The Family Pension Plan

Overview

This “Cliff-Hanging” series has focused on strategies to reduce taxation for the current tax year and the impending fall off the Cliff next year

In case you are thinking this series is starting to resemble the redundancy of movie sequels a la Halloween or Airplane, I have included a new idea that should hold your interest a while longer.  This installment will focus on the benefits of qualified retirement in an unusual setting – a family investment company.

This installment will focus on a method on how to convert taxable investment income into tax deductible pension contributions. As long term capital gain and dividend tax rates are about to increase, this strategy has more relevance on a going forward basis.

A. The Long Fall Off of the Cliff?

The top marginal tax bracket increases to 39.6 percent in January 2013. The long term capital gains rate increases to 20 percent. Most states tax long term capital gains as regular income. As a result, most long term gains will end up being taxed at a 24-28 percent rate.

Dividends will return to being taxed as ordinary income once again. With the increase in personal tax brackets along with the new Medicare tax, dividend and interest income could end up being taxed at rates of 43.8-55 percent. The implementation of ObamaCare adds another 3.8 percent of taxation on unearned income for joint filers with taxpayers with adjusted gross income (AGI) in excess of $250,000.

Top bracket income earners are also exposed to the phase out of personal exemptions and itemized deductions. The phase outs have the effect of adding an additional two percent to the marginal bracket. The total effect is to give the New Yorker, New Jersey, or Californian a top bracket of 53-55 percent. Ouch!!!

B. The Family Pension Plan

(1) Qualified Plan Overview

Qualified retirement plans are excellent investment vehicles that provide a taxpayer with the ability to make pre-tax contributions into a pension plan and allow the investment earnings to grow on a tax deferred basis. Investment accounts grow quickly when you can make contributions with pre-tax dollars while enjoying tax deferral. The problem is that the contribution limits for the highly compensated are often inadequate.

Most high income earners with primarily W2 income as statutory employees of an employer are somewhat hand tied when it comes to tax and retirement planning. Unlike a business owner who has the ability to take advantage of deductions through a business, most W2 income earners are limited to deductions taken on Schedule A (itemized deductions) of Form 1040.

These executives participate in the employer’s pension plan which in current times means the employee defers part of his salary in a 401(k) plan and is lucky if the employer has some sort of match. Defined benefit plans have largely disappeared from the retirement planning landscape.

The family pension plan envisions the creation of a business entity – a family limited liability company (LLC) or family limited partnership (FLP)- designed to serve as a management vehicle for family and personal investments. The LLC will pay the Client a salary or management fee for his role in the management of the family LLC. The family LLC and payment of the management fee are the legal basis of a tax deductible contribution to a newly formed defined benefit plan within the family LLC.

(2) Defined Benefit Plans

Unless you work for a state or municipal government, you are highly unlikely to be a participant in a defined benefit (DB) plan. Participants in defined benefit plan enjoy the eternal peace and comfort of knowing that they will receive the same fixed amount each month regardless of investment performance. With the current volatility of the market place, this type of benefit plan offers enormous comfort.

Defined benefit plans provide a fixed benefit at retirement. While many formulas exist using iterations of years of service and compensation, our strategy is designed to create the largest tax deductible contribution. Defined benefit plans do not have a contribution limit. DB plans have a maximum annual benefit of $200,000 (increasing $205,000 in 2013). Essentially, an actuarial determination is made based upon the participant’s age, compensation, interest assumption, and retirement age in order to determine the annual contribution.

Fully insured Defined Benefit Plans under IRC Sec 412(e)(3) are specialty qualified retirement plans that are conservatively funded using life insurance and annuities. In most circumstances, fully insured DB plans yield the highest tax deductible contributions. Fully insured plans are the most simple and straight-forward of defined benefit alternatives in formation and administration.

(3) Defined Contribution (DC) Plans

DC Plans have a contribution limit of $50,000 (increasing $51,000 in 2013). A variety of DC plans exist – profit sharing, 401(k), money purchase et al. 401(k) plans provide for a salary deferral of $17,000 with a catch up provision allowing for an additional contribution of $5,500 for participants that are age 50 and older.

