taxmandotcom

Overview

Many of you may recall a series of articles that I wrote on JD Supra regarding the benefits of business owners having their employees covered under a collective bargaining agreement with a labor union. The Internal Revenue Code provides an important exception for ERISA-based plans that basically says that if your employees are covered under the collective bargaining agreement then the business owner does not have to include the employees in the business’s benefit plans. In the current environment, the benefits of this provision may be “supersized”. The combination of increased tax rates and new healthcare law may have many business owners saying – “Enough is enough”.

The Family Defined Benefit Plan is a fully insured defined benefit plan under IRC Sec 412(e)(3) that allows a business owner to excluded his “rank and file” employees and make a contribution for the business owner and spouse if desired. The only mandatory contribution for the employees is a 3 percent match in the union’s 401(k) plan.

The fully insured defined benefit plan provides for the largest tax deductible contribution into a qualified plan. It provides for a rock solid guaranteed retirement benefit of a maximum of $205,000 per year. If the spouse is included, the family defined benefit is $410,000 per year. This benefit is not altered by the volatility of the stock market. Nothing like having your retirement account go down by 40 percent in the year of retirement.

Yes, the insured defined benefit is a very conservative plan with the highest contribution requirements. I am certain that you might be able to achieve a higher investment return in other investment vehciles but you miss the point. The actual benefit of the plan is really two-fold – (1) The retirement benefit plus (2) the tax savings reinvested presumably at a higher rate than the guaranteed rate within the insurance contracts within the fully insured DB plan. Suppose the tax savings are invested in another tax deferred vehicle. There is nothing wrong with higher tax savings.

The business owner also has the ability to layer a defined contribution plan on top of the fully insured DB plan. The professional service company will be able to max a full 401(k) contribution of $17,500 and a catch up contribution of $5,500 if the business owner is age 50 or older. The business will be able to make a profit sharing contribution equal to 6 percent of earned income. Multiply that by two if the spouse is included. A 50 year old doctor might be able to contribute close to $400,000 in a series of pension plans. This quite the nice deduction without any audit risk.

Alot of you might say “Are you crazy, telling me to have my employees to joint the union. they will be on strike by Monday.” Is your hatred of unions worth more than the $200,000 plus tax benefit that you will receive on the way to a secure retirement with a guaranteed retirement benefit as the foundation of your retirement income? Your potential distrust or dislike of unions might be overstated and exaggerated.

The structure of the Family Defined Benefit is designed in a manner to buffer the business owner’s dealings with the union which is unfamiliar territory for the business owner. The costs and benefits for the business owner far exceed any valid concern with having unionized employees. The business owner does not even have to worry about negotiating directly with the union. Everything is done for him where the union is concerned.

The tax winds are shifting quickly. Add the fuel of healthcare if you are a MD, and pretty soon you will wonder how quickly you can get out of the Rat Race. The Family Defined Benefit Plan will give you a very quick start.

Overview

As discussions regarding immigration continue to unfold, one point that is not under discussion or open for debate is the contribution of foreign scientists and engineers to the New Economy. The statistics are pretty startling.

According to a 2012 report  from the Information Technology Industry Council, the Partnership for a New American Economy, and the U.S. Chamber of Commerce, research has found that “every foreign-born student who graduates from a U.S. university with an advanced degree and stays to work in the U.S.  has been shown to create on average 2.62 jobs for American workers—often because they help lead in innovation, research, and development.”

A 2011 report from the Partnership for a New American Economy concluded that immigrants were founders of 18 percent of all Fortune 500 companies, many of which are high-tech giants.

A 2007 study by researchers at Duke University and Harvard University concluded that one-quarter of all engineering and technology-related companies founded in the United States from 1995 to 2005 “had at least one immigrant key founder.”

A 2006 study by the National Venture Capital Association found that, during the previous 15 years, immigrants started one-quarter of the public companies in the United States backed by venture capital. These companies had a market capitalization of more than $500 billion and employed 220,000 workers in the United States in 2006.

One of the aspects that is recently of interest to me is the tax planning of foreign scientists and engineers who emigrate to the U.S. who become part of the New Economy. In many cases, these scientists become naturalized citizens. In other cases, they are green card holders. One thing is for certain though, Uncle Sam taxes these scientists on their worldwide income and assets once they become citizens or obtain a green card.

In many cases, these scientists still have family members living in the the scientist’s home country. When you consider the impact of an IPO on the personal tax planning of these scientists and engineers, the foreign-based parents becomes an important planning fact.

