Multi-Generational Tax Strategy for High Net Worth Families

Efficient Estate Planning with Variable Annuities

Tax and estate planners familiarize themselves with the tax advantages of insurance contracts, but unfortunately, limit themselves and their clients to fully commissionable insurance contracts that suffer from a lack of investment flexibility. For high-net-worth families looking for a robust multi-generational tax strategy, private placement variable annuities are more than a viable solution to the problem.

The problem is a lack of information regarding private placement insurance contracts for tax and estate planners. Hopefully, this article adds another arrow to the quiver in favor of private placement variable annuities (PPVA).

Before Jumping Into Tax Strategy…

Six months after graduating from the United States Military Academy in 1982, I married the love of my life. As a young, married lieutenant at Fort Hood, I enjoyed watching the TV series of the day with my wife – think Dynasty, Knott’s Landing and Dallas. The question is: why did we do this?

First, those series entertained us. Second, we lived on a lieutenant’s budget — what else were we going to do? Lastly, growing up in the Panama Canal Zone, my childhood included my mom and Panamanian housekeeper watching Spanish “novelas” together.

In other words, it was in the blood!

Fun fact: The Inter-American Development Bank commissioned a study attributing declining birthrate in Brazil to the cultural influence of “novelas” (soap operas) and their depiction of urban, white, upper-middle-class women in Brazil. The learning point here: “novelas” are important.

What Does That Have to do With Private Placement Variable Annuities?

Maybe a lot! In my 30+ years in financial services, I observed top life insurance salesmen had little involvement in selling fixed or variable annuities. My primary sales focus centered around large life insurance policies for business succession or estate planning purposes.

It was only in the early 2000’s — about the same time life insurers began offering higher guaranteed returns — that life insurance and stock brokers started selling significant amounts of variable life insurance. Life insurers issuing these variable annuities inevitably ran into financial problems as a result of the policies’ guarantees.

While the tax benefits of life insurance remain intact, the sale of life insurance for the ultra-high net worth (UHNW) fell. (Part of this has to do with the difficulty of financial underwriting following September 11, 2001.) Policies with large face amounts are more difficult to obtain now that life reinsurance market limits have fallen.

In times past, a wealthy individual might obtain policies from all large life insurers with large retention amounts before approaching the life reinsurance market. It was not unheard of, then, to arrange a portfolio in the $400-500 million coverage range.

Planning Techniques to Transfer Wealth

Since the mid-1990’s, estate planners employed a series of planning techniques to transfer wealth outside of a taxpayer’s taxable estate. These strategies focus primarily on the estate tax consequences.

The use of grantor trusts proliferated, allowing an asset transfer outside of the taxpayer’s estate for estate tax purposes while the taxpayer remains the owner for income tax purposes. This planning allows the taxpayer to pay income taxes associated with trust income without depleting trust assets to pay the tax liability and without income tax payments considered an additional gift to the trust.

Any increase in personal marginal tax rates will only make grantor trusts more onerous to trust settlors. In my personal experience, trust settlors groan every step of the way, regardless of the logic and sense of grantor trust planning. In either event, the grantor of the trust paying taxes erodes family wealth, whether the income generating asset exists inside or outside the taxpayer’s estate. No taxpayer feels content paying more taxes than they have to.

The Lesser-Known, Multi-Generational Tax Problem: Non-Grantor Trusts

Non-grantor trusts, or NGTs, hit the top marginal tax bracket at only $12,750 of annual income. The top marginal federal bracket for trusts is 37%. The government taxes trusts such as marital trusts, credit shelters, asset protection trusts and dynasty trusts as NGTs. Unfortunately, estate planners rarely discuss income tax planning for NGTs.

This article addresses private placement variable deferred annuities (PPVA) as a vehicle to maximize tax deferral. Unique rules for trust-owned annuities make excellent planning opportunities for taxpayers to maximize and extend tax deferral on trust assets over multiple generations. This is increasingly important as wealthy individuals and family offices allocate a larger percentage of family investment assets to hedge fund strategies. This primarily generates short-term capital gain income taxed at ordinary rates. I refer to this type of arrangement as a “Dynasty Annuity.”

