balance.

Premium financing arrangements can be complex and involve a number of risks. The act’s expanded gifting limits also create life insurance funding alternatives outside of premium financing. Because gifts in 2011 and 2012 have a much higher exemption limit, some clients may decide to bypass the complexity and risks of premium financing altogether.

Three available premium financing alternatives include:
1. Make Large Cash Gifts Directly to the ILIT. In Smith’s case, he could give up to $5 million directly to his ILIT over the next two years (assuming no prior use of his lifetime gifting exemption). The trustee could use these funds to pay policy premiums. If Smith is married, his spouse could agree to “split gift” with him and allow the use of part or all of her $5 million lifetime exemption to be applied to the gift. Thus, together they have the ability to supply the ILIT with up to $10 million gift tax free to pay premiums.

2. Create a Private Loan Arrangement. Instead of making large gifts to the ILIT, Smith could decide to lend the trustee the premium dollars himself. These transactions are known as private loan arrangements. The trustee and grantor enter into an arms-length loan agreement, using reasonable terms and setting a fair market interest rate. Smith would lend the trustee the premiums under the loan arrangement’s terms. In addition to lending the trust the premium dollars, Smith could make a lump sum cash gift to the trust so the trustee has funds to pay him interest on the outstanding loan.

3. Use a Gift/Private Loan Combination. Mr. Smith could also decide to use both gifting and private loans together in an integrated strategy. This combination approach could be useful if Smith’s remaining gifting exemption is not large enough to cover the needed premium dollars or if he wants to have the option of getting back some of his premium dollars if his financial circumstances change, the tax law changes, or be becomes dissatisfied with the life insurance policy. An example of this combination strategy would be for Smith to gift the trust $5 million in 2011 and lend it $1 million annually for each of the next five years.

Conclusion
The two year expanded gifting window created by TRA 2010 continues the long term uncertainty around wealth transfer planning. TRA 2010 provisions are temporary and expire at the end of 2012. Clients who can benefit from life insurance policies with large death benefits often borrow the dollars needed to pay premiums from commercial lenders in premium financing arrangements. The act’s expanded lifetime gifting limits appear to create temporary opportunities for premium financing clients to make their arrangements more flexible and potentially more efficient. The expanded gifting limits may allow them to reduce how much their trusts have to borrow to pay premiums and give them cash to pay interest on outstanding loans. The expanded gifting limits may also give them the opportunity to avoid premium financing arrangements altogether.

Now is a great time to show suitable clients and their tax and legal advisors how the new “pilates-like” flexibility in premium financing arrangements can enhance their wealth transfer planning.

These materials are not intended to and cannot be used to avoid tax penalties and they were prepared to support the promotion or marketing of the matters addressed in this document. Each taxpayer should seek advice from an independent tax advisor.

The Tax Relief, Unemployment Insur­ance Reauthorization and Job Creation Act of 2010 (TRA 2010 or the Act) temporarily extends most of the provisions of the Bush-era tax cuts. Because it is set to expire on December 31, 2012, the Act creates a two-year window to take advantage of its provisions. Following is a discussion on the Act’s wealth transfer provisions with suggestions on how they could be used to encourage life insurance sales.

Federal Estate and Generation
Skipping Transfer (GST) Taxes
In most cases TRA 2010 was designed to extend tax provisions that were about to expire. However, in the estate, gift and GST tax arenas, the Act didn’t just extend tax benefits, it significantly expanded them.

Estates of wealthy people who die between 2011 and 2012 can take advantage of these expanded estate tax and GST tax benefits:

• Maximum rate estate and GST tax rates of 35 percent.

• Estate tax exemption of $5 million (indexed for inflation in 2012).

• GST tax exemption of $5 million.

• Estate and gift taxes are reunified at $5 million.

• Estate tax unified credits can be “portable” between spouses. This means that a surviving spouse may elect to take advantage of the unused portion of a deceased spouse’s estate tax exclusion and add it to the remainder of his own estate tax exemption; only the unused credit of the last deceased spouse can be “imported.”

Although these estate tax changes sound beneficial, their use will likely be limited because clients must die to take advantage of them. The portability provision is even less likely to be used because both spouses must die during the two-year window. Clients who don’t expect to die before 2013 should probably plan on an estate tax exemption of $1 million and a maximum tax rate of 55 percent (the exemption amount and maximum tax rate percentage set by current law after the two-year window ends).

Federal Gift Taxes on Lifetime Transfers
Favorable New Rules. The Act also significantly expands the gift tax limits. Some of the expanded gift tax provisions include:

• Maximum gift tax rate of 35 percent.

• Lifetime gift tax exemption of $5 million per person (indexed for inflation in 2012).

• Reunification of the gift tax and estate tax, which means that transfers of wealth will have essentially the same tax result regardless of whether they were made during life or at death. In 2011 and 2012 the same rate schedule which will be applied to both lifetime gifts and transfers after death.