While it is true that Congress enacted legislation in 1996 to make it very difficult for American taxpayers to utilize and exploit foreign trusts to avoid U.S. income taxes, it is not impossible. The foreign scientist who owns one million shares of founder’s stock in his company that is about to undergo an IPO can minimize the impact of U.S. taxes on the value of those proceeds when the stock is sold following the expiration of a restriction period on the sale of the stock.

The ultimate tax goal is the creation of a foreign grantor trust with the scientist’s parents or family member treated as the grantor or the trust. If this planning is respected, the scientist’s shares owned within the foreign grantor trust cvan be sold without U.S. capital gains taxation. For the engineer or scientist in California, the benefit is a 36 percent gain on the sales proceeds. But as the cliche goes, the Devil is in the details. The combination of IRC 679 and the rest of the grantor trust rules and IRC Sec 684 make the planning a minefield. You can make it to the other side without being blown to pieces.

While the foreign parents are still alive, the foreign grantor trust can provide for tax-free accumulation and distributions to the foreign engineer. At the death of the parents, the foreign trust loses its grantor trust status. The taxes and penalities on undistributed net income within the foreign trust are onerous. At this point, it may be wise to to migrate the trust onshore to a jurisdiction without state income taxation on trust income such as Nevada or South Dakota.

The problem is an odd problem but an important one. What is at risk tax-wise is also pretty substantial- millions of dollars in capital gains taxation. The foreign born scientist or engineer may be able to realize the American Dream but avoid taxation on it as a result of their foreign roots. If you or your colleagues have these facts, it may be worth looking a little harder at your tax planning before your company has its IPO.

I hope to blog more regularly going forward. Over the last six to seven months, I have been writing and posting 1-2 articles per week on JD Supra. These articles are usually 1500-2000 words each. It is tough and a grind to come up with fresh and new content each week across multiple platforms while trying to making a living. Additionally, I published 4-6 different articles( 5-7,000 words each) last year in tax periodicals. I have as many people looking (I did not say reading) my stuff on JD Supra in a month as I had view my blog in a year.

Meanwhile back at the ranch, I am trying to navigate my way through social media. The books are still sitting on my desk. I am like anyone else trying to build my social media presence. I was happy and oblivious until my friend Charlie Garcia told me about all these different things – Empire Avenue; Klout Score. He has a Klout score of 82 which makes him online presence at the same level as media heavy weights. Plus he has a one million Twitter followers.

I was willing to accept the fact that I was Old School and a “Has Been” until I saw that Yoko Ono (fruitcake that she is) with 3.5 million followers on Twitter. She tweets such wisdom as “The wind blows through the trees”. After that, the gloves were off. Now the challenge is like the challenge to deadlift 600 or bench 400 or squat 500. It might be argued that Yoko’s tweets are better than my tweets. I am still looking for my personality and I can’t seem to find it anywhere. I am up to 700 versus her 3.5 million. As Francis Scott Key said (or maybe it was Chico Escuela said)- I have not yet begun to fight! (Carajo! – that was Chico’s contribution to the quote).

So my new thinking is trying to become New School is to blog frequently while publishing once or twice per week on JD Supra and a few times per year in tax periodicals. I am thinking that this will give the me the oppty to write more frequently in smaller soundbites.

Stay tuned! I will contunue to p[ost my new articles on the blog but write on alof of other things as well. I am excited about a few things in the tax world – the same old stuff private placement insurance; captives, and Puerto Rico.

 Overview

My last article focused on the attractiveness of Puerto Rico for hedge fund managers . Poor John Paulsen cannot make a move without the financial press reporting on the story. If he bought a Big Gulp at Seven-Eleven, the Press would declare it as being tax motivated! First, it’s the Bermuda reinsurance company and next it’s his possible relocation to Puerto Rico The news of this information did not uncover a heretofore unknown love of Salsa music but instead focused on the brilliant legislation adopted by the Puerto Rican government in 2012 to attract high net worth investors.

These tax changes offer the potential to make Puerto Rico the new Florida. Access to Puerto Rico is extremely easy. A recent check counted in excess of fifty daily flights to the PR from the East Coast daily. Hence, the wealthy retiree could conclude that it is easier to get to the PR then Jackson Hole, Wyoming. The next important ingredient – sun (check);beaches (check); golf courses – plenty (check); rum – check. Additionally, a quick review showed three synagogues in San Juan and plenty of churches.

