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by David Holaday and Rodney Piercey, J.D.
As planners, we constantly seek to find strategies that have a high probability of success at achieving our clients' goals with a low level of risk. Sometimes it takes an unusual and creative combination of strategies to produce the desired outcome. The authors recently used the following combination of strategies to achieve certain client objectives. The subject of this article is one strategy combination that was part of a comprehensive estate plan.
A widower in his early 70s , in the maximum estate tax bracket, had a wide range of goals and concerns:
To accomplish these goals, we combined three concepts, including 1) a charitable lead annuity trust (CLAT), 2) a family limited partnership (FLP) and 3) a combination of universal life insurance policy and a single premium immediate annuity policy (SPIA) on the life of the client as the primary investment inside the family partnership. The life insurance and annuity became the financial instruments owned by the partnership and collectively generated a cash flow of 8.5 percent before tax but after premiums. The client contributed limited partnership interests to a "zeroed-out" CLAT. Considering the discount applicable to the value of the limited partnership interests, the yield of limited partnership as measured by its distributions divided by its appraised value was over 12 percent. Thus, the partnership distributions were able to support a relatively high CLAT payout rate. After 11 years of making charitable distributions and achieving the clients' philanthropic goals, the CLAT will terminate and distribute its assets (primarily limited partnership interests) to the client's adult children. Thereafter, they will enjoy income distributions from the partnership and ultimately receive a benefit from the insurance policy.
A charitable lead annuity trust (CLAT) is an irrevocable trust that pays a fixed income to charity1 for a period of time measured either by the donor's life or a fixed number of years. At the end of the period, the assets remaining in the trust either revert to the donor or pass to the noncharitable beneficiaries designated by the donor with a greatly reduced or eliminated gift tax impact. It is a planning tool that meets both family wealth transfer and philanthropic objectives.
There are many variations of the CLAT. In this situation, we employed a nongrantor trust with a term for a fixed number of years. The term of the trust was not measured by the life of the grantor but continued on after his death for the balance of the term. A non-grantor CLAT does not generate a charitable income tax deduction.2 Instead, it generates a charitable gift tax deduction.3 Like other qualified interest gifts, the amount of this deduction is determined by reference to Code Sec. 7520.4
We designed the CLAT terms with the following ideas in mind. First, we wanted the payout rate to be as high as possible yet still supportable by the actual income generated by the trust assets each year. In other words, we wanted to have the CLAT distribute most, if not all, of its income annually but still preserve the principal. We had a high degree of confidence that the investment strategy would consistently produce over 12 percent (to be explained later in this article) in annual cash flow. We then selected a term of years to be as short as possible but still produce a gift tax deduction nearly equal to 100 percent of the contribution. Thus, the remainder interest for transfer tax purposes was nearly zero.5 In our case, we designed the CLAT with a payout rate of 10.795 percent and a term of 11 years. The Code Sec. 7520 rate at the time was 3.8 percent, resulting in a remainder interest value of approximately 0.04 percent of the contribution.
This CLAT had an ambitious payout requirement. In general, planners must consider the income production capacity of any asset contributed to or owned by a CLAT in light of the annual charitable distribution requirements.
It would have been possible, of course, to contribute securities directly to the CLAT. However, in addition to our client's interest in continuing his philanthropy and initiating a plan of family wealth transfer, we also needed to consider his desire to maintain an acceptable level of influence over the assets that would pass from the CLAT to his children as well as his desire to protect the assets from a range of other risks. To address these concerns and to potentially enhance the performance of the CLAT as a wealth transfer vehicle, we considered a family limited partnership as an additional structure.
Family partnerships have been widely used in business and estate planning. They have also come under increasing scrutiny as the IRS has intensified it efforts to inhibit the use of this device as a means simply to reduce the value of assets for transfer tax purposes. It is always necessary to have significant nontax business purposes for the partnership. In this particular case, our business purposes were clearly established by the client's interest in maintaining a level of involvement in business decisions, protecting assets from creditors and divorced spouses, mentoring children, facilitating gifts, etc.