• GST exemption of $5 million per person.

The Act’s gift tax provisions present immediate and valuable opportunities for those willing and able to make large lifetime gifts. Like the estate tax provisions, the gift tax provisions expire at the end of 2012. However, they are potentially much more valuable than the estate tax provisions because people can use them without dying (as long as they complete their gifts before the two-year window closes).

Tremendous Gifting Opportunities over the Next Two Years. Even though temporary, the expansion of the lifetime gift tax exemption to $5 million could be one of the most important changes in federal wealth transfer taxes in recent memory. This exemption had been fixed at $1 million since 2001. Increasing it to $5 million is unprecedented.

Clients who had previously used up their $1 million exemptions have now been “restocked” with an additional $4 million of tax-free gifting capacity. Married spouses who have both used their gift exemptions are now able to make additional gifts separately or in split gifts to transfer up to an additional $8 million gift tax-free. Married couples who haven’t used any of their exemptions could together give away a total of $10 million ($5 million each) gift tax-free during 2011 and 2012.

Wealthy clients have nearly two full years to design and implement their gifting plans. If they want to give away more, they can do so and pay gift taxes at the relatively low rate of 35 percent.

Life Insurance and Gifting. Many financial professionals know that life insurance is a tool with the potential to efficiently transfer wealth to younger generations. To make the sale, you will need to effectively answer at least two client questions:

Question 1:  Why should I make gifts? Donors who can afford to make lifetime exemption gifts need to understand that lifetime gifts can have important advantages over transfers at death because:

• Leverage (growth in asset value) after the gift occurs is outside the taxable estate.

• If the gift is made through a trust, future control over the gifted assets can be maintained through a trustee who has a legal duty to follow the terms of the trust.

• If the gift qualifies as a generation skipping transfer, the $5 million GST exemption can be used to potentially remove the gift from the federal transfer tax system for several generations (the actual length of time depends on state law).

• Donors may be able to see the benefits the gift provides with their own eyes.

• Gifting creates more certainty because the tax consequences for 2011 and 2012 are known; unfortunately, no one can be certain what the gift/estate tax laws will be after 2012.

• Income tax savings may be generated when an income-producing asset is gifted to a donee who is in a lower income tax bracket than the donor.

Question 2:  Why should I use life insurance in my gifting? A convincing answer to this question is critical to making the sale. The fact is that life insurance has the potential to offer a unique combination of several valuable advantages when it is used as part of a gifting strategy:

• Growth/Leverage. Premiums paid for life insurance death benefit protection can provide significant leverage in the early years and may provide a competitive rate of return through life expectancy.

• Income Tax-Free Payment. Policy death benefits (including the amount in excess of premiums paid) are generally income tax-free under IRC Section 101.

• Predictable Value. A policy may be structured to pay a known death benefit amount when the insured dies.

• Value Not Directly Linked to Market Performance. The policy may be structured so that the death benefit may not directly depend on financial market performance.

• Liquidity. The death benefits are paid in cash; generally no income taxes, transfer costs, commissions or management fees are subtracted from the death benefit.

• May Avoid Estate and Generation Skipping Taxes. Ownership of the policy may be structured so that the death benefits will not be subject to federal estate or GST taxes as part of the insured’s taxable estate.

Life Insurance Sales Opportunities
for Wealthy Clients
Healthy parents and grandparents who can afford to make lifetime gifts have a great opportunity in TRA 2010—perhaps a once in a lifetime opportunity. The increase in both the gift tax and GST exemptions to $5 million creates unique potential to pass on large amounts of wealth to younger generations. Some of the time-tested gifting strategies that regularly use life insurance to effectively transfer wealth include:

• Irrevocable Life Insurance Trusts (ILITs). Funding opportunities for new and existing ILITs commenced on January 1, 2011, when the gifting and GST exemption increases became effective. Clients who were happy with their current ILITs could gift more to them; those who wanted something different could create new ILITs and fund them with new gifts. For married couples, the combined lifetime transfer opportunity increased from $2 million to $10 million. Depending on the terms of the trust, using the exemption increases could potentially help clients avoid problems that may arise from funding the trust with $13,000 annual exclusion gifts (Crummey withdrawal powers).

Healthy & Wealthy Prospects Do You Know Someone Who…
• Has a net worth of more than $5 million (single) or $10 million (married)?
• Has already used his $1 million lifetime gift tax exemption or who has written a check to the IRS to pay a gift tax?
• Is well off financially and has grandchildren he cares about?
• Is uncomfortable making gifts that require sending out a temporary (Crummey) withdrawal power notice or who doesn’t want his children or grandchildren to know he is making a gift for them?
• Makes large gifts to charity?
• Is an attorney or CPA and gives tax/legal advice to wealthy clients?
• Has implemented a life insurance premium finance arrangement?
• Has established an Irrevocable Life Insurance Trust (ILIT)?
• Has created a generation skipping transfer (GST) trust for his family?
• Has created a private split dollar or private loan arrangement?
• Has one or more special needs child or grandchild?