Both specialty products impact tax-advantaged wealth accumulation within trusts dramatically — at a very low cost to the taxpayer. Even HNW and UHNW families often know little about (or utilize) these specialty insurance contracts and strategies. I hope this article places the strategies and products on the radar screen of trust companies, family offices, CPAs, and tax and estate planning attorneys.

Variable Deferred Annuity 101

I am not certain “when” or “why” variable deferred annuities garnered a bad reputation with the financial press.

When did tax deferral become a bad thing? Most likely, variable annuity product pricing and sales loads created this negative bias. It is rare, in my experience, to find an ultra-high net worth client who owns a variable annuity contract.

In spite of volatile public equity markets, the retail variable annuity marketplace manages close to $2 trillion in AUM. These products sell on an after-tax basis to individuals as well as retirement plans—401(k) and 403(b).

The variable annuity industry competes ferociously with the mutual fund industry. In the face of market volatility, the variable annuity industry responded with strong contractual guarantees for policyholders. Nevertheless, variable annuity sales are at their lowest in twenty years. We see greater interest towards equity-indexed annuities. However, a lack of interest in VAs coincides with the trend of financial services representatives dropping their registered representative status with FINRA-based broker-dealers.

Variable Deferred Annuity Contracts

A variable deferred annuity contract is a type of insurance contract. It provides payment of an annuity in the future. Assets supporting future annuity payments match up with the performance of investment funds held in the insurance company’s separate or segregated account. These investments are not part of the insurer’s general account assets (which remain subject to claims of the insurer’s creditors).

The policyholder receives direct pass-through on their investment’s performance. The typical retail variable annuity contract includes 5 to 8 years of declining surrender charges and compensates the agent through his broker-dealer 4 to 6% of contract premiums.

The policy includes two levels of fees: insurance contract fees and investment fund fees. At the contract level, the life insurer charges a mortality and expense (“M&E”) of approximately 125-150 basis points (1.25 – 1.50%) per annum. This load acts as the primary profit load for most insurers. Most states do not impose a premium tax unless the policyholder “annuitizes” their annuity (i.e., converts it into to a stream of monthly payments). Each variable sub-account investment option imposes another level of fees for investment expenses. These investments resemble mutual funds and impose similar charges based on the underlying investment strategy.

What Is a Private Placement Variable Deferred Annuity Contract?

PPVA contracts maximize tax deferral benefits. They do not impose surrender charges, and the contract offers sophisticated investment options, such as hedge funds. The contract pays the agent an asset-based charge of 25-35 basis points. PPVA contracts – with customized and negotiated sales loads — often equal to 1-2% of premiums. Unlike life insurance (with a 1.5-2.5 percentage tax of each premium payment), variable annuities only pay when the contract annuitizes.

Investment flexibility and range of possibilities make PPVA contracts an ideal vehicle. The contract complements asset classes that generate “ordinary income,” such as interest, dividend and short-term capital gain income. PPVA contracts may have alternative investments (such as hedge funds, commodities and private equity) as fund options in the private placement offering memorandum (PPM). The insurer may amend the PPM to add new investment options to the contract.

 A Brief Overview of the Legal and Tax Authority for PPVA

(1) Securities Law

PPVA contracts are treated as a non-registered security for federal and state law purposes. The product is available to accredited investors and qualified purchasers as defined in federal securities law. Under Section 4(2), the U.S. Securities Act of 1933 provides an exemption from securities registration for accredited investors as defined in Rule 501(a) of Regulation D.

PPLI offerings are exempt from the Investment Company Act of 1940 under Section 3(c)(1) and 3(c)(7) offerings. Under Section 3(c)(1) the number of beneficial owners is limited to 100 investors. Investors must be accredited investors or qualified purchasers. A qualified purchaser has investable assets of at least $5 million. Under Section 3(c)(7) the number of investors is technically unlimited, but in practice remains at 1,999 or fewer because those with 2,000 or more must register with the SEC under the Securities Exchange Act of 1934. The investors must be qualified purchasers. New SEC proposals exclude the value of an investor’s principal residence.