This article will focus on the tax benefits for high net worth investors. The potential tax benefits for U.S. high net worth investors are too great to ignore. Two pieces of legislation Act 20 of 2012 and Act 2012 have put Puerto Rico on the map in a major way at a time when the compliance requirements for offshore planning has become a dangerous game. The compliance requirements and penalties for failing to meet these requirements is extremely confiscatory for taxpayers including a possible short trip to the Big House.

Why bother, just have your client move to Puerto Rico and become a Puerto Rican.

Puerto Rican Tax Basics

Puerto Rico (“the PR”) is an unincorporated territory of the U.S. and is subject to most federal laws unless “locally inapplicable”. The currency of the PR is the U.S. dollar. No passport is required for travel to the PR for U.S. citizens. The banks in the PR are regulated by the U.S. Federal Deposit Insurance Corporation.

The definition of a U.S. person under IRC Sec 7701(a)(3) does not include Puerto Rican entities. As a result, Puerto Rican entities are not subject to U.S. income taxation unless the business is engaged in a trade or business within the U.S.- effectively connected income (ECI); or investment income that would be subject to a withholding tax under IRC Sec 871(a) with an exemption for portfolio interest.

Under IRC Sec 933, bona fide residents of the PR that have PR-sourced income are exempt from U.S. taxation. IRC Sec 937 defines a bona fide resident for tax purposes. A person is a PR resident for tax purposes if present in the PR for at least 183 days during the taxable years and does not have a tax home outside of the PR and does not have a closer connection to the U.S. or a foreign country than the PR.

Export Services Act (Act 20 of 2012)

Businesses that relocate to the PR can significantly reduce their taxable income providing the PR entity is not engaged in a U.S. trade or business. The top federal corporate tax rate is 35 -40 percent for most corporations assuming a federal rate of 35 percent and a state rate of 5 percent.

 Under the Export Services Act (Act 20 of 2012), the tax rate is 4 percent. Additionally, shareholders that relocate to the PR will have a 100 percent exemption on corporate distributions. Under the Export Services Act, services that are directed to foreign markets may qualify as services under the Export Act. Services for foreign markets include services performed for non-resident individuals and businesses. In order to qualify as “promoter services” under the Export Act, the net income must be earned and service performed within the 12-month period ending on the day preceding the day the business commenced operations withinthe PR.

A business (service provider) must request and obtain a tax exemption decree on or before December 31, 2020. The decree has a 20 year term and may be renewed for an additional 10 years providing certain conditions are met. During the period of the exemption, the business will enjoy a 4 percent tax rate on its export services income and a 100 percent exemption on the distributions of earning and profits from the services income. The business is also eligible for a 100 percent property tax exemption during the first five years of operation and 90 percent after the fifth year.

Existing businesses that become eligible for benefits under the Export Services Act only receive the special tax rate (4%) on the portion of net income that exceeds the average net income for the three years preceding the request for a tax exemption decree. This aspect of the law is designed to prevent existing businesses from becoming tax exempt without a corresponding increase in economic activity in the PR.

The Individual Investors Act

The Puerto Rican government passed The Individual Investors Act on January 17, 2012 (Act 22). Under IRC Sec 933, interest and dividends that qualify as PR-sourced income are excluded from the income of a “resident individual investor (an individual who has not been a resident of the PR for the past years before his first year of residence in the PR).  The new legislation exempts passive income from taxation – capital gains, interest and dividends.

Long term capital gains derived by the “resident individual investor” that were deemed to have accrued before the individual became a PR resident and are recognized within the first ten years after the date the individual becomes a PR resident, will be taxed at a 10 percent rate. If the gains are recognized after the ten year period but before, January 1, 2036, the gains will be taxed at a 5 percent rate. Gains considered to have accrued after the investor becomes a U.S. resident will receive a 100 percent exemption. Dividend and portfolio interest income are exempt from PR taxation under the new law.

Unlike states without a state income like Florida or Nevada, the PR solution provides an opportunity to completely avoid federal taxation on passive income as well as Puerto Rican taxation on the same income. The high net worth investor enjoys these benefits without the headache and legal consequences of FBAR requirements, Form 8938 and Form 3520 and Form 3520-A. The absence of not having these filing requirements is a very good thing.

The Strategy

Facts

Dan Jones operated a successful plumbing contractor business in the New York tri-state area for 30 years. He would like to retire and has an offer to purchase his business for $30 million. The offer is an “all cash” offer. In the year preceding the sale and in anticipation of his retirement, Dan and his wife purchase a home in Puerto Rico. They also agree to meet the Closer Connection Test – they will register to vote in Puerto Rico, and obtain a Puerto Rican Driver’s license. The Jones will purchase a home in Puerto Rico and reside in Puerto Rico at least 183 days per year. 