• Generation Skipping Trusts and Dynasty Trusts. The increased gifting exemption may be combined with the increase in the GST exemption to create new funding opportunities for generation skipping and dynasty trusts. Allocating GST exemptions to lifetime gifts funding these trusts could possibly insulate large amounts of wealth from the transfer tax system for many generations (depending on state law). Lifetime exemption gifts (especially gifts to GST/dynasty trusts) may also be attractive because they don’t require a present interest on the part of trust beneficiaries.

As a result, the use of temporary withdrawal powers (also known as Crummey powers) and the need to give notice of them to beneficiaries could possibly be avoided. Present interest gifts (also called annual exclusion gifts) currently have a ceiling of $13,000 per donee; these gifts could be used on other transfers.

• Charitable Gifts Replaced with Life Insurance Death Benefits. Clients who are charitably inclined could decide to make lifetime or testamentary gifts to their favorite charities or charitable foundations and use life insurance to replace some or all of the assets given away. A potential application for this strategy is a charitable remainder trust (CRT).

The client establishes a CRT and funds it with a gift of securities or real estate. The CRT trustee sells the donated asset and uses the sale proceeds to make annual payments back to the client. The client uses the after-tax value of these payments and the value of the income tax deduction generated by funding the trust to make gifts to an ILIT or dynasty trust which purchases life insurance on the client’s life to replace the assets given to the CRT. At the client’s death the remaining CRT assets are distributed to charities named as CRT beneficiaries. The life insurance death benefits are paid to the ILIT/dynasty trust trustee who manages and distributes them under the trust’s terms.

• Premium Financed Life Insurance. Clients who have existing premium financed life insurance arrangements may decide to use part of the increase in the gifting exemption to transfer assets to the ILIT so it can fully or partially repay the funds it borrowed from commercial lenders. They could also make gifts to the ILIT to provide the trustee with the cash needed to make interest payments on the outstanding loan.

Clients considering new premium finance arrangements have the potential to contribute more funds to the ILIT gift tax-free and thus could potentially reduce or eliminate the need for the ILIT trustee to borrow funds from outside lenders to pay policy premiums.

• Existing Private Split Dollar and Private Loan Arrangements. Clients who have advanced funds for the benefit of their families in private split dollar or private loan arrangements may have an opportunity to reduce the amount to be paid back to them or to “roll out” of these arrangements completely. The two year increase in the gift exemption to $5 million in 2011 and 2012 may allow them to forgive some or all of the repayment they are entitled to receive under the arrangement.

Forgiving the repayment of a private loan or a private split dollar advance could be attractive because it does not require the transfer of any additional cash or property. It also has the advantage of reducing or eliminating the economic benefit reporting (private split dollar) and interest reporting (private loans).

Questions That May Come Up
During the Sales Process
• Assuming the client is insurable, how much life insurance should he purchase? Many clients have no idea how life insurance companies view their potential for life insurance coverage. In many cases it can be helpful to know how much new life insurance coverage they could potentially purchase under an insurer’s underwriting guidelines (their insurability reserve). Knowing this number can be an important factor in deciding how much life insurance to buy. Knowledge of their available insurability reserve can help clients make informed decisions about how much life insurance to purchase.

• What Non-Life Insurance Gifting Alternatives May Be Considered? Life insurance isn’t the only financial tool that could deliver positive wealth transfer results for high-net-worth clients. A disadvantage for life insurance is that the gifts generally must be made in cash. Other gifting strategies may not require cash to make gifts. Instead the client may be able to make gifts by transferring title to property. Some of these strategies include: qualified personal residence trusts (QPRTs); grantor retained annuity trusts (GRATs), and family limited partnerships (FLPs).

• Does life insurance make financial sense for me? How financially efficient will a life insurance policy on my life actually be? For life insurance to be useful in gifting scenarios, it must deliver an internal rate of return (IRR) that is competitive with those generated by other financial vehicles and strategies. If the life insurance proposal for a particular client doesn’t show a competitive after-tax IRR at the client’s life expectancy, it may be wise to consider other gifting strategies.

• Where will the premium dollars come from? Premium dollars can come from a variety of places. Cash and short term, liquid savings vehicles are best, but many clients may not have millions of dollars in savings accounts or certificates of deposit, etc. readily available.

IRAs and tax-qualified retirement accounts could potentially be used. Tax-qualified retirement accounts can potentially be attractive as premium sources for wealthy clients who are over age 591/2 and who do not expect to need the account balance for retirement income. Any distributions will be subject to income taxes, so it is wise to consider only the after-tax distribution as a potential source of premiums.