(2) Tax Law

A. Taxation of Variable Annuities

The taxation of annuity contracts is governed by IRC Sec 72. PPVA contracts are subject to the same investment diversification and investor control considerations as retail variable life and annuity contracts under IRC Sec 817(h) and Treas. Reg. 1.817-5.

The primary planning benefit of variable deferred annuities is tax deferral. A variable deferred annuity contract has an owner, a beneficiary and an annuitant. In the event of annuitization, payments are based on the annuitant’s life. Distributions from the annuity are treated as “annuity” payments, payments of interest only, or “amounts not received as an annuity.”

The term “annuity” includes any periodic payment resulting from the systematic liquidation of a principal sum. “Annuity” refers to payments throughout the annuitant’s life and installments without a life contingency, such as a fixed period of years. A portion of each annuity payment is excluded from the policyholder’s gross income (as a return on the contract’s cost basis), and the remaining balance is treated as interest earned on the investment (taxed at ordinary rates).

The exclusion ratio calculation is slightly different than for a “fixed” or non-variable annuity. For a variable annuity, you can calculate it by dividing the contract investment (basis) by the number of years of expected payout. The exclusion ratio treats part of each annuity payment as a return of principal. Once the investment in the contract recovers, the government considers all of it taxable.

Interest only payments are not annuity payments and not taxed under the annuity rules. Periodic payments on a principal amount that are returned intact are interest payments. If not an “annuity” payment or an interest payment, payments are an “amount not received as an annuity.” An “amount not received as an annuity” is taxed under the “last in, first out” (or LIFO rules) as investment income.

Premature distributions from the contract face a 10% tax penalty. This applies to payments before the taxpayer becomes age 59 ½. Some exceptions apply to the penalty rule: disability, a pension annuity, death of the policyholder, an immediate annuity payment providing a series of substantially equal periodic payments and a structured settlement annuity.

The Non-Natural Person Rule provides that deferred annuities lose the benefit of tax deferral when an annuity owner is a non-natural person. The legislative history of IRC Sec. 72(u) and IRC Sec. 72(u)(1)(B) provide an exception for annuities “nominally owned by a non-natural person but beneficially owned by an individual.” The IRS has ruled favorably for the taxpayer on this issue on trusts at least eight times in Private Letter Rulings (PLR9204014, PLR199905013, PLR199933033, and PLR199905015 et al.)

At the policyholder’s death, the contract gain is subject to taxation at ordinary rates. The beneficiary will not be taxed on a lump-sum basis if the beneficiary (within 60 days after the policyholder’s death) elects payment under a life contingency or installment option. If the policyholder dies on or after the annuity start date and the entire contract has yet to distribute fully, the remaining balance must be distributed at least as rapidly as the method used at the policyholder’s death.

But, if the policyholder dies before the annuity start date, the contract must distribute fully within five years of the policyholder’s death. If the policyholder’s spouse is the beneficiary of the contract, the distribution requirements are applied by treating the spouse as the owner.

IRC Sec. 72(s)(6) handles the distribution requirements of an annuity that is owned by a non-natural person (e.g., a trust). It provides that the primary annuitant’s death triggers required distributions from the annuity contract. The primary annuitant must be an individual. Distributions begin within five years following the death of the primary annuitant.

B. Taxation of Variable Insurance Contracts

IRC Sec. 817(h) covers taxation of variable insurance products. Treasury regulations 1.8171-5 briefly overviews the diversification requirements for variable insurance vehicles. Such regulations discuss many investment alternatives that you won’t find in retail variable annuity products — such as direct investment in real estate, and commodities. This accommodates insurers that have wholly-owned investment advisory firms. The use of annuity contracts allows tax-exempt investors to overcome the tax limitation of unrelated business taxable income.