Solution

Dan creates a Puerto Rican corporation that serves as the general partner to his family limited partnership which was formed in Delaware. The management fee for the general partner provides for a two percent annual management fee and a 20 percent profits interest. His management fee will be taxed at a 4 percent rate. This fund structure will allow Dan to convert some of his income that is treated as fixed and determinable or periodic income and effectively connected income to a U.S. trade business (his real estate investments) in service income taxed at four percent.

Dan assign his ownership in his company stock to the FLP. As a Puerto Rican residence, Dan will be taxed at a 10 percent capital gains rate as the gain is within ten years of his declaration of  residency in the PR.

Dan’s investment portfolio will be structured in a private bank in Puerto Rico. Dan’s banker is a Rutgers alumnus and fan just like Dan. The investment income will be completely income tax-free for both federal and Puerto Rican purposes. The projected investment income is $2 million per year. 

Dan is still subject to U.S. federal estate taxes and will implement domestic tax planning options in Nevada and South Dakota. The trust income will not be subject to income taxation in those states.

Summary

The PR is the real deal! The tax benefits, weather, accessibility and accommodations make it the New Florida. One could argue that more English is spoken in San Juan than Miami. In effect has become an onshore jurisdiction with offshore attributes without all of the red tape and compliance and reporting requirements of being offshore. Forget Mexico, Panama (it hurts me to say that) and all of the foreign ports that are calling you. The provisions of Export Services Act and Individual Investors Act create a new and unprecedented opportunity for U.S. high net worth taxpayers.

Overview

Every financial mediaoutlet (including Bloomberg and the Wall Street Journal)in the last several weeks has run an article on the possibility of billionaire hedge fund manager becoming a Puerto Rican resident. Having grown up in the Panama Canal Zone, and being a double major in college in Spanish and Portuguese, may not qualify to offer investment advise but I know a thing or two, about heat and humidity. Additionally, I can throw in a decade of living in Miami as well as well as being a “major league” fan of Afro-Cuban music aka Salsa.

The temptation to unleash a couple of one-liners in the current situation is too great. For starters, Mr. Paulsen may have the financial credentials but lacks the Salsa dancing credentials to become a Puerto Rican resident. Additionally, he may not be able to pass the standard residency test because he probably does not know who Gilberto Santa Rosa is and is not familiar with the music of El Gran Combo or La Sonora Pocena.

However, the Puerto Rican government may be willing to have Mr. Paulsen submit to a probation period – Dancing with the Stars, the Salsa version.” All kidding aside, the potential tax benefits for hedge fund managers are too great to ignore. Hence, Mr. Paulsen was willing to travel four hours to the Isla del Encanto to kick the tires.

This article will present the basic tax provisions of the new Puerto Rican tax incentives. These tax changes may be the most compelling financial and tax events for hedge fund and private equity managers since tax reform and the adoption of IRC Sec 457A.

Hedge Fund Basics

The typical fee structure of a hedge fund provides for a two percent annual management fee and a twenty percent carried interest (incentive) for investment performance over an investment high water mark. Many hedge funds are set up in a master feeder structure. The domestic fund is a pass-through entity such as a limited partnership or limited liability company that invests into the Master Feeder structure – a domestic LLC or partnership. The offshore fund is a foreign corporation usually formed in a jurisdiction with no taxation for corporations.

The offshore fund also invests in the Master Feeder structure. The investment management firm is the investment advisor to both funds. Domestic funds were never able to defer the carried interest as the investment manager as domestic funds typically operate as pass-through entities. Investment management firms were able to enter into deferred compensation agreements with the offshore fund (corporation).

The Emergency Economic Stabilization Act ended the not so well well-kept secret of hedge fund managers, the deferred compensation arrangement with their offshore funds or as the New York Times described, “an unlimited Super IRA for the super-wealthy.” A reporter recently told me that he estimated the amount of offshore carried interest to be in excess of $200 billion based on a review of materials from the joint Committee of Taxation.

The addition of IRC Sec 457A effectively ended the ability of investment managers to defer tax recognition of the carried interest in the investment manager’s offshore fund. Under IRC Sec 457A, hedge fund managers must repatriate the offshore deferred compensation not later than December 31, 2017. Many hedge fund managers probably feel that the current Administration has a gun pointed at their heads and they are probably correct.