Another alternative is for clients to look through their asset portfolios and decide to sell one or two of them. The after-tax proceeds from the sale could provide some of the cash needed to fund the gift. Because TRA 2010 retains the 15 percent rate on capital gains, 2011 and 2012 may be good years to sell capital gain assets.

• What Timing Options Are Available? There are at least three options for implementing a life insurance-based wealth transfer strategy under TRA 2010:

1. The Do It All Now Strategy. Some clients will be in a position to make their gifts and purchase the life insurance immediately. They may have both tax and legal advisors who recommend acting quickly and enough liquid assets.

2. The Wait Till the Last Minute Strategy. Other clients will decide to wait until just before midnight on December 31, 2012, to establish their trusts and gift away the funds to pay the premiums. Of course, by waiting, they assume a variety of risks, including that they will become uninsurable or die unexpectedly and that the assets/funds they expect to use to make their gifts may dry up or disappear.

3. The Secure the Insurance Now, Make the Big Gifts Later Strategy. Still other clients will want a low risk strategy that keeps them in control and their options open for as long as possible. They may decide to make their life insurance decisions early and put the coverage in force and use convertible term coverage to keep their initial outlay low. In 2012 they could convert the term coverage to cash value life insurance. They will make gifts needed to pay the premiums, but they may wish to postpone making the biggest gifts to the fourth quarter of 2012, at the end of the two-year window.

Conclusion. TRA 2010 continues the uncertainty that surrounds wealth transfer planning. Its provisions are temporary and expire at the end of 2012. The temporarily expanded lifetime gifting limits seem to create valuable life insurance sales opportunities for wealthy clients. TRA 2010 gives them a two-year window in which to transfer large sums of wealth to children and grandchildren or to trusts for their benefit. Life insurance is a tool with a unique combination of potential advantages which may help increase the value that is passed on to clients’ families.

Now is a great time to set up meetings with clients and their tax and legal advisors to discuss the planning options TRA 2010 makes available over the next two years.

These materials are not intended to and cannot be used to avoid tax penalties and they were prepared to support the promotion or marketing of the matters addressed in this document. Each taxpayer should seek advice from an independent tax advisor. This information is general in nature and not comprehensive, the applicable laws change frequently and the strategies suggested may not be suitable for everyone.

Many business owners have had a difficult time over the past two years. Most have been challenged to keep revenues up and costs down. Many have had to reduce or freeze employee salaries and benefits. They may even have had to let some people go.

Experts predict business conditions will improve in the coming months. Hopefully, they will be right and businesses that survive will return to their previous profitability.

Experts predict business conditions will improve in the coming months. Hopefully, they will be right and businesses that survive will return to their previous profitability.
Until then, CEOs and business owners have a lot on their plate. Between making key decisions for their company, and preventing employees from taking off, there seem to be more problems than solutions for them. In such a situation, it could benefit the leaders if they had business peer groups to discuss important decisions, or even just to brainstorm with people who own and lead other companies. However, for a business owner flying solo, these problems can lead to ignorance of the problems their employees might be facing.

Moreover, since they’ve had to focus on their own problems, many business owners haven’t had the time or resources to focus on the toll the recession has taken on their employees. In many cases, employees and their families have borne the brunt of the cost-cutting strategies owners have implemented. Many employees have found their jobs less satisfying because they’ve had to work longer and harder with fewer resources. The pay and benefit reductions they’ve suffered have forced many to make sacrifices in their personal lives, scale back their activities, and revise their plans for retirement.

A Big Problem on the Horizon
When the economy rebounds and relatively good times return, business owners may have to face another big problem. Their unhappy employees may leave to join competitors or quit to start their own businesses. Most employees are like “free agents” on professional sports teams; most are “employees at will” who can resign and leave with relative ease to sell their services to competitors. Very few are “locked in” under written employment agreements.

Often business owners think this couldn’t possibly happen to them. Many think their employees should be grateful and stay loyal; especially after all that they have done to keep their people employed during the tough times.

In fact, many employees are probably grateful, but their primary loyalty is to their families. They may need to make up for the financial losses they’ve suffered during the recession or they may feel they need a change of scenery and a fresh start. If that means finding a different employer or going to work for themselves, there may be little an employer can do to stop them.

A number of recent studies show the risk of employee departure is very real. On March 24, 2010, Modern Survey published a report showing a precipitous decline in U.S. workers’ psychological investment in their organizations. While the economic recession may have temporarily motivated employees to put forth extra effort on the job, the data from this study suggests U.S. workers may have hit their breaking point.