IRC Sec 817(h) provides that investment diversification test separately in each fund within the policy. Per the code:

• No single investment may represent more than 55% of the fund
• No two investments may exceed 70%
• For three investments, 80%
• Four investments, 90%

Funds must maintain five investments to meet the diversification requirements.

In an annuity contract, it is the policyholder (owner) who controls and manages any incidents of ownership. One such incident of ownership allows the policyholder to control investment decisions or fund selection within the policy.

Two notions of investor control exist. The first notion deals with “wrapping” publicly available investments and is the subject of several rulings and cases.

The Service has sometimes ruled regarding the ability of a taxpayer to “wrap” investments that are “publicly available,” i.e. not limited exclusively to life insurance company separate accounts. Ultimately, the decision in Christoffersen v. U.S. was that the taxpayer, not the insurance company, should be taxed on the policy’s underlying income.

The second notion of the investor control doctrine is a more sinister problem. With this, a policyholder retains so much direct or indirect control over investments that the policyholder is deemed to be in constructive receipt of the policy’s underlying investments. The consequence is that the policyholder forfeits the substantial tax advantages of life insurance and annuities. Determining what constitutes investor control for tax purposes is a fact-specific determination.

On a certain level, investor control is somewhat of a mystery. It is not a tax issue with much notice. Some tax practitioners believe the investment diversification rules of IRC Sec 817(h) and Treasury Regulations 1.817-5 were designed to replace the investor control doctrine. Some practitioners would love to litigate the issue — but not at the risk of making their clients famous. The IRS does not agree with this point of view. (This discussion is observed in the commentary of Internal Revenue Bulletin 2005-12.)

The Service updated these rulings with the issuance of Rev. Rul. 2003-91 and Rev. Rul. 2003-92. These rulings dealt with the issue of non-registered partnerships that were not exclusively limited to investment by insurance company separate accounts. The ability to look through to the underlying investments of these non-registered are to meet the diversification requirements. Internal Revenue Bulletin 2005-12 (TD9185) announced a change to Treasury Regulation 1.817-5(f)(ii) by removing this section about non-registered partnerships as well as the example of the rule.

C. Taxation of Grantor Trusts

You can find the tax rules for grantor trusts in IRC Sec 671-679. Grantor trusts proved to be a mainstay of advanced tax and estate planning for the last 15-20 years. Advanced planning focuses on the combination of tax valuation planning techniques (such as family limited partnerships and family limited liability companies (LLC)) with the sale of that limited partnership or LLC interest to a grantor trust.

Under the grantor trust rules, the trust settlor owns trust assets for income tax purposes. As a result, all trust income and losses flow through the trust to the settlor. The trustee can accumulate assets without any depletion for income tax purposes. The IRS does not consider grantor or settlor’s payment of the income tax liability as an additional gift to the trust. At the same time, the trust assets are outside of the settlor’s taxable estate.

The sale to a grantor trust is a freezing technique for an outstanding estate. In the typical sale to a grantor trust, the taxpayer sells capital assets to the grantor trust. The sale results in no gain to the seller. The seller is the settlor of the trust. The sale is usually made on an installment basis—the interest rate on the note is set at the applicable long-term rate. Interest rates have been at historically low rates for the last 5 to 7 years. In the event the trust sells the underlying asset, the taxable gain is reportable to the settlor and paid by the settlor. The settlor’s estate shrinks by the amount of the tax liability. This does not erode the trust corpus has not been eroded.

Virtually any estate planner on the planet would agree that the tax results associated with the sale to an intentionally defective trust, aka grantor trust, are outstanding. I agree with everyone else. However, I believe the tax results are greatly enhanced if the grantor does not have to reduce his/her taxable estate by the annual income tax amount.

The likelihood of increased marginal tax rates (at both the federal and state level) along with a capital gains tax increase make the benefits of tax-advantaged compounding even more compelling.