We will assume our readers are familiar with the bevy of recent cases6 in which Tax Courts and District Courts have found in favor of the IRS. Proper drafting and design, implementation, business purpose and compliance with state partnership law will help to ensure such a partnership will be recognized and upheld if ever challenged by the IRS.
The client transferred marketable securities to the partnership in exchange for a one-percent general partnership interest and, upon formation, contributed a 99-percent limited partnership interest to the CLAT. The subsequent sale of these securities produced a negligible amount of capital gain income. The client held his general partnership interest in a newly formed management corporation to assure the continuity of the plan and protect against an involuntary termination of the partnership in case the client did not survive the term of the CLAT.
The client obtained a professional appraisal of the limited partnership interests. The appraiser provided a written opinion that the value of the gift of the LP interests should have a value 30 percent less than the value of the pro rata underlying assets.
Having sold the bonds, the general partner proceeded to allocate the assets of the partnership to a strategy that would provide sufficient cash flow to meet the needs of the partners. We worked with the client to implement an investment strategy commonly known as "annuity arbitrage" or "mortality arbitrage."
Arbitrage is defined as the nearly simultaneous purchase and sale of securities in different markets in order to profit from price discrepancies. Arbitrage opportunities are exploited daily in the financial markets. Arbitrage opportunities also exist in the insurance marketplace and skilled life underwriters have employed them for many years to create benefits for their clients.
Annuity arbitrage is the simultaneous purchase of a life insurance policy and a single premium immediate annuity policy on the same person (or persons) but from different insurance companies. The company issuing the insurance takes the risk that the insured will die before her current life expectancy. The company issuing the SPIA takes the opposite risk that the annuitant will live beyond her life expectancy. Thus, the arrangement is a hedged transaction using a risk management strategy. It is comparable to certain strategies that a hedge fund manager might use such as taking long and short positions on securities or using put and call options to generate attractive returns while minimizing downside risk.
In a typical annuity arbitrage arrangement, a portion of the investment capital is used to pay the first insurance premium and the balance is used to purchase the SPIA. Subsequently, the SPIA generates the cash flow needed to pay future insurance premiums and provides an attractive return on investment. Planners often design the arrangement so that the death benefit on the insurance policy is equal to the amount of capital invested. Thus, the insurance policy provides a return of capital at the death of the insured.
A SPIA is a contract between an investor and an insurance company whereby the investor invests an initial amount of cash in exchange for a contractually determined amount paid periodically by the insurance company. There are various kinds of contracts and features available in the marketplace but the kind that is suitable for this strategy has a fixed and guaranteed dollar value payment payable for the life of the annuitant (with no payment to a surviving spouse or refund feature).
Payments from immediate annuities are treated partially as a return of principal and partially as interest. Each annuity has an "exclusion ratio" determined by the issuing company based on the life expectancy of the annuitant. The exclusion ratio is multiplied by the total annuity amount to determine the portion that will be excluded from income for tax purposes. Generally, the exclusion ratio is determined so that payments are taxed as though the annuitant receives a pro rata portion of her original principal back each year over her life expectancy. Thus, young annuitants will have a low exclusion ratio because their return of principal will be spread out over a large number of years. Older annuitants will enjoy higher exclusion ratios. If an annuitant lives beyond her life expectancy, her payments will continue at the same dollar value but be taxed entirely as ordinary income.
This favorable tax treatment can result in a very high net after-tax income from the SPIA as long as the annuitant has not yet fully recovered her basis in the contract. However, planners must be careful to avoid an unexpected and unpleasant surprise if the annuitant lives beyond her life expectancy and the entire annuity payment becomes taxable.
It is critical to the strategy that the life insurance policy deliver the benefits when needed. It must not be allowed to lapse. A permanent form of insurance such as universal life is most commonly used. Modern policy designs allow the policy owner to acquire a guarantee that, as long as the scheduled premiums are paid on time, the policy will never lapse. Although these kinds of policies may cost somewhat more than those without such guarantees, we believe that it is well worth the extra cost to avoid the risk of the policy lapsing.