Don McPherson, a founder of Modern Survey, said, “Some people have been asked to do too much for too long…What I’m predicting is that when opportunities happen, some of these experienced people will leave for other opportunities. Some of these companies will have to go through the expensive process of hiring and training new people.”1 Other studies/surveys reporting similar findings are listed in Chart 1.

Who Can Your Clients Afford to Lose?
This is a good time for you to suggest to your clients who are business owners to take a careful look at their employee rosters and estimate the value each employee adds to their business. Suggest that they might consider ranking their employees as A, B or C employees. “A”s are top performers who would be extremely difficult to replace. “B”s are solid, dependable workers who are good contributors but are replaceable. “C”s are the ordinary or under-achievers who can easily be replaced.

Once the ranking process has been completed, owners should consider strategies for “locking in” their A employees, because they bring the most value to the business.

How are employees weathering the recession? A study by The Center For Work–Life Policy concludes: “How is top talent dealing with this onslaught? In a word-badly. In focus groups conducted for this study, senior executives talked about being angry, anxious and deeply stressed. Troubled firms are finding that precisely the wrong people (top performers with other job options) are heading for the door.”2

Losing an A employee may trigger several problems. Owners should focus on at least two. First, replacing a key employee can be expensive. A recruiter may have to be hired and the replacement may command a higher salary and better benefits, or need extensive training because of the uniqueness of the business. It may take some time before he can perform at the same level as the old key employee.

Second, when a key employee leaves, he may take some valuable and important customers with him to the new business. This can be a business disaster, particularly when business is slow. Valuable revenues will be lost. New clients will have to be found to replace the lost revenues. Attracting new clients is often time-consuming and expensive.

After working so hard to stay afloat during the tough times, it could be devastating for a business to lose key employees and important clients just when the business climate is starting to improve.

Carrots and Sticks
A carrot and stick approach could potentially keep the A employees from looking for greener pastures. Carrots are strategies designed to motivate them, create loyalty and make them happy. Sticks are strategies designed to make leaving more difficult. A plan to retain A employees could include both.

Carrots. Carrot strategies include: (1) formal recognition of the contributions and sacrifices they’ve made to keep the business going, (2) a heartfelt “thank you” for their service to date, (3) a tangible reward for their efforts, and (4) new financial incentives to continue their high level of performance in the coming years.

A life insurance-funded executive benefit could potentially provide all four of these carrots. It could provide the recognition necessary to keep key employees on board and committed for the coming years. Executive benefits such as a 162 bonus plan, REBA (restricted executive bonus arrangement), split dollar loan, 401(k) look-alike plan, or a non-qualified deferred compensation plan/supplemental executive retirement plan (NQDC/SERP) could be customized for each key employee. As they remain productive and feel appreciated, their skills could produce the revenues needed to pay the costs of the benefit.

Why use life insurance? Life insurance policies have several unique features which may be quite useful in customizing executive benefits. For example:

•”‚When the plan includes a death benefit, life insurance offers the potential to have this obligation informally funded immediately when the plan is implemented by matching the policy’s death benefit to the benefit promised under the plan. Life insurance has the potential to make the plan self completing if the employee dies before the promised benefits are due to be paid and the policy is still in force.
•”‚When the plan promises to pay a key employee supplemental retirement income, life insurance cash values may provide the business a potential source of funds from which to make the promised payments; if the policy is not a modified endowment contract (MEC), the business may generally access policy cash values on an income tax-deferred basis.3
•”‚Life insurance policy death benefits are generally paid out income tax-free and, if properly structured, may allow the business to recover some or all of the costs it incurred to provide the benefit.4

Benefit Ladders
Life insurance-funded executive benefits may also be structured as a related series. The benefits can be designed to build on each other over time to provide greater incentives to participating key employees. Such arrangements are known as executive benefit ladders, and they may be attractive to businesses because the costs can start low and increase as business cash flow permits. Also, the benefit may potentially be changed over time and become more valuable the longer a key employee stays with the business. In fact, increases in the key employee’s productivity could possibly provide the revenues needed to pay for the benefits. Apart from providing life insurance for their employees, other rewards and recognition systems (such as gift cards) , too, could provide an incentive for them to stay. Employers might need to buy bulk gift cards if they are a large enough enterprise to provide substantial rewards to their staff. This would not only build a solid enough foundation for the employee benefits, but also let the employee know that the employer truly cares about their physical and mental well-being.

Sticks. Sticks are strategies that place a cost on a key employee’s departure from the business. One example is a restriction in a 162 bonus plan that prevents the key employee from accessing life insurance policy cash values without the written consent of the employer. This type of restriction converts the arrangement into a REBA. Another commonly used restriction is a provision in an employment agreement which requires the key employee to repay bonuses received if he leaves the business prior to a specified date or before retirement.