D.Taxation of Non-Grantor Trusts

The government treats trusts not taxed as grantor trusts as separate taxable entities. In general, marital trusts and most testamentary trusts are non-grantor trusts. Most asset protection trusts are also non-grantor trusts for income tax purposes. Unfortunately, it takes very little investment income to push a non-grantor trust into the top marginal tax bracket of $11,200.

Many wealthy families have generation-skipping trusts that are taxed as non-grantor trusts. A non-grantor trust is a trust that does not fall within any of the provisions of IRC Sec 671-679. The necessary trust provisions—to classify a trust as an NGT—is retention of power by the settlor to name new trust beneficiaries or to change the interest of trust beneficiaries, except as limited by a special power of appointment (ascertainable standard). The settlor’s transfer to a trust with this power renders the transfer an incomplete gift for gift tax purposes. The second method of avoiding grantor trust treatment is to require an adverse party’s consent on any trust distributions.

The major focus of this article is tax-advantaged wealth accumulation across multiple generations. Many wealthy families and family offices have multi-generational planning as a component of their tax planning. It makes much sense to reduce the “drag” of income taxation along with avoiding future estate and generation-skipping transfer taxation.

When Should You Use the Dynasty Annuity?

The Dynasty Annuity involves the purchase of a PPVA contract by the trustee of the Family Trust, taxed as a non-grantor trust. Alternatively, taxation as a grantor trust does not limit the idea of a trust-owned annuity. Trust income is taxable to the grantor, who may already pay top marginal tax rates.

The trustee selects young annuitants (grandchildren or great-grandchildren) as the measuring lives of the annuity, to maximize tax deferral. This structure maximizes tax deferral over the lifetime of the PPVA’s young annuitant(s). In the case of a three-year-old grandchild, tax deferral could be accomplished for more than 70-80 years before requiring a distribution.

As mentioned earlier, the death of the annuitant triggers tax-deferred income distribution, within five years of the annuitant’s death or over the beneficiary’s lifetime.

How to Set Up a Dynasty Annuity

The steps of the transaction can be summarized as follows:

(1) Purchase a PPVA Contract

The trustee of the Family Dynasty Trust is the applicant, owner and beneficiary of a PPVA contract(s).

(2) Select Young Annuitants

The critical element in the maximization of tax deferral: the selection of a young annuitant(s) with the greatest potential of outliving their normal life expectancy(ies). Annuitants must be selected for each separate PPVA contract. The trustee may purchase multiple policies with different individual annuitants to “hedge” against the possibility of the premature death of the annuitant, which could expose the trust to a tax burden as a result of distribution requirement.

PPVA investment income and gains accrue on a tax-deferred basis. At any time before the annuitant’s death, the trustee may request a distribution from the life insurer to a trust beneficiary. At the death of the annuitant, the trustee must make an annuity distribution based upon and over the life expectancy of trust beneficiaries.

The approximate cost of the PPVA contract is 40 basis points per year. The PPVA contract has the investment flexibility to add investment options to the contract. The customized account provides an open architecture, allowing the investment advisor to manage based upon its asset allocation model and changes to the model. The PPVA contract is suited to manage trust assets that generate ordinary income.

A $10 million single premium invested into a PPVA contract earning 8% per year over an 80-year period would grow to $2.5 billion in the 80th year. This small example illustrates the power of tax-deferred compounding over a long period.

A Multi-Generational Tax Strategy in Action

A. The Setting

Pierre Jones, age 72, established The Jones Family Office following the sale of his technology company to Peachtree Computers for $100 million. Pierre transferred stock to the Jones Family Trust early on (before the value of the company appreciated). Southern Trust acts as the trustee of this trust; the trust is a grantor trust. The Jones Family Trust has $50 million of corpus invested in a diversified portfolio. Pierre listed his children and grandchildren as beneficiaries of the trust.

Pierre lives in New York City. He will be in a combined (local, state and federal) marginal income tax bracket of 53.4%. The trustee invested $10 million in a diversified hedge fund portfolio. The portfolio consistently returns 10% net of all fees. The government taxes all of the investment income at short-term capital gain income rates.