In our case, we also designed the premium schedule so that the required premiums will decline starting in year 15 to coincide with the time that the exclusion ratio of the SPIA will expire and the tax liability on the SPIA income increases. Thus, the net after-tax after-premium income will be roughly equal over the entire life of the program.
Combining a life insurance policy and a SPIA in an annuity arbitrage strategy produces a result that is comparable to a bond in a number of ways. Like a typical bond, the annuity arbitrage strategy provides a regular stream of income. A bond provides a return of capital after a stated period of years. Similarly, the annuity arbitrage strategy provides a return of capital at the death of the insured.
Table 1 compares the results of an annuity arbitrage strategy to a municipal bond investment. The net after tax yield of the annuity arbitrage strategy is 5.6 percent compared to the 3.5 percent from the tax-exempt bond. This represents a dramatic 59-percent increase in spendable income with no appreciable risk!
The annuity arbitrage strategy is not liquid and cannot, as a practical matter, be undone. Thus, there is a risk that the client may need the money but be unable to convert this future income into capital. However, this can be an advantage also. The fact that the annuity arbitrage strategy is not liquid also means that it is not subject to the risks of market value fluctuation. A prudent planner will always consider the liquidity and flexibility needs of the client and be careful not to allocate too much of the client's net worth to this strategy despite the higher yield it may offer.
There is a risk that the companies issuing the insurance and annuity policies may become insolvent. This risk can be minimized to the point of being negligible by using only companies that have top financial rankings.
When properly designed, risk is nearly nonexistent because the annuity income is guaranteed, the life insurance premiums are guaranteed never to go up, and the death benefits are guaranteed as long as the premiums are paid.
It is generally known that insurance companies will compete for business among brokers by making concessions on the underwriting class they assign to a potential insured. Thus, an insurance broker serves her clients well by making a convincing argument to home office underwriters that the client should receive a standard or even preferred rating in spite of some minor health issues revealed in the attending physician statements or the medical exams. It is common in the world of life underwriting for a company to initially offer rates based on substandard underwriting class (especially in the older ages) and then, through negotiation, move their offer up three or four "tables." In other words, good brokers have learned not to accept the first offer but to ask for a better one. It is not widely known that some insurance companies will also negotiate their SPIA interest rate offers based on medical underwriting. A good broker will know the companies that engage in these practices and serve the client by advocating a higher than normal payout rate.
Here the broker really earns her compensation. She advocates to the life underwriters that the insured is in good health and should qualify for a lower premium. She also advocates to the annuity underwriters, based on the same medical data, that the annuitant is not in perfect health and that the company should therefore offer a higher than normal lifetime income. This is perfectly appropriate and fair. Naturally, the insurance broker must fully disclose all relevant facts. Both companies are fully capable of evaluating the business proposition and make offers that they believe to be reasonable.
It is important to remember that the company offering the life insurance and the company offering the SPIA will always be different.
Figure 1 indicates the flow of funds and the relationship of all of the individual elements of the strategy.
For ease of illustration, we will use a $1 million example. Planners should carefully consider the set-up and administrative expenses to be sure that suitable economies of scale exist to justify the time and expense of this relatively complicated structure. In the authors' view, $2 million or more is a more appropriate minimum.
Before incurring any significant drafting expenses, we worked with an experienced life insurance broker to submit informal inquiries to life insurance and annuity providers to determine if we could obtain offers that would produce a sufficient economic benefit. Upon learning that satisfactory offers were forthcoming, we proceeded to draft, execute and fund the FLP. It is important that the FLP is the applicant, owner, and beneficiary of the insurance policy to avoid any incidents of ownership on the part of the insured.
