The Use of Private Placement Group Variable Deferred Annuities in Generation Skipping Trusts
Over the last several decades, trust and estate lawyers have placed great emphasis on proper planning regarding the proper allocation of the generating skipping transfer (GST) exemption in order to maximize generational wealth accumulation. Over the same time period, a number of jurisdictions have also competed aggressively competed for trust business through the repeal of the common law Rule against Perpetuities in the jurisdiction. During this same period of time, practitioners pontificated on the merits of maximizing the grantor trust rules in order to preserve trust assets outside of the grantor’s taxable estate. More recently as state marginal tax rates increased, practitioners effectively touted the merits of non-grantor trusts as a method of avoiding state income taxation on trust assets.
The problem with grantor trusts is that they ultimately become non-grantor trusts at the death of the grantor, and the best available research still suggests that no one lives forever! The top marginal tax bracket for trusts is reached at only $12,300. Over the last several decades, discretionary trusts have also become very much in vogue for many good reasons. The “rich and famous” want their children and grandchildren to have a good reason to get out of bed every day! The asset protection benefits of trusts have also received great emphasis favoring discretionary trusts. The question remains, what can be done to minimize the gaping tax leak in the Dynasty Trust after Grandpa passes away? If practitioners are able to successfully to avoid future estate taxation and the GST, what can be done to avoid income taxation of trust assets over the same time period?
Generally, life insurance is more tax-advantaged than a deferred annuity. However, at the death of the insured, the death benefit is likely to be recycled and reinvested Om a taxable basis within the trust. On the other hand, a deferred annuity with a large class of annuitants, might be in force for an extended period of time particularly as new annuitants are listed to the class of annuitants within the annuity contract.
This article focuses on a novel approach to maximize wealth accumulation within a Dynasty Trust, a Dynasty Annuity. I have previously written on the topic with seemingly little notice and interest. This article steps up the discussion a little in terms of maximizing wealth accumulation using a Private Placement Group Variable Deferred Annuity Contract (GAC) featuring multiple annuitants.
Private Placement Annuity Contracts
Private Placement Variable Deferred Annuities (PPVA) are an institutionally priced variable deferred annuities that are offered exclusively to accredited investors and qualified purchasers. PPVAs also provide for tax-deferred accumulation, with the proviso that withdrawals are treated as income (as compared to return-of-principal) first and that there is a 10% penalty tax on withdrawals prior to age 591/2 (subject to certain exceptions). There are no policy loans and death benefits are not income tax free.
The difference between the individual policy and the group policy are generally the number of annuitants. The individual policy form typically features a single or joint annuitants. The group policy form usually is issued to institutional buyers such as the trustee of a pension plan or an endowment or foundation. The group policy form usually features multiple annuitants such as the participants of a pension plan or a class of employees such as the officers and directors of a foundation or endowment.
Tax Considerations
The Non-Natural Person Rule of IRC Sec. 72(u) provides that deferred annuities lose the benefit of tax deferral when the owner of the deferred annuity is a non-natural person. A trust would ordinarily be considered a non-natural person. However, the legislative history of IRC Sec. 72(u) and IRC Sec. 72(u) (1) (B) provide an exception for annuities that are “nominally owned by a non-natural person but beneficially owned by an individual”. This rule describes the typical arrangement in a personal trust. The trust is the nominal owner while the individual trust beneficiaries are the beneficial owners.
The IRS has reviewed this issue with respect to trusts at least eight times in Private Letter Rulings (PLR9204014, PLR199905013, PLR199933033, PLR199905015) has ruled favorably for the benefit of the taxpayer in each instance.
IRC Sec. 72(s)(6) deals with the distribution requirements of an annuity that is owned by a non-natural person (e.g. a trust). It provides that the death of the primary annuitant is the triggering event for required distributions from the annuity contract. The primary annuitant must be an individual. Distributions must begin within five years following the death of the primary annuitant for the trust-owned annuity. At death, the annuity account balance may be paid out over the life expectancy of the beneficiary providing additional deferral.
