Many employers, when considering the adoption of a retirement plan, do not take into account the estate planning purposes that may be served by the plan. Granted, for the bulk of the employee-participants, the motive is to establish some amount of retirement income at a specified retirement age. However, for highly compensated employees, there are apparent estate planning possibilities in these plans as well as opportunities for the avoidance of estate taxes by using a life insurance product.

Basically, most distributions from qualified plans are subject to both income taxes and estate taxes upon death. There are certain exclusions from income taxes such as: 1) the employee's own investment in the plan; 2) payments under a QDRO (Qualifying Domestic Relations Order) where the income is reportable by the payee; and 3) the amount of life insurance proceeds which are in excess of the cash value immediately before death plus the aggregate of P.S. 58 costs (Rev. Rul. 55-747, 1950, 1955-2 CB228) which were reported by the decedent during lifetime.

In addition, there is the 15% excise tax (Sec. 4981A of TRA 86, renumbered Sec. 4980A by TAMRA 88) on "excess distributions" for estate tax effective for all accumulations" for estate tax effective for all distributions made after December 31, 1986. The income excise tax is based on amounts distributed annually from the aggregate of all types of qualified plans in excess of the greater of $150,000 or $112,500, indexed for inflation. If the special grandfather election was made on the 1988 income tax return, the $150,000 limitation would not apply.

In the case of a lump sum distribution, the limitations are multiplied by five, either $750,000 or $562,500 (as indexed, $612,900 for 1989), as the amounts above which distributions would be subject to the income excise tax.

In the event of death, the estate excise tax is measured as the present value of a hypothetical life annuity. The hypothetical life annuity is a single life annuity contract that provides for equal annual annuity payments beginning on the decedent's date of death and continuing to his/her normal life expectancy from that date as if he/she had lived. For example, if the decedent died at age 60, the annuity would be determined by using Table R(1) of IRC Reg. 20.2031-7. The rates change monthly. Applying the single life annuity factor for December, 1989 at age 60, (7.9547 X $150,000), the threshold amount not subject to the 15% estate excise tax would be $1,193,205. Any excess would be subject to the tax. It should be noted however, that one of the statutory exclusions from accumulations subject to the tax is life insurance proceeds in excess of the cash value as of the day prior to death.

Life insurance premiums paid out of qualified plan assets are deductible as part of the employer contribution and therefore less costly than identical coverage outside of a plan. In addition, the proceeds of the amount at risk, less the cash value at death, provide a death benefit which is excludable for income tax purposes.

The proceeds are includible for the estate tax computation but with the use of a subsidiary trust within the pension trust (with an independent trustee), may be excluded from the gross estate. It is essential that the insured be divested of all incidents of ownership.

A pre-retirement death benefit funded by life insurance coupled with proceeds from the investment fund in a split funded plan would invariably result in a larger death benefit for the participant's estate. Of course, the plan document should have the proper language authorizing the use of contributions and fund balances for the payment of premiums and appropriate death benefits.

New Kid on the Block

Rather recent additions to the insurance market in the past few years have been the "Survivor" or "Second to Die" policies. Because of joint coverage and life expectancies, these insurance products are much less expensive as opposed to identical coverage on one life. If the disparity in ages of the insureds is great, the cost advantage is maximized.

Survivor insurance can be purchased with profit sharing funds if the plan so provides and certain incidental death benefit tests are met. Funds held by the plan may be used to the extent of 100% of employer contributions. Alternatively, five year dollars may be used to the fullest extent (contributions plus earnings including forfeitures) for an employee who has been a participant for that period. In fact, ordinary whole life insurance may be purchased from day one, as long as less than 50% of the contribution is used for premium.

If the participant dies, the non participant-spouse would take the policy as a distribution with a concurrent income tax effect to the extent of the cash value of the policy decreased by the participant's basis in the policy, the participant having reported annual P.S. 58 costs as income during his or her lifetime.

In the alternative, an irrevocable trust may be used to receive the policy proceeds and would pay the income tax. The balance at the second death would be used for beneficiaries other than the spouse, thereby bypassing both estates.

However, because the policy was acquired by the profit sharing plan, an estate tax would be due on the cash value at the first death as the decedent had an interest in the policy at death. The eventual proceeds would not be subject to the estate tax.

Survivor Insurance Outside the Retirement Plan

Survivor insurance may be acquired by an irrevocable grantor trust from its inception, paying premiums with gifts from both insureds. With $20,000 (and spousal consent) available for each beneficiary for gift tax excludability, the proceeds upon the second death would avoid estate and income taxes in both estates. It should be noted that the irrevocable trust should have "Crummey" Powers." (Crummey v. Commissioner, 397 F. 2nd 82 (9th Cir. 1968). The Crummey powers preserve the right of a beneficiary to be offered to withdraw corpus and/or income and to be accepted within a reasonable time (30 days, is acceptable). If not accepted, the property remains in the trust. This power qualifies the gift as one of a present interest and therefore eligible for the $10,000 per donor annual exclusion to each donee.

The right to withdraw property from the trust is considered a general power of appointment. If the power is not exercised, it may be considered a gift from the beneficiary if it exceeds the greater of $5,000 or 5% of the principal (corpus). If the premium is greater than $5,000 during the first few years, the excess might be subject to gift or estate taxes due from the beneficiary, or will use some of the beneficiary's unified credit.

The possible solution is to provide for "hanging powers" which allow a carryover of the excess which would normally lapse. However, the hanging Crummey power has been attacked recently by the IRS in certain private letter rulings.

In time as annual contributions of premiums have been made, the point will be reached when they are no longer necessary to carry the policy because of dividends and cash values used to purchase additional coverage. Payment of premiums can then cease.

The "hanging powers" will be used each year thereafter until any excess from prior years is used up. The above assumes that the trust has been funded with ordinary whole life insurance.

Non-Qualified Plans

In a non-qualified deferred compensation plan, "split dollar" insurance offers a method of avoiding estate taxes under the proper circumstances. Basically, the employer offers, on an interest free basis, to lend the premium to an irrevocable trust created by the employee. The employee may contribute the P.S. 58 costs. The employer's loan is collateralized by the policy's cash value or death benefit.

The employer will advance premiums for a fixed number of years. After a few years, the cash value will exceed the aggregate premium payments. The excess will accrue to the benefit of the trust-owner.

Upon the expiration of the fixed number of years, the cash value will be sufficient to repay the loan to the employer and leave enough to carry the policy without further premium payments. With the death of the insured, the trust and beneficiaries will receive the proceeds income and estate tax free.

This technique is also feasible if estate taxes are not a consideration and the employer would like to provide retirement funds to the employee at a certain age. In that event, the employee would be the owner rather than an irrevocable trust. The proceeds would not be subject to income taxes but would be subject to estate taxes if the estate was of sufficient size.

As this split dollar policy would not be in connection with a qualified plan, the employer could discriminate in selecting employees to be covered. By using the split dollar approach, the employer in selected cases could offer this benefit as a substitute for covering the employee under a group life policy with related costs to the employer and employee on coverage in excess of $50,000.

The use of life insurance in the qualified and/or non-qualified plan is an important tool in financial planning for executives.

George Mandel, CPA, Vice President, National Pension Service, Inc.