Another useful stick is a noncompete agreement. This is an agreement (or part of an employment agreement) in which the key employee agrees not to solicit the business’ clients for a specified period of time (usually not longer than one year) and within a specified geographic area. A noncompete agreement helps protect the business’ client base and puts employees on notice that they won’t be able to just walk out the door with the business’ client list. Noncompete agreements may also be effective in retaining A employees because their inability to take customers with them may decrease their value to competitors.

Noncompete agreements are not a do-it-yourself project. Because the rules for noncompete agreements vary from state to state, a knowledgeable attorney should be engaged to draft the agreement. Some states have laws that prevent the enforcement of noncompete agreements unless the employee receives something of value (consideration) in return for making the noncompete promise. A life insurance-funded executive benefit created as a carrot may provide the valuable consideration needed to satisfy these state law requirements.

Linking the executive benefit and the noncompete agreement could potentially provide the best of both worlds. The executive benefit can provide recognition for the employee’s efforts, incentive to continue topnotch performance, and the value needed to make the noncompete agreement enforceable (assuming the agreement is drafted to comply with all applicable state laws).

Attracting New Key Employees
Every year some professional athletes join new teams as free agents. Their contracts with their old teams have expired and teams that needs their unique skills hire them to increase their chances of winning a championship. Business owners have the same opportunity. There may be skill or knowledge gaps in their organizations which need to be filled, or they may know some talented people who could add extra value to the business. Attracting new key people with unique skills, experience or relationships may reduce costs or increase revenues and profits.

New key executives could come from several possible sources. Some businesses have been forced to terminate smart, experienced employees to reduce costs. Many of these people are looking for the right opportunity to restart their careers. In addition, there are likely some employed key people who aren’t happy in their current working environments and who may be open to making a change.

Customized executive benefits are often included in the compensation packages offered to new key executives. Split dollar loans, 162 bonus plans and NQDC/SERP plans are examples of customized executive benefits that use life insurance.

Conclusion
As the recession ends, business owners will find themselves with new opportunities and problems. A potential problem they can’t afford to overlook is the loss of valuable A employees who may be unhappy with their current situation. They may be looking to make up for the salary and benefits cuts they experienced over the last several years. Life insurance-funded executive benefits can be customized to give them incentives to stay and be even more productive. They may also be used to attract new key employees who could bring new skills, experience and customers to the business. As the economy rebounds, life insurance has the potential to help business owners lock in their key employees and grow their businesses. Ë›

Footnotes
1.”‚Minneapolis Star Tribune, “As Workloads Go Up, Worker Loyalty Falls, Survey Finds,” March 30, 2010.
2.”‚The Center for Work-Life Policy, “Sustaining High Performance In Difficult Times,” by Sylvia Ann Hewlet, Laura Sherbin, Peggy Shiller & Karen Sumberg, September 2009.
3.”‚Policy loans and partial withdrawals may vary by state, reduce available surrender value and death benefit or cause the policy to lapse. Generally, policy loans and partial withdrawals will not be income taxable if there is a withdrawal to the cost basis (usually premiums paid), followed by policy loans but only if the policy qualifies as life insurance, is not a modified endowment contract.
4.”‚For policies issued after August 17, 2006, IRC 101(j) provides that death benefits from an “employer-owned life insurance” policy are income taxable in excess of premiums paid, unless an exception applies and certain notice and consent requirements are met before the policy is issued. Additionally, life insurance owned by a C corporation may subject the corporation to the alternative minimum tax.

In the December 2009 issue of Broker World we introduced the executive benefits ladder concept as a flexible benefits strategy which may appeal to business owners seeking to retain non-owner key employees during tough economic times.

An executive benefit ladder uses a series of related executive benefits which build over time, are funded with life insurance, and can be designed to help retain, reward and motivate most valuable employees.

Executive benefit ladders offer employers several potential advantages, including:
 • The ability to start funding benefits at a lower level of costs.
 • Increased effectiveness in retaining key employees because the benefits offered to an employee improve over time to reaffirm an employer’s commitment to and appreciation of an employee.
 • A laddered approach to benefits may motivate employees to work harder as increased benefits may be based on an employer’s increased ability to pay for more benefits.

Additionally, using a laddered approach to benefits gives agents regular opportunities to meet with clients and review their planning and insurance needs.

Executive Benefit Ladders Are Flexible
In the December 2009 issue we explained the five-rung company-owned life insurance ladder (COLI). That series of selective benefits progressed as follows: (1) death benefit only (DBO) plan; (2) endorsement split dollar arrangement; (3) split dollar loan arrangement; (4) split dollar loan with bonuses for the tax costs; and finally (5) split dollar loan with a roll-out.

But the COLI ladder isn’t the only possible design for an executive benefit ladder. Executive benefit ladders are flexible and can be designed in a number of different ways. What makes these laddered arrangements particularly attractive in difficult economic times is the ability to start with a relatively inexpensive benefit (i.e., a DBO arrangement or an endorsement split dollar arrangement) and potentially improve it over time into a more valuable benefit.

