Using a profit sharing plan as an estate planning tool.by Maisel, Melvin L.
The hunger of taxing authorities for more revenue suggests that this state of affairs will continue, a circumstance that forces estate planners to approach the estate preservation process cautiously, and to view the life insurance alternative as an important element in the process.
During the last few years a new type of insurance product, survivorship life insurance (SLI) or second-to-die insurance, has become an important tool for the estate planner. The cost of SLI is substantially less than for individual life policies, and it can provide liquidity when most needed. For a discussion on what to look for in purchasing SLI see, "Evaluating Survivorship Life Insurance" by Melvin L. Maisel in the July 1991 issue of The CPA Journal.
A significant number of individuals have accumulated substantial amounts in their qualified pension or profit sharing plans. These assets are subject to both estate and income taxes, and, in some cases, excise tax. Because assets are subject to these taxes before they become available to the next generation, they are ideal assets to use for the purchase of life insurance.
PURCHASING SLI FOR A
PROFIT SHARING PLAN
A new form of life insurance can be purchased in a profit sharing plan as well as in a Sec. 401(k) plan. Provided the plan has enabling language, rollover funds from other qualified plans, including defined benefit plans, money purchase plans, target benefit plans, Keogh plans and certain individual retirement accounts (IRAs), can be made available for life insurance premiums. IRA funds can be used only if derived from a rollover from a qualified plan provided they have not een commingled with personal IRA funds. SLI can reduce taxes on assets of a qualified plan--income taxes, the new 15% excess accumulations estate tax, and all or part of the tax attributable to the remainder of an estate.
Life Insurance in a Profit Sharing
Profit sharing plans have long been used as vehicles for purchase of life insurance. The investment of a participant account fund in life insurance policies is an efficient means of providing death benefits for plan participants. An advantage of using profit sharing plan assets to purchase life insurance is that the assets used by the plan to pay the premium have not been subject to income tax as would otherwise be the case.
Using assets in profit sharing plans to purchase life insurance for individuals who are not likely to need the amounts accumulated in a plan during their lifetimes or the lifetimes of their spouses provides the most highly leveraged premium available. Further, the amount at risk under life insurance policies can be structured so as not to be taxable to the beneficiary. The amount at risk is the excess of the benefit available from the policy over its cash value.
Amounts accumulated in a profit sharing account or in other retirement plans including rollover IRAs are included in the estate of an individual or of the individual's spouse, and estate taxes are levied thereon. These amounts also constitute income in respect of a decedent, and income taxes are imposed thereon payable by recipients of plan distributions. Even under current income tax rates, the combined tax liability on distributions from qualified plans after death can range from 65% to 93% of the amounts involved.
Estate Tax Considerations
Life insurance, whether part of a qualified profit sharing plan or separately owned directly, by the insured, is, with certain exceptions, considered part of the estate of an insured if the insured exercised certain powers over the policy within the three years prior to death. If the insured exercises no powers over the policy, the proceeds of a life insurance policy held in a profit sharing plan should be excluded from the insured's estate. If the proceeds are payable to a trust structured to exclude its assets from the spouse's estate, the estate tax will also be avoided.
NEED FOR SLI
Virtually all planning techniques, designed to freeze or control the growth in value of an individual's estate have been affected by tax law changes contained in RA 87 and subsequent legislation. Partnership freezes, corporate recapitalization, holding companies and similar planning tools are no longer viable as planning devices.
Effective tax planning is reduced to the use of the marital deduction and the unified credit, both of which have limited impact in protecting estates larger than $1.2 million. For an individual whose estate consists primarily of non-liquid assets, such as real estate or closely- held business interests, SLI provides at the second death the funds needed when liquidity and other financial concerns arise. Such needs include estate taxes and settlement costs.
Premiums are generally lower for SLI than for conventional life insurance on either of the insured parties. Individual term life insurance premiums are, over time, substantially higher and provide no lifetime values. SLI is a permanent program which costs less than term life insurance and generally, after a period of years, develops cash values that equal or exceed the premiums paid, making the total investment refundable on demand through policy loan or surrender.
SLI provides liquidity in one policy at a potentially lower cost than other available alternatives. Federal estate tax rates are the highest imposed at the federal level and start at 37% on assets in excess of $600,000. If the $600,000 unified credit has been gifted away, or the estate is large enough, taxes are levied at the first dollar in the estate. The rate increases until it reaches 55% on assets in excess of $3 million, to 60% on assets in excess of $10 million up to approximately $21 million. In addition to the federal estate tax, planning is necessary for payment of state taxes, probate and administrative expenses, debts and other expenses.
The federal estate tax is a transfer tax, imposing a tax on transfers between individuals. Because under federal estate tax rules a husband and wife are treated as one person, the tax is generally not imposed until the death of the survivor of a husband and wife.