The creation of tax-advantaged reinsurance companies by hedge fund managers in jurisdictions such Bermuda has also attracted negative attention. The creation of tax incentives under recent Puerto Rican jurisdiction is a horse of a different color. Puerto Rico is a U.S. commonwealth and not a tax-haven jurisdiction.

This article will outline the tax benefits that are available to investment management firms and individuals that become Puerto Rican residents.

Puerto Rican Tax Basics

Puerto Rico (“the PR”)is an unincorporated territory of the U.S. and is subject to most federal laws unless “locally inapplicable”. The currency of the PR is the U.S. currency. No passport is required for travel to the PR for U.S. citizens. The banks in the PR are regulated by the U.S. Federal Deposit Insurance Corporation. The definition of a U.S. person under IRC Sec 7701(a)(3) does not include Puerto Rican entities. As a result, Puerto Rican entities are not subject to U.S. income taxation unless the business is engaged in a trade or business within the U.S.- effectively connected income (ECI); or investment income that would be subject to a withholding tax with an exemption for portfolio interest.

Under IRC Sec 933, bona fide residents of the PR that have PR-sourced income are exempt from U.S. taxation. IRC Sec 937 defines a bona fide resident for tax purposes. A person is a PR resident for tax purposes if present in the PR for at least 183 days during the taxable years and does not have a tax home outside of the PR and does not have a closer connection to the U.S. or a foreign country than the PR.

Businesses that relocate to the PR can significantly reduce their taxable income providing the PR entity is not engaged in a U.S. trade or business. The top federal corporate tax rate is 35 -40 percent for most corporations assuming a federal rate of 35 percent and a state rate of 5 percent. Under the Export Services Act, the tax rate is 4 percent. Additionally, shareholders that relocate to the PR will have a 100 percent exemption on corporate distributions.

Under the Export Services Act, services that are directed to foreign markets may qualify as services under the Export Act. Services for foreign markets include services performed for non-resident individuals and businesses. In order to qualify as “promoter services” under the Export Act, the net income must be earned and service performed within the 12-month period ending on the day preceding the day the business commenced operations withinthe PR. A business (service provider) must request and obtain a tax exemption decree on or before December 31, 2020.

The decree has a 20 year term and may be renewed for an additional 10 years providing certain conditions are met. During the period of the exemption, the business will enjoy a 4 percent tax rate on its export services income and a 100 percent exemption on the distributions of earning and profits from the services income. The business is also eligible for a 100 percent property tax exemption during the first five years of operation and 90 percent after the fifth year. Existing businesses that become eligible for benefits under the Export Services Act only receive the special tax rate (4%) on the portion of net income that exceeds the average net income for the three years preceding the request for a tax exemption decree.

This aspect of the law is designed to prevent existing businesses from becoming tax exempt without a corresponding increase in economic activity in the PR. The Individual Investors Act Under IRC Sec 933, interest and dividends that qualify as PR-sourced income are excluded from the income of a “resident individual investor (an individual who has not been a resident of the PR for the past years before his first year of residence in the PR). Long term capital gains derived by the “resident individual investor” that were deemed to have accrued before the individual became a PR resident and are recognized within the first ten years after the date the individual becomes a PR resident, will be taxed at a 10 percent rate.

If the gains are recognized after the ten year period but before, January 1, 2036, the gains will be taxed at a 5 percent rate. Gains considered to have accrued after the investor becomes a U.S. resident will receive a 100 percent exemption. Dividend and portfolio interest income are exempt from PR taxation under the new law.

IRC Sec 457A – Dealing with Offshore Carried Interest

IRC Sec 457A provides that any deferred compensation becomes taxable when it is no longer subject to a substantial risk of forfeiture. Deferred compensation attributable to services performed after January 1 2009 is entitled to 10-year transition relief.

The deferred compensation must be included in income by the later of (1) the last tax year of “the non-qualified entity beginning before 2018 or (2) the taxable year in which the deferred compensation ceases to be subject to a substantial risk of forfeiture. A “non-qualified entity” is any foreign corporation unless all of its income is subjectively connected with a U.S. trade or business or (2) Subject to a comprehensive foreign income tax. Any partnership (foreign or domestic) is a “non-qualified” entity unless substantially all of its income is allocated to persons other than (1) foreign persons that are not subject to a comprehensive foreign income tax and (2) tax-exempt organizations.

A foreign person will be considered subject to a comprehensive foreign income tax if the person is eligible for benefits under a comprehensive tax treaty with the U.S. An operating partnership will be a non-qualified entity under IRC Sec 457A unless its income is allocated directly to someone taxed in the U.S. or under a comprehensive income tax treaty. Under the IRC Sec 457A rules, deferred compensation paid by a “non-qualified entity” is subject to a substantial risk of forfeiture only if the recipient’s rights to such compensation are conditioned upon the future performance of substantial services (service-based vesting).