The best SPIA offer was a 14.7-percent payout with a 47-percent exclusion ratio; this was from an insurance company with a Standard and Poor's rating of AA. This offer was "medically underwritten" and, due to the client's medical records, was based on a hypothetical client age of 78, six years older than the client's nearest age. We also received an offer for life insurance with a preferred underwriting class. This significant difference between the way the annuity provider's underwriters and the insurance provider's underwriters evaluated the health of the client is the primary reason for the attractive economic result. Based on these offers, we designed a life insurance premium schedule of $54,000 annually for the first 14 years and $27,333 thereafter. The life insurance contract provided guarantees that, so long as these premiums were paid, the contract would stay in force until age 100.
The general partner used the $1 million of partnership capital to pay the first insurance premium and invested the balance in the SPIA.
In reality, we held back sufficient capital in the partnership so it could make distributions during the first year enabling the CLAT trustee to make quarterly charitable distributions. We omitted this operational detail in this article in the interest of simplicity. Planners should be careful to consider when funds will be needed for payment of premiums, distributions, expenses, etc. and structure the arrangements to deliver income when needed.
Another factor we ignored in the interest of simplicity is the pro rata distribution to the general partner. Based on the assumptions in this illustration, there will be about $8,000 annually in excess income in FLP available for such distributions and expenses. Any funds not needed will be accumulated in the partnership and ultimately pass to CLAT remainder beneficiaries.
The FLP will have projected earnings as follows:
This taxable income will be allocated one percent to the general partner and 99 percent to the CLAT as the sole limited partner.
The partnership will derive and distribute cash as follows:
The CLAT is a taxable entity. Each year it will report its pro rata share of the partnership earnings. Its annual distributions to charity will be deductible against gross earnings. Thus, the CLAT will have taxable earnings as follows:
It will be important for the general partner to be aware of and responsive to the CLAT trustee's need for partnership distributions to meet the distribution and expense obligations of the CLAT. In general, we anticipate that the general partner will make partnership distributions periodically to provide for these needs. In this example, we assumed that the general partner will distribute all excess cash flow to the CLAT trustee and that any excess cash flow will accumulate in the CLAT as follows:
In our simple example, we have deliberately overlooked partnership expenses, CLAT expenses and distributions to the general partner. These should be easily covered by the $9,497 cash retained annually as indicated above. We also ignored any earnings attributable to the accumulating cash reserves. These are relatively small matters financially speaking, and we believe simplifying the example by omitting them does not materially affect the analysis. However, in reality, it is very important to take these factors into consideration and to operate the partnership and the trust with rigorous attention to detail.
The client should not be given the discretion to direct CLAT distributions on an annual basis. Retaining this power of appointment could result in the CLAT assets being included in the client's estate should he die during the term of the CLAT. A safer way to provide for a considerable amount of donor influence would be to have the CLAT distributions paid to a Donor Advised Fund (DAF). The board of directors of the organization sponsoring the DAF will generally follow the advice of the client enabling him to maintain an acceptable amount of flexibility and accomplish his charitable objectives.
After the 11-year term expires, the CLAT trustee will distribute the remaining trust property to the remainder beneficiaries. We anticipate that the only asset the trust will hold at that time is its share of the partnership. Thus, the client's two children will each receive a 49.5-percent limited partnership interest.
Presumably, the client will still control the general partnership interest at this time. The client may choose to continue to hold the GP interest and manage the affairs of the partnership. Perhaps at age 83, the client may give the GP interests to his children if he is satisfied that they (then in their 50s) would be capable of managing the partnership themselves. This asset may have a value in the $10,000 range and would be easily sheltered by the annual gift tax exclusion. Giving the GP interests away prior to the client's death would certainly help to reduce any risk that the IRS would attempt to include the partnership property in his estate because of an implied understanding of a retained right to income.
The partnership should continue after the CLAT expires. The SPIA will continue to generate income. The general partner may continue the practice of distributing most or all of the earnings to the partners, in which case the two children would begin to receive sizable distributions. Approximately three years after the CLAT expires, two new things will happen. First, the exclusion ratio will expire and the SPIA payments will be fully taxable thereafter. Second, the scheduled life insurance premiums will drop by design so that the reduction in life insurance premiums will be approximately equal to the increase in the tax liability on the SPIA income. Thus, net distributable after tax cash flow should not change appreciably.