In the past, many planned for estate liquidity with minimum deposit life insurance. Minimum deposit interest payments in many instances exceed term life insurance premiums, and, since consumer interest is no longer deductible, they provide no cash value and no tax benefit. In addition, the borrowing causes the death benefit to decrease each year, which can mean the insurance may not be available in the amounts really needed. Furthermore, if the policy is surrendered or terminated, an income tax liability may be created that will require cash to pay. This liability arises when the total premium paid in to the policy is less than the cash values plus any outstanding loans.
SLI is available from certain insurance companies even though the insured has a health problem, is an impaired risk, or has been rated or declined for single life insurance. It may be obtained at standard or favorable rates because the underwriting for such policies generally is more liberal than for single life policies. As a result, SLI is especially helpful for insured persons at older age.
THE PROFIT SHARING PLAN
SLI in the profit sharing account is purchased in the same manner as a single life policy. The owner of the policy is the profit sharing plan, and the participant retains the right to designate or change the named beneficiary. The plan should include a provision that permits plan participants to make an election to invest part of their accounts in life insurance. The limit on premium, described in detail later, is the same as would apply if the policy were purchased solely on the participant's life, and the participant is subject to tax on the economic value of the at risk amount of death benefit.
Because SLI is almost always used to provide liquidity at the death of the survivor of husband and wife, the estate tax exclusion is a critical concern when SLI is purchased. When it is purchased by a participant's profit sharing account, some preparation is required to assure that the exclusion will be available.
PLANNING FOR THE
PARTICIPANT'S DEATH FIRST
Create an Irrevocable Trust
To assure an estate tax exclusion for the SLI, certain steps should be taken at the time the policy is issued. Most important is the creation by the insured of an irrevocable insurance trust. This trust is necessary to obtain the estate tax exclusion, because it will be the beneficiary of the policy should the participant die before the spouse.
The SLI policy does not mature as a death benefit until the death of the survivor of the two insureds. If the participant dies first the profit sharing plan account continues to hold the policy, which is now a policy on the life of the surviving spouse. At that point, the policy should be transferred from the plan to the irrevocable trust.
The participant would have executed a beneficiary designation, directing the trustee of the profit sharing plan to transfer ownership of the policy to the irrevocable trust if the participant dies before the spouse. This transfer to the trust will preclude inclusion of the policy in the estate of the spouse when the policy matures, because the spouse will have had no control over the policy at any time. There is no transfer for value because no sale of the policy occurs. There is no three-year inclusion rule because that rule only applies to gifts, and, as is discussed later, the cash value of the policy at the participant's death is part of the participant's taxable estate.
Designate the Spouse as
Beneficiary of the Balance of the
Profit Sharing Account
If the participant dies before the spouse, the need to pay premiums on the survivorship policy may still exist. Planning for the SLI with the profit sharing account assumed that premiums would be paid from such account. On the death of the participant, the account value, other than the SLI policy cash value, should be payable to the surviving spouse to permit the spouse to continue paying the premium.
The surviving spouse can roll the account into an IRA or draw death benefits directly from the profit sharing plan. If death benefits are drawn directly from the plan, they can be withdrawn without the 10% early distribution penalty even if the participant is under age 59 1/2 at the death of the participant. The premium can then be paid with profit sharing account money, although income taxes will first have to be paid on the funds withdrawn.
Obtain a Waiver of the Pre-Retirement
At the time the policy is purchased, the spouse should waive his or her right to a pre-retirement survivor annuity to the extent the payment of that annuity would require a distribution to the spouse of part of the cash value of the policy. Under the rules governing pre-retirement survivor annuities, the spouse is entitled to 50% of the amount held in the participant's account at death. If the cash value of the survivorship policy is greater than 50% of the total balance in the participant's account, the spouse would be entitled to some part of that cash value as a death benefit.
Income Tax Consequences
When the participant dies, and the survivorship policy is transferred to the irrevocable trust, the trust must pay an income tax on the cash value of the policy. This income tax is the same as would be imposed on any other distribution from a profit sharing plan not rolled into an IRA.
Although the trustees of the irrevocable trust could borrow sufficient value from the policy to pay the income tax, such borrowing would effect the death benefit payable under the policy, and the time at which no further premiums would be required could be extended.
As an alternative to borrowing, the insured could make contributions to the irrevocable trust, while the policy is in the profit sharing plan, sufficient to cover the anticipated income tax or provide individual life insurance with third-party ownership.
Estate Tax Consequences
Under federal tax law, amounts payable as a death benefit from a profit sharing plan are considered assets of the participant's estate and are subject to tax when the participant dies. Because the survivorship policy is passing to an irrevocable trust to which no estate tax exclusion is available, the cash value of the policy is included as an asset of the insured's estate and is not eligible for the marital deduction. The cash value will therefore use some of the participant's unified credit at that time, and the estate planner must recognize this in the planning process.