It may be possible that compensation paid by the domestic corporate subsidiary of a “non-qualified entity or foreign entity that is subject to a comprehensive foreign income tax, avoids the tax treatment of IRC Sec 457A. The regulations to IRC Sec 457A do not address whether an entity in a U.S. Commonwealth such as the PR qualifies as a domestic corporate subsidiary or a foreign jurisdiction subject to a comprehensive foreign income tax. Without a lot of legal analysis, my legal instinct suggests that a Puerto Rican entity would most likely qualify as an entity that is subject to a comprehensive foreign income tax.

As a practical matter based upon legislative intent, it seems difficult to believe that the federal government would afford greater preferential tax treatment to a treaty partner ahead of an economically challenged U.S. Commonwealth. As a result, it may be possible to restructure existing hedge fund deferred compensation arrangements so that they continue to qualify under IRC Sec 457A for deferral or alternatively provide for taxation at a 4 percent rate under the Export Services Act. Additionally following payment, proceeds would be able to be reinvested and distributed to a PR resident on a tax-free basis.

This subject will be analyzed in greater detail in a subsequent article.

The Strategy

Facts

Acme Investment Management, LLCis a New York-based hedge fund specializing in mortgage backed securities. The firm has $1.5 billion of assets under management primarily in Acme’s offshore fund which is located in Bermuda. The firms’ assets under management have tripled in the last three years. The fund’s investment performance is strong and has averaged 15 percent per year over the last three years. The firm’s fee structure includes a 2 percent management fee and 20 percent incentive fee.

The fund continues to attract new investor capital. The fund has 20 employees. John Smith and Bob Jones are former college roommates and respectively own 50 percent of the investment management firm which is a Delaware LLC. John and Bob both reside in New York City and have a combined marginal tax bracket of 55 percent. Both principals are married and have school-aged children.

The firm’s gross revenues in 2012 were $75 million. Net profits were $40 million to the two principals. Solution The principals decide to restructure Acme. The firm creates a new investment management company based in San Juan. The new firm will serve as the investment manager for all Acme funds.

The company is designed to qualify for special tax treatment under the auspices of the Export Services Act. The firm will continue to have a New York-based office that provides services to the new investment management firm. John and Bob retain their NY residences but become Puerto Rican residents effective in 2013. The two principals agree to reside in Puerto Rico for at least 183 days during the year.

They also agree to meet the Closer Connection Test – they will register to vote in Puerto Rico, and obtain a Puerto Rican Driver’s license. The Smith and Jones families will purchase a home in Puerto Rico and enroll their children in the best English speaking school on the Island. They will consider the PR their tax home. The families will spend six months of the year in NYC while the children attend summer camp in New England. New York is a four hour flight from San Juan. Acme enjoys repeat investment performance in 2013 and 2014.

The difference is that the net profits of $40 million per year in 2013 and 2014 will be taxed at 4 percent instead of 55 percent. John and Bob will be able to reinvest their income on a tax-free basis in the offshore fund without taxation. The Puerto Rican relocation has enabled the John and Bob to save approximately $21.4 million for the two years in the example in personal income tax. Furthermore, the reinvestment of the proceeds will generate passive income that will be completely exempt from personal income taxation as a resident of the PR when distributed from the company or paid individually.

Summary

I grew up in the Panama Canal Zone and know what it is like to live outside of the continental United States. Hedge fund managers, you can do this and have a good life. I also lived in Miami for a long time. Facetiously, I might argue that there is more English spoken in the PR than in Miami. The Puerto Rican government has done a brilliant job creating incentives for businesses and high net worth individuals to move to the PR and become PR residents. It is my prediction that the PR will become the new Florida (only much better from a tax perspective).

Travel to the PR is easy and accessible. These days, every airline flight is a few hours by the time you park and wait for your flight. Many managers already spend six months per year somewhere other than their primary state of residence. As Congress prepares to change the tax treatment of carried interest which will impact every investment manager – hedge fund, real estate, private equity and venture capital – I promise you that the Puerto Rican hedge fund or private equity firm is the “next big thing”.

The preferential taxation provides tax reduction possibilities that do not exist anywhere else. If Mr. Paulsen needs a special advisor who knows “La Sonora Pocena and “El Gran Combo, I am qualified to help him with that. The second installment of this series will focus on the possibility of restructuring and incorporating existing offshore carried interest arrangements into the Puerto Rican provisions outlined in the Export Services

“Clorin Colorado, este Cuento se ha acabado” (translated – this story is over).