DC plans generally provide for a contribution that is a percentage of compensation. The ultimate retirement benefit is dependent upon the level of the participant’s contributions and investment performance. Generally, the age threshold that favors DB plans is age 45.

(4) Proposed Solution

Step 1 – Formation of the Family LLC

The proposed solution envisions the creation of a family limited liability company (LLC) by the taxpayer. The taxpayer is an individual with W2 income and ample investment income. The taxpayer may also be any type of non-business owner such as a retiree.

The non-tax business purpose for the creation of the LLC is to facilitate the consolidation of investment assets and management for the family. This business is valid for tax purposes according to IRS guidelines and case law. The LLC may be a single member LLC that is member managed or alternatively may be a LLC that is member managed.

Following the creation of the family LLC, the taxpayer may transfer title to investment accounts and holdings to the LLC. Investment income flows in the Family LLC. The Client who serves as manager of the Family LLC is entitled to pay himself a management fee.

The LLC structure under most state LLC laws confers important asset protection benefits in that a personal or business creditor may not compel a distribution or liquidation of the LLC in order to reach LLC assets or undistributed income. The LLC may only receive a legal remedy known as a “charging order” which essentially allows the creditor to stand in the shoes of the Client as an assignee. In other words, the creditor may only receive access to LLC assets and income when distributed from the LLC.

The Client may in the absence of a transfer of assets to the LLC create an arms-length management agreement between the LLC and the Client to provide investment management services.

Step 2 – Conversion of Investment Income into Active Earned Income

Passive investment income is not a legal basis of determining contributions to a qualified plan. The Family LLC must either compensate the taxpayer through a management fee or a salary for serving in the capacity of managing member.

Step 3 – Adoption of the Qualified Plan as a Fully Insured Defined Benefit Plan or Defined Contribution Plan

The Family LLC in its corporate minutes will formally authorize the adoption of the qualified retirement plan for the Family LLC. The Plan is a fully insured defined benefit plan under IRC Sec 412(e)(3). The benefit formula for the Plan is based upon the highest three year income of the participant, the Client. The Plan must be funded with annuities and/or life insurance. The combination of the two provides for the highest contribution.

The plan provides for a pre-retirement death benefit. Unlike a traditional defined benefit plan, the fully insured plan does not require annual actuarial certification which makes it a much simpler plan to administer. The accrued benefit under the Plan is equal to the cash value of the insurance contracts which also feature a strong guaranteed component.

As an additional planning bonus, the taxpayer may also adopt and make an additional contribution to a profit sharing plan equal to six percent of payroll in the Family LLC. In the event the Client and his spouse are not participants in a 401(k) plan with their employer, they may make contributions as salary deferrals within a 401(k) within the Family LLC. The combination of these contributions can be quite significant - $16,500 in 2011 with a catch up provision for taxpayers 50 and older.

Pension law allows the Family LLC to provide a minimum benefit of $10,000 under a defined benefit plan regardless of absence of compensation for a non-working or compensated spouse. In the LLC format, the cumulative contribution can’t exceed the gross income of the Family LLC.

 In the event the family investment enterprise was structured as a regular corporation (C Corporation), contributions could result in a tax loss to the corporation that could be carried back three tax years or forward for fifteen tax years. The corporate tax rate for small regular corporations is much lower than the top individual rate.

Strategy Example

Facts

John Doe, age 48, is a managing director in a private equity firm in New York City. He has W2 income each year of $1.5 million. As a resident of New York City, his combined marginal tax bracket is 48 percent. He participates to the maximum extent in his company’s 401(k) plan. He is married and has two children. John and his wife (Mary) file a joint tax return and report investment income each year of approximately $300,000 per year.

Solution

John forms a LLC in Delaware – Acme Investments. John and Mary are the members. Acme is member managed by John and Mary jointly. John and Mary assign their investment accounts and holdings in various alternative investments – hedge funds and private equity – to Acme.  John will receive a management fee of $245,000 per year. Mary will receive a management fee of $10,000 per year.