The GAC policy form is usually issued in two distinct formats – aggregated and non-aggregated. GAC policies owned by retirement plans such as large defined benefit plans frequently are frequently non-aggregated proving for no named annuitants initially. Qualified retirement plans such as a 401k frequently are aggregated with separate accounts for each annuitant. Tax-exempt policyholders such as endowments and foundations have contracts with multiple annuitants.
The impact of the tax rules under IRC Sec 72, is that the death of the annuitant triggers the need to distribute the annuity within five years of the annuitant’s death or over the life expectancy of the annuitant. In the case of group annuity that has a class of twenty annuitants, only five percent of the policy’s account value will be allocated to the annuitant at the time of death an annuitant. Contractually, the amount attributed to the deceased annuitant is deemed to be distributed and recontributed as additional premium to the GAC without ever liquidating the policy investments.
Dynasty Annuity Strategy Example
John and Mary Doe, age 60, allocated $10.8 million to a Dynasty Trust in South Dakota. The trust assets will be invested in a diversified hedge fund portfolio that is taxed as ordinary income. John is the grantor of the trust and is taxed in a combined marginal tax bracket of 50 percent. The trust is a discretionary trust. The trust is taxed as a grantor trust. The trustee is the applicant, owner and beneficiary of a GAC.
Assuming a pre-tax return of ten percent, trust assets are projected to be worth $188.5 million in Year 30 when the trust becomes a non-grantor trust at the death of the grantor. However, the present value of the taxes paid by the grantor over the same time period is $16.6 million discounted at 5 percent.
Alternatively, the trustee of the Dynasty Trust might purchase a GAC featuring John’s children, grandchildren and nieces and nephews and their children as the annuitants on the contract. The size of the Class is twenty annuitants. No more than five percent of the policy’s account value is allocated to each annuitant. Any distributions from the policy will reduce any future distributions payable in the future on account of the death of an annuitant. The accumulation at the end of Year 30 is $188.5 million without any taxation to the grantor during the grantor’s lifetime. The projected accumulation in Year 60 is $3.29 million. The projected accumulation in Year 90 is $57.4 billion.
Annuitants will be added to the class of policy annuitants, as grandchildren and great grandchildren are born. Status as an annuitant within the policy does not confer any benefits under the provisions of the Trust. At the death of each annuitant, prior policy distributions will be deducted from the amount required to be distributed on account of the annuitant’s death. The small portion of the account value will not actually be distributed from the policy to the trustee but will be deemed to be recontributed to the policy as new premium.
Summary
Trust ownership of group PPVA contracts is a powerful wealth accumulation technique. In the present case, the trust is taxed as a grantor trust. Upon the death of the grantor, the trust will be taxed based on trust brackets. The income threshold for the top bracket is very low- $12,300. The PPVA is an institutionally priced variable deferred annuity contract that provides investment flexibility in a manner that is not available.
There is no argument that life insurance is highly tax-advantaged. Nevertheless, insureds eventually die and the death benefit gets reinvested on a taxable basis. Assuming high marginal tax brackets on an ongoing basis, the breakeven point immediate. Even with a future tax rate that is higher such as a 70 percent rate, the breakeven point in the strategy is approximately nine years.
Life insurance agents have controlled the dialogue with trust and estate lawyers for too long in order to convert them to the gospel of whole life. As more of these agents gravitate and incorporate money management to their business model, the benefits of tax deferral over a long period of time using annuities must become the new gospel. PPVAs are more cost efficient as there is no leakage to cost of insurance charges.
The ability to structure the trust owned PPVA contract based upon the life of the annuitant using a young life with a long life expectancy is a powerful wealth accumulation mechanism as a result of achieving tax deferral for up to 60-100 years or longer. The wealthiest of taxpayers should give strong consideration of actually purchasing or starting a life insurer with a dual purpose – business and personal wealth accumulation.
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Gerald Nowotny – Osborne & Osborne, PA
266 Lovely Street
Avon, CT 06001
United States
860-404-9401
TaxManDotCom.com
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Photo credit: miqul via VisualHunt / CC BY-NC-ND
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