PLANNING FOR THE COMMON
If the participant and spouse die in a common disaster, the estate tax exclusion will be controlled by the terms of the wills of the participant and spouse. Those documents should provide that the participant is deemed to predecease the spouse, at least as to the life insurance policy held under the profit sharing plan. This will permit the policy to pass in the same fashion as if the participant died first, with the same positive tax results.
PLANNING FOR THE SPOUSE'S
If the spouse dies before the participant, there are no immediate tax consequences. The survivorship policy is part of the participant's account under the profit sharing plan, and becomes a single life policy on the life of the participant. The policy should be removed from the profit sharing plan to protect the estate tax exclusion.
Removing the Policy from the
A policy can be removed from a participant's profit sharing account either by distribution or by purchase while the participant is alive. As explained later, a distribution is possible if the cash values can be atttributed to "two-year-old money," or if the individual has participated in the plan for at least five years. Alternatively, a policy can be purchased for its current cash value. For S corporation stockholders and owner employees, such a purchase, while not exempt from the prohibited transaction rules under ERISA, is exempt from the prohibited transaction requirements of IRC Sec. 4975. The IRC provision establishes the excise tax penalty for such transactions, and the penalty is therefore not applied to such a purchase.
A purchase of a policy from a qualified plan must be made in accordance with ERISA Prohibited Transaction Exemption 77-8. The exemption permits the purchase of a policy provided the trustees are unable to maintain the policy under the plan. For this reason, the profit sharing plan should by its terms prohibit the maintenance of insurance on the life of a participant upon the death of his or her spouse if the insurance is in the form of SLI at the time of its purchase.
Effect of Policy Transfer
Under the prohibited transaction exemption, a policy held under a profit sharing plan can be purchased by the participant or any other person who has an insurable interest in the participant. If the participant purchases the policy, the estate tax exclusion will be lost unless the participant transfers the policy to an irrevocable insurance trust. Because the transfer will involve a gift of the cash value of the policy to the trust, the participant will be consuming some of the unified credit at that time.
In addition, the participant will need sufficient capital to purchase the policy, or if the policy is distributed to the participant instead of being purchased to pay the income tax liability on the distributed value. At death these cash needs can be provided through other assets, through a small life insurance policy on the spouse, or through borrowing.
Once the policy is transferred by the participant to the irrevocable trust, three years must elapse before the policy proceeds will be certain to escape the estate tax. One way to cover the tax during the three year perios is to have the irrevocable insurance trust purchase a single life policy on the participant either at the same time the SLI policy is purchased or at a later date in an amount sufficient to pay the estate tax. Such policy proceeds will not be part of the participant's estate should the participant die.
If the participant dies before the spouse, the single life policy proceeds will be held in the irrevocable trust to which the SLI would be transferred, and will provide the capital to pay future premiums on the survivorship policy.
If the spouse dies before the participant, the single-life policy proceeds will be available should the participant die within three years of the spouse's death to cover the estate tax on the survivorship policy proceeds.
The procedure previously outlined assumes that the participant is the purchaser of the policy from the profit sharing account upon the spouse's death. Under the prohibited transactions exemption, the policy can be purchased by anyone who has an insurable interest in the participant. The class of available purchasers is restricted because of the transfer for value rule that can cause the death benefit to be subject to income tax when paid. Included among the class of purchasers who can purchase a policy without a transfer for value are partners of the insured. This means a child of the participant who is a partner of the participant in a partnership can purchase the policy without causing a transfer for value to result.
If a partnership exists between the parent and some or all of the children, the children-partners can purchase the policy. The purchase will not cause the insurance proceeds to be taxable income to the children, as would be the case if a non-exempt transfer for value had occurred. Because a purchase and not a gift is involved, the three-year rule will not be invoked. Because the children are the heirs who are intended to benefit from the insurance purchase in the first place, the purchase by the children will be in accord with the original planning intent.
If no partnership exists at the time the SLI is purchased, a partnership can be created later but must exist as a legal entity at the time the insurance is purchased by the children.
THE INCIDENTAL DEATH
The amount that can be used to purchase insurance in a profit sharing plan is subject to certain incidental death benefit rules developed by the IRS. These rules limit the amount in the participant's account that can be used to pay premiums on life insurance policies. The limitations applicable to profit sharing plans provide, as a general rule, that if whole life insurance is purchased, the cumulative premium must be less than 50% of the cumulative employer contributions allocated to the participant's account. If term insurance or some form of universal life insurance is used, the cumulative employer contributions allocated to the participant's account.
Exceptions to the General Rule
There are two exceptions to the general rule, both based on a requirement that must be satisfied if a profit sharing plan is
to be treated as a plan of deferred compensation. The IRS has determined that a profit sharing plan will be treated as a plan of deferred compensation if a participant cannot receive money as a distribution until at least two years after the money has been placed into the trust. This two-year rule permits a profit sharing plan to make distributions to employees to the extent the amounts distributed have been in the plan for at least two years.