Tax Reduction and Deferral Strategies for Trial Attorneys – Part 6          

 I Overview

Over the last few weeks I have been diligently outlining tax planning strategies for trial attorneys with contingent fee income. These strategies have ranged from structured settlement arrangements using private placement variable deferred annuities (PPVA), captive insurance, and Qualified Settlement Funds (QSFs) combined with private placement variable annuities. In my last installment I introduced structured settlement life insurance, a new concept for trial attorneys.

Structured settlement life insurance is a powerful tool that combines the benefits of a Qualified Settlement Fund (QSF) and private placement life insurance (PPLI) to provide a powerful combination of deferred compensation along with tax-free income and benefits for the trial attorney and his family. The same benefits are achievable for the claimant such as the UBS Whistleblower.

In Part 5, I focused on the utility of the QSF from an investment funding perspective to illustrate how private placement life insurance can be used in a split dollar life insurance funding format in order to  create a scenario where the trial attorney is able to create a retirement fund that exploits the tax advantages of life insurance – (1) Tax-free inside buildup of the policy cash value (2) Tax-free lifetime distributions from the policy through policy loans and withdrawals. (3) Income and Estate-tax free death benefit.

I thought it would be useful to focus on the case of the UBS Whistleblower (Brad Birkfeld) situation to illustrate what could have been accomplished in structuring the tax consequences of  his record $104 million settlement award from the IRS in conjunction with his role as a whistleblower. Unlike cases that involve physical injury that result in tax-free treatment for the plaintiff, a Whistleblower case results in taxable treatment at ordinary rates for both the Whistleblower and his attorney.

Through sophisticated tax planning, the UBS Whistleblower would have demonstrated clearly to his employer (UBS) that there was never a need to hide the money under a rock! Additionally, the law firm representing the UBS Whistleblower could have structured their $30 million fee. Perhaps, the Government and UBS (and affected clients) might not like the result, but the difference here is the fact that is legally supported by the Book (Internal Revenue Code) and case law. It’s how you connect the dots!

The latest installment will also illustrate the flexibility of structure settlement life for the UBS Whistleblower.

III  Qualified Settlement Funds (QSF)- A Quick Review

QSFs are trusts that are designed to resolve litigation and satisfy claims of the litigation even if they are not the subject of litigation. The QSF is authorized and governed by the provisions of IRC Sec 468B. A QSF has no statutory time limit within IRC Sec 468B or the treasury regulations in regard to how long a QSF may be kept in place.

The QSF has benefits for both plaintiffs and defendants. From a defendant’s perspective, the ability to transfer assets to a QSF can resolve the claim and release the defendant from further liability while achieving an immediate tax deduction regardless of when claimants actually receive distributions. This is a significant tax planning point for the defendant particularly for non-physical injury tort cases.

The plaintiff is able to achieve numerous benefits. Claimants can use the QSF to time the receipt of their income. Plaintiffs are not taxed until they actually receive distributions from the QSF. The QSF provides the plaintiff and their attorney with the ability to work out the details of their distribution.

IV Tax Advantages of Life Insurance  A Quick Summary

A few of the tax benefits:

(1)   Tax-free inside buildup of cash

(2)   Tax-free loans and withdrawals during lifetime.

(3)   Income Tax-free death benefit.

(4)   Estate tax-free death benefit if owned by an irrevocable trust.

V Private Placement Life insurance – A Quick Summary?

PPLI is a security under federal securities law and is limited to accredited investors and qualified purchasers. PPLI is a state of the art institutionally priced variable universal life insurance policy that allows for customized investment options including a wide range of investment options such as hedge funds and private equity funds.

VI Structured Settlement Life Insurance

1. The Basics

The thrust of the structured settlement life insurance strategy is use of the QSF as a source of funds to invest in a PPLI contracted owned by the trial lawyer’s family trust using a split dollar life insurance arrangement. The objective is to provide the taxpayer (hereinafter “Whistleblower”) with tax-free insurance benefits, tax-free income along with deferred compensation payments. Not a bad combination, right

The Whistleblower’s family trust is the applicant, owner and beneficiary of a PPLI contract insuring the Whistleblower’s life. The policy is funded over several years so that the policy is treated as a non-modified endowment contract (Non-MEC). Non-MEC status is a technical acronym to label the policy as one that is eligible for all of the tax benefits that I outlined above.