It is possible that that the insured will not survive the term of the CLAT. In that case, the SPIA payments would stop, the life insurance proceeds would be paid, and the partnership would have $1 million in cash to invest. The CLAT trustee would still own a 99-percent LP interest and look to the GP to distribute $75,565 plus funds for administrative expenses each year until the term expires. Although it may be difficult for the general partner to find an investment that provides a guaranteed return large enough to cover the distributions' remaining CLAT, many attractive nonguaranteed alternatives will still be available. Consequently, the premature death of the client should not jeopardize the overall effectiveness of the strategy.
Assuming the insured/annuitant dies after the CLAT expires, we anticipate that the partnership will still be the owner and beneficiary of the life insurance policy. The partners may meet and elect to dissolve the partnership and liquidate the assets.
The strategy should accomplish the following results:
It should also be of interest to clients who are very philanthropic that the annual CLAT distributions to charity will not erode the ability of the client to use other charitable deductions against personal income up to the normal 30- or 50-percent deduction limitations.
By comparison, if the client had continued to give away the earnings of the $1 million previously invested in municipal bonds (and given away the tax savings from the charitable deductions also) he would have accomplished the following results:
Annuity arbitrage is a financial strategy that has the potential to increase investment returns with low risk. It may be an attractive alternative investment strategy for a partnership that has a long-term need to make moderately high distributions, such as would be the case if a partnership interest was the sole asset owned by a CLAT with a high payout rate. Employing all of these concepts in a coordinated way as described requires expert drafting and careful attention to detail in its implementation and long-term administration. It also requires the efforts of a skilled life underwriter with knowledge of the industry and the negotiating skills to secure attractive offers from product providers. But if the client is willing to endure the added complexity, combining these legal and financial instruments can be a very effective means to achieve a wide range of philanthropic, asset protection, and family wealth transfer planning goals.
Copyright ©2004 by CCH INCORPORATED ("CCH"). Selected journal articles/columns from the Journal of Practical Estate Planning are provided under a license from CCH. All Rights Reserved. Copying without permission of CCH is prohibited. To order or obtain information regarding the Journal of Practical Estate Planning, please call 1-800-449-8114 or visit http://tax.cchgroup.com.
Codes Secs. 2055(e)(2)(B) and 2522(c)(2)(B).back
HOWARD ZARITSKY, TAX PLANNING FOR FAMILY WEALTH TRANSFERS, at 5.04 (4th ed. 2004)back
K. HENKEL, ESTATE PLANNING AND WEALTH PRESERVATION, at 35.04 (1997).back
Code Sec. 7520(a)(2).back
We wanted to file a gift tax return, so this gift was intentionally small but greater than zero. We applied a portion of the client's unused lifetime exemption, because a gift of a remainder interest is considered a gift of a future interest and therefore ineligible to be sheltered under the annual exclusion.back
A. Strangi Est., 115 TC 478, Dec. 54,135 (2000), aff'd in part and rem'd in part, CA-5, 2002-2 USTC 60,441, 293 F3d 279, on remand, TC Memo. 2003-145; M.B. Harper Est., 83 TCM 1641, Dec. 54,745(M), TC Memo. 2002-121; T.R. Thompson Est., 84 TCM 374, Dec. 54,890(M), TC Memo. 2002-246, on appeal to 3d Cir.; and C.E. Reichert Est., 114 TC 144, Dec. 53,774 (2000).back
Derived as follows: $35,000 / (1 - 40% tax rate).back
Looking for an alternative or supplemental investment for a nongrantor charitable lead annuity trust? In this article from the August/September 2004 issue of the Journal of Practical Estate Planning, David Holaday and Rodney Piercey discuss the benefits and design considerations of using a combination of life insurance and single premium immediate annuity as the investment engine in a family limited partnership used to fund a charitable lead annuity trust.