The Restricted Bonus Ladder
The COLI ladder featured a series of benefits which culminated with offering an employee a split dollar loan with a roll-out. This ladder design appeals to employers who want to use “golden handcuffs” to retain key employees. For employers who not only want a plan with “golden handcuffs,” but who would also like an income tax deduction for some of their premium payments, a different ladder of benefits may be assembled: “the REBA ladder.”

A REBA (restricted executive bonus arrangement) ladder may be created using five levels of benefits.
 1. A Survivor Income Death Benefit Only (DBO) Plan is the simplest benefit. The business promises an employee that if he dies while still employed, a series of payments will be made to one or more persons designated by the employee (e.g., $50,000 annually for 10 years). This type of death benefit is taxable as income in respect of a decedent and can supplement a key employee’s personal life insurance program, or it could be a substitute for personal life insurance.
 Such a benefit provides potential savings to an employee; he doesn’t have to use personal after-tax dollars to purchase personal life insurance. Life insurance can be purchased by a business on the key employee designed to offset this new liability and to provide the funds needed to pay the promised benefits if the employee dies. However, death benefits received by an employer policyowner may be subject to income tax unless the parties have complied with the notice and consent provisions of IRC 101(j). Additionally, death benefits received by a C corporation may be subject to the corporate alternative minimum tax.¹
 2. An Endorsement Split Dollar (using the economic benefit regime) builds on the DBO plan and may be considered a more valuable benefit in two ways.
 First, the death benefit from an endorsement split dollar arrangement paid to an employee’s designated beneficiaries is generally income tax-free. DBO plan payments, on the other hand, are fully taxable. Upgrading the plan design to make the death benefit income tax free potentially increases its value by 15 to 40 percent (depending on the beneficiaries’ marginal income tax brackets).
 Second, the death benefit can be paid in a lump sum rather than in installments. The beneficiaries don’t have to wait for multiple years to receive the benefit’s full value; rather, they can choose to receive it right away and use it immediately. Also, they don’t have the risk that the business may fail during the payment period.
 Life insurance purchased to fund a DBO plan’s obligation can continue to be used to fund an endorsement split dollar benefit. This life insurance can be either a cash value policy or a term policy. If an employee dies during the term of the split dollar arrangement, the business will receive a portion of the death benefit equal to the greater of the policy cash value or the total premiums paid. The balance of the death benefit will be paid to the employee’s designated beneficiary(ies). However, unlike a DBO plan, the value of the life insurance protection from the split dollar arrangement (known as the “economic benefit”) is taxed to the employee annually.
 The first two rungs of the ladder focus on death benefits and if desired, can be funded with term insurance. When a business increases its profitability and has more money to spend on incentives to retain key employees, it may be time to consider a restricted executive bonus arrangement (REBA).²
 3. The REBA is an arrangement in which an employer makes premium payments on a cash value life insurance policy owned by an executive. The parties may enter into a supplemental employment agreement spelling out the terms and conditions that motivate an executive to remain with an employer for an agreed upon period of time. The parties may also file an endorsement with the insurance company which restricts the executive’s rights in the policy until the terms of the arrangement have been satisfied.
 While an executive must recognize premium payments as ordinary income, after expiration of the restrictions, an executive may use the policy as a source of supplemental retirement income, as a source of survivorship benefits for his family, or both.³
 To transition to a REBA, an employer will either need to transfer ownership of the policy to the employee (in which case the policy’s fair market value would be treated as taxable income to the employee) or a new policy may be purchased to fund the arrangement. If the policy used for the endorsement split dollar arrangement is a term policy, then it will need to be converted to a cash value policy or a new policy may need to be purchased.
 4. A Double Bonus REBA. At some point an employer may choose to enhance the benefits of the REBA by offering to cover an employee’s income tax costs. The bonus used to pay premiums in a REBA is treated as taxable income for an employee, and since there is usually a restriction on access to the policy’s cash value, an employee may have to pay these tax costs out of pocket. In addition to the bonus used for premium payments, an employer can bonus an additional amount to an employee to cover the income taxes owed on the bonus amount. This type of arrangement is often referred to as a “double bonus” or a “zero net outlay” arrangement and offers an employee a benefit with no annual out-of-pocket costs.
 5. An Unrestricted Bonus Plan. To implement the REBA, a key employee agrees to restrict his access to policy cash values. The employment agreement or the endorsement agreement filed with the insurer (or both) imposed these restrictions. An employer has the ability to lift these restrictions at any time and give a key employee full access to the cash values. Because the cash values are the property of the employee, there is no cost to the employer by lifting the restriction.
 Although there is no economic cost to lifting the restriction, it is an action which should be thoroughly considered. Changing the benefit to an unrestricted bonus plan is the last rung in the REBA ladder because it involves giving up an important element of control—an employer’s “golden handcuff.” Once the restrictions are gone, an employer’s only remaining bargaining chips are the amount and timing of the bonus payments.