The trustee wants to manage this alternative asset class with a tax-advantaged structure on a long-term basis. The balance of the portfolio can generate income for trust beneficiaries.

B. The Strategy

PPVA

Southern as trustee of the Jones Family Trust is the applicant, owner, and beneficiary of four PPVA contracts.

The Trust funds each contract with a $2.5 million single premium. The underlying investment within the contracts is a customized insurance dedicated fund managed by the family’s investment advisor. The IDF is a customized portfolio that invested $1 million with ten different fund-of-funds and single strategy hedge funds.

Each annuity contract has a different annuitant. The Jones grandchildren and grandchildren are each named the annuitants for every contract. The ages of each annuitant are 2, 4, 6 and 8, respectively. The annuitant has no control over contract assets.

Over an 80-year period, the chart below illustrates the powerful effect of tax-deferred compounding versus a taxable account. At the death of each annuitant on each separate PPVA contract, the trustee has several choices.

The trustee can take a lump sum distribution, resulting in a very substantial taxable event at ordinary rates. Alternatively, the trustee can annuitize the contract. This achieves an extended deferral by paying out the account balance over the life of the trust beneficiary(ies). Distributions during lifetime are treated as taxable income and are taxed at ordinary rates. The trust may take a deduction as part of its Distributable Net Income (DNI) and the beneficiary(ies) pay taxes on the trust distribution.

The after-tax column reflects the grantor’s income taxation based on the combined marginal tax rate, assuming a net investment return of 10%.

*Graph displays best in full screen

			Male Age 50 – $10.0 Million PPVA HYPOTHETICAL ILLUSTRATION
Year			Net TaxableInvestment Value @ 53.4%	PPVA End of Year Policy Cash Value	PPVADeath Benefit	Net TaxableInvestment IRR	DeathBenefit IRR
1			10,466,000	10,950,000	10,950,000	4.66%	9.5%
10			15,769,141	25,009.530	25,009.530	4.66%	9.5%
20			24,866,497	61,461,121	61,461,121	4.66%	9.6%
30			39,212,263	152,203,127	152,203,127	4.66%	9.7%
40			61,834,267	377,193,992	377,193,992	4.66%	9.7%
50			61,834,267	1,024,074,091	1,024,074,091	4.66%	9.7%
60[10] 70			97,507,163	2,584,625,676	2,584,625,676	4.66%	9.7%
80			382,347,656	16,463,804,711	16,463,804,711	4.66%	9.7%

 

Summary

As the example illustrates, the wealth accumulation potential of the Dynasty Annuity strategy is immense. The power of compounding tax savings, along with the time value of money, produces a long-term result that is 5-10x more powerful than its taxable equivalent.

The grantor trust is a sophisticated solution, but the payment of income taxes by the grantor reduces family wealth. In the case of a New York or California resident, the income tax burdens are more onerous than current estate taxes. Tax-advantaged accumulation produces a much better long-term result. I submit that a wealthy family will be a lot wealthier if it does not have to pay taxes on certain investment income over several decades.

The non-grantor trust includes the greatest propensity for heavy taxation. The top marginal tax bracket is only $15,500 of taxable income. How many marital trusts, credit shelters, asset protection trusts and Dynasty Trusts face this problem?

The Dynasty Trust can perpetuate family wealth from income, estate and generation-skipping transfer tax standpoint. Inevitably, trustees (as part of their asset allocation model) will have a reasonable allocation to investment asset classes that the government taxes as ordinary income. The flexible investment structure of PPVA provides a platform for customizing investment options on an ongoing basis.

[Editor’s Note: To learn more about this and related topics, you may want to attend the following webinars: Estate Planning and Asset Protection – 101 and The Legal & Tax Aspect of Investing: Asset Protection; Estate Planning, and Tax Efficiency. This is an updated version of an article originally published on April 18, 2017.]