Acme adopts a new fully insured defined benefit plan. The plan will be funded using annuities and life insurance. The Plan is administered and funded with insurance contracts issued by The Good Life Insurance Company of America. The projected contribution to the plan on John’s behalf in 2011 is $125,000. His account features a pre-retirement death benefit of $4 million.

Mary’s projected retirement contribution is $8,300. His account features a pre-retirement death benefit of $4.6 million. The combined contribution is $170,000. John will have a retirement benefit of $10,020 per month at age 62.  Mary will have a benefit of $515 per month at age 62 and a pre-retirement death benefit of $235,000.

The combined contribution provides a tax benefit of $170,000. The Does are sophisticated investors who are able to reinvest the tax savings at a higher rate of return than the conservative guarantees available through the fully insurance plan in private equity investments. However, they realize that the fully insured defined benefit provides the highest tax deductible contributions and that the benefit of the planning is the combination of the plan benefits plus the tax savings created by tax deductible contributions.

As an additional bonus, Mary could contribute an additional $17,000 into a 401(k) plan within Acme . Acme could also contribute an additional $15,300 each into a profit sharing plan. The additional contributions of $37,500 bring the total contribution level to $201,800.

They also understand that under a defined benefit plan, higher investment returns only serve to reduce future contributions. The ultimate retirement benefit is finite regardless of investment performance within the Plan.

Tax and Legal Authority

IRC Sec 412(e)(3) provides the tax authority for using life insurance and annuities as the funding for defined benefit plans. Fully insured defined benefit plans were the original defined benefit plans before the adoption of ERISA. The plan unlike a traditional defined benefit plan does not require annual actuarial certification of the Plan. The Plan must exclusively use individual annuity and life insurance as the underlying investment vehicles of the Plan.

The use of life insurance is limited to the incidental best test for life insurance in a qualified plan. These limits would allow a policy death benefit that provides for up to 100 times the anticipated benefit at normal retirement age. Another benchmark for contributions would allow up to fifty percent of the contribution to be invested in life insurance.

Under the limited liability company statute of all of the states, the proposed business purpose of “investment management” would be a valid business purpose. This business purpose would also be valid for federal tax purposes under the tax rules governing partnerships.

The Family LLC is subject to all of the existing rules dealing with ERISA and qualified retirement plans – non-discrimination, coverage, et al. The Family LLC is a planning concept that creates a closely held business separate and apart from the Client’s role and status as a statutory employee of his employer.

Summary

The Family Pension Plan is a planning concept that seizes creative license and opportunity within existing tax law. In a certain respect, it is not that unusual as so many taxpayers have become entrepreneurs by design starting Internet-based businesses or real estate investment businesses. Only a small amount of planning and legal vision is necessary to incorporate that idea as a standalone incorporated business. Family LLCs and limited partnerships have been on the landscape for the fifteen years for estate planning purposes. The Family Pension Plan is an extension of the same idea.

The retirement and tax planning benefits of the Family Pension Plan are substantial. The contribution limits far exceed the benefits of an Individual Retirement Account (when available). Defined Benefit Plans provide for the largest retirement contribution in most cases. The “fully insured” version of the defined benefit plan furthers enhances the benefits. Depending upon the level of investment income, a combination plan might be possible adding a 401(k) and a profit sharing plan into the mix.

These limits provide an additional $17,000 for the 401(k) deferral plus an additional $5,500 “catch up” for a taxpayer 50 years old or older as well as a six percent of compensation in a profit sharing plan. For a 50 year old tax payer with $100,000 of investment income (and management fee income), this combination of plans might provide for close to $100,000 of tax deductible contributions – fully insured define benefit plan ($70,000); profit sharing ($6,000), and 401(k) with catch up provision ($22,000). 

The Family Pension Plan provides multiple benefits – (1) Secure retirement income (2) Conservative and guaranteed investment growth (3) Asset protection (4) Pre-retirement death benefit. (5) Significant tax savings. It can easily become the most important planning tool in the planning arsenal of the high income executive or retiree.