Hypothetical Example:
The Restrictive Bonus Ladder in Action
Joe Smith (age 50) is a key employee at Black Star Industries. Even though salaries have been frozen, the owners want to show their appreciation for his hard work and give him special incentive to stay with Black Star and do his very best. Their agent has suggested they use a series of integrated executive benefits for Joe. Here’s the timeline:

Year 1—The DBO Plan. Black Star gives Joe the opportunity to name beneficiaries to receive a benefit of $50,000 paid annually by the company for 10 years if Joe dies while still an employee. There is no cost to Joe and he benefits through increased financial security for his family if he dies unexpectedly. Joe is currently under-insured and likes being able to increase his family’s financial security without incurring any out-of-pocket costs. Black Star purchases a $500,000 term insurance policy on Joe to fund its promise.

Year 3—Endorsement Split Dollar Arrange­ment. Black Star wants to reinforce how much it likes Joe’s work. It decides to increase the benefit’s value by restructuring the agreement so that the payments to Joe’s beneficiary(ies) may be income tax-free. An endorsement split dollar agreement is drafted and signed.

Black Star can continue the term insurance policy or potentially convert it to a cash value policy. If Joe dies while still an employee, the policy death benefit will be split. Black Star will receive an amount equal to the greater of the policy’s cash value or the total premiums it has paid. Joe designates his spouse to receive the balance in a lump sum, which generally is income tax-free. Each year Joe will include the economic benefit value of the life insurance protection in his taxable income.

Year 4—REBA. Black Star has fully recovered from the recession and Joe has remained a loyal and productive key employee. Black Star agrees to fund the purchase of a new life insurance policy to be owned by Joe as part of a REBA.

Black Star and Joe execute a supplemental employment agreement in which Black Star agrees to pay Joe annual bonuses in exchange for Joe’s promise to remain an employee of Black Star for an additional 10 years. The supplemental employment agreement includes a “liquidated damages” provision requiring Joe to reimburse Black Star in the event he breaches the contract.

The parties also file a “modification of ownership” form with the insurance company, which restricts Joe’s access to the policy’s cash value for 10 years. During the term of the arrangement, Black Star will continue to pay premiums on the policy, which will be treated as taxable income to Joe. After 10 years, when the restrictions have been lifted from the policy, Joe may be able to use the policy as a potential source of retirement income.

Year 6—Double Bonus REBA. Under the REBA, Joe is responsible for paying income taxes on the bonuses used to pay the policy premiums. Black Star wants to reduce Joe’s cost for the arrangement and agrees to pay additional bonuses which Joe can use to pay for the income taxes generated under the REBA.

Year 9—Unrestricted Bonus Plan. Because of Joe’s loyalty and continued good performance, Black Star agrees to lift the restrictions that require him to get its consent before accessing cash values from the life insurance policy. These restrictions were established in year four when the endorsement split dollar agreement was revised to become a REBA. Under their agreement, these restrictions were due to end after 10 years. Black Star is lifting them five years early because it wants to display its confidence in Joe and because to do so doesn’t cost it anything.

Conclusion
In today’s tough economic times, small business owners need to find ways to retain, reward and motivate their most valued employees. Executive benefit ladders offer employers the chance to fund benefits at a level they can afford now while offering potential increases in benefit levels in the future. Designing the ladder as a “restricted bonus ladder” provides incentives for key employees to stay with a business while potentially allowing an employer to have “golden handcuffs” and to take deductions for some of the costs of funding the benefit.

Each taxpayer should seek advice from an independent tax advisor. The ING Life Companies and their agents and representatives do not give tax or legal [or accounting or lending] advice. This information is general in nature and not comprehensive, the applicable laws change frequently, and the strategies suggested may not be suitable for everyone.

Footnotes:
 1. Proceeds from an insurance policy are generally income tax-free (e.g., absent a transfer for value) and, if properly structured, may also be free from estate tax.
 2. This description of a REBA assumes that income taxation is pursuant to IRC sections 61 and 162 and is not subject to IRC sections 409A or 83. A REBA may also be subject to ERISA plan requirements. Clients should seek advice from their tax and legal advisors.
 3. A portion of the policy’s surrender value may be available as a source of supplemental retirement income through policy loans and partial withdrawals. Policy loans and partial withdrawals may vary by state, reduce available surrender value and death benefit or cause the policy to lapse. Generally, policy loans and partial withdrawals will not be income taxable if there is a withdrawal to the cost basis (usually premiums paid), followed by policy loans (but only if the policy qualifies as life insurance, is not a modified endowment contract and is not lapsed or surrendered).