Because two-year-old money could be distributed to the participant without affecting plan qualification, provided all other qualification conditions, including coverage, continue to be met, the IRS has ruled that two-year-old money can be used to acquire life insurance under the plan.
The purchase of life insurance is considered by the IRS as a distribution of the value of the death benefit to the participant, while the policy cash value remains part of the participant's account. As a result, the participant is taxed only on the imputed income, which is the measure of the value of the death benefit, even when two-year-old money is distributed.
Another ruling by the IRS provides that anyone who has participated in a profit sharing plan for at least five years can receive a distribution of all of the monies held in his or her profit sharing account. Applying the same principle as is applicable to two-year-old money, the entire account balance of an employee who has participated in a profit sharing plan for at least five years can be used to purchase life insurance policies.
The purchase of insurance with money held in a profit sharing plan must be supported by appropriate plan language. If enabling language is not set forth, the purchase would result in a violation by the plan fiduciaries of their responsibility to operate the plan in accordance with its terms.
The enabling language should be specific in the authority granted to the fiduciaries and plan participants, and if the two-year or five-year exception is to be used, the exception must be described in the plan language.
INCOME TAX CONSEQUENCES
The purchase of life insurance through a profit sharing plan results in certain income tax consequences to the plan participant. The income tax consequences to be considered occur both at the time of premium payment and subsequent distribution of benefits.
Employer contributions and earnings held in a profit sharing plan have never been taxed. When such amounts are used to purchase life insurace policies, the policy purchase is treated as providing two separate benefits for the participant. One benefit is life insurance protection; the other is the accumulation of value in the policy through cash value and dividend accumulations. Only the amount of the premium attributable to current death benefit protection, the economic value of the pure life insurance, is taxed to the employee in the year the premium is paid. This is commonly known as the "PS 58" cost. This economic benefit cost is also referred to as imputed income.
However, the IRS has indicated that a special calculation can be used to determine the amount of imputed income when SLI is purchased. That rate, sometimes called the "Table 38" rate, is multiplied by the amount at risk (the face amount less the cash value) under the policy in the year the premium is paid to determine the taxable amount. This amount is treated as basis in the cash value of the policy when the death benefit is paid. A comparison of the PS 58 and Table 38 rates appears in Exhibit 1.
A second difference in income tax treatment between personally purchased policies and policies purchased under a profit sharing plan is that only the amount at risk on the policy is protected against income tax. The cash value of the policy, measured immediately before death, is considered taxable income to the plan participant.
The amount at risk under a policy is the death benefit reduced by the cash value. For example, if the policy pays a death benefit of $ 1 million and immediately prior to the insured's death the policy had a cash value of $ 100,000, the amount at risk under the policy would be $ 900,000. The $900,000 would be received by the beneficiary income tax- free. The $ 100,000 reduced by any basis the participant has in the policy, would be taxed as ordinary income.
There are many profit sharing plans that could be used to secure substantially greater benefits for the family of a participant if such SLI purchases are made.
THE CURRENT ENVIRONMENT
The informed CPA/advisor should explore the purchase of life insurance under a profit sharing plan. In the current tax environment, money held in qualified plans is generally less valuable to the next generation than other assets because they constitute income in respect of a decedent. By using these amounts to purchase life insurance, they can be put to significant and efficient use in the family and estate planning context.
The profit sharing plan provides a valuable opportunity for the plan participant to do insurance planning in the tax leveraged environment of the plan. Such a program must be considered a significant source of premiums when estate planning with life insurance is involved.
Copyright 1991, Andrew J. Fair and Melvin L. Maisel
Andrew J. Fair, Esq., is an attorney with Kenneth J. aufsesser, Esq., P.C., in White Plains, NY. Mr. Fair specializes in the area of pension, business, and estate planning. He has written and lectured extensively in these areas for many professional groups. Mr. Fair is a member of the American Bar Association, N.Y. state Bar Association, Westchester County Bar Association, and Nassau County Bar Association, among other professional organizations.
Melvin L. Maisel is Chairman, First National Bank of stamford, Connecticut; Vice President, National Pension Service, Inc.; and President, Stabilization Plans For Business, Inc., White Plains, NY. Mr. Maisel is the author of numerous articles and other material dealing with pension and estate matters.
The CPA Journal is broadly recognized as an outstanding, technical-refereed publication aimed at public practitioners, management, educators, and other accounting professionals. It is edited by CPAs for CPAs. Our goal is to provide CPAs and other accounting professionals with the information and news to enable them to be successful accountants, managers, and executives in today's practice environments.
©2009 The New York State Society of CPAs. Legal Notices
Visit the new cpajournal.com.