The trustee of the family trust enters into a split dollar arrangement with the trustee of the QSF. Split dollar is a contractual arrangement that provides for the co-ownership and sharing of benefits of a life insurance contract between two or more parties. In the typical split dollar arrangement, the QSF would have an interest in the policy cash value and death benefit equal to its premium payments. The excess portion of the cash value and death benefit would inure to the benefit of the family trust.

The big “take away” regarding split dollar is how it is taxed to the Whistleblower. The participant (Whistleblower or his attorney) is not taxed on the QSF trustee’s premium payments. Final Treasury regulations (Treas Reg 1.61-22) provide two different methods of taxation.- the economic benefit method or the loan method.

Under the economic benefit method, the taxpayer is taxed on the value of the death protection provided under the policy. The economic benefit is valued using term insurance costs. The term insurance cost is determined using the lesser of the Table 2001 rates or the insurer’s cost for annual renewable term.

The loan method of split dollar treats the premium payments as loans to the taxpayer. The minimum interest rate is the applicable federal rate (AFR). If the loan rate is a below market rate loan, the rules of IRC Sec 7872 apply. The forgone interest is treated as taxable income and treated as an imputed gift by the taxpayer if the policy is owned by a trust. Interest payments can accrue and be repaid at the insured’s death.

VII   Strategy Example

 A.     The Facts

Brad Best, age 42, is a former private banker with a well-known Swiss Bank. He recently was awarded $104 million for his role in the IRS Whistleblower Program for reporting the Bank’s role in assisting American taxpayers in hiding assets and income that were reportable under American tax law. Best’s efforts allowed the IRS to recover $800 million in tax revenues.

Brad will have to serve a minimum sentence for his own involvement at Club Fed, a minimum security prison and will be released to a “half way” house for six months. He is currently single but plans to remain in New England and eventually marry and raise his children in a small New England town. Brad plans to write a book and serve as an advocate for whistleblowers such as himself. Brad would like to have an annual payment of at least $3 million per year that has some degree of inflation protection.

The award is more than he will need for the next five lifetimes but he would like to defer taxation and pass as much wealth as he can to future generations as he can as well as endow the National Whistleblower Center, a 501(c)(3) organization.

Solution

During the course of settlement discussions, the U.S. Government agrees to place the entire amount of the Whistleblower award into a QSF.  The amount of the award is $104 million. Brad’s fee agreement with the Whistleblower law firm, The Justice Law Center,  provides for a 30 percent contingency fee – $31.2 million. The balance of the fee is $72.8 million. The Government acquiesced to this arrangement as the QSF is authorized by IRC Sec 468B.

Both Brad and the law firm plan to structure their payout.

(1)   Distribution for Personal Expenses

Brad takes an initial distribution of $10 million. Brad plans to purchase a $2.5 million home in cash with the after-tax proceeds and place the balance in an investment portfolio that will not be managed by his former bank.

(2)   Private Placement Immediate Annuity-

The trustee of the QSF purchases a single premium private placement variable immediate annuity (SPIA) issued by Acme Life. The initial premium is $25 million. The projected annual annuity payment is $1 million. The annuity payment will adjust each year based upon the policy’s investment performance. Payments will increase each year to the extent that investment performance exceeds 3.5 percent per year. Payments will continue for the balance of Brad’s lifetime. Additionally, the QSF will not be taxed on any of the SPIA investment income.

(3)   Structured Settlement Life Insurance –

The QSF trustee allocates another $25 million of the Whistleblower award to a structured settlement life insurance arrangement. The QSF enters into a split dollar agreement with the trustee of Brad’s family trust. The family trust is the applicant, owner, and beneficiary of  a policy insuring Brad’s life. The policy has a death benefit of $70 million and premiums of $5 million per year for five years. The policy uses the increasing death benefit option so that the minimum net amount payable to the trust is a minimum of $70 million.

The split dollar arrangement  is initially structured using the economic benefit regime. The QSF collateral assignment interest in the policy cash value and death benefit is equal the greater of the policy’s cumulative premiums or cash value. The excess death benefit is payable to the family trust. Brad’s annual tax cost for both income and gift tax purposes in Year 1 is $29, 400; Year 10- $56,000; Year 20- $107,800; and Year 30-$290,000 . The death benefit payable to the family trust income, estate, and generation skipping transfer tax free in the event of death is $70 million.

In Year 30, the trustee decides to switch the split dollar method to the loan method. The collateral assignment is terminated and the family trust provides a promissory note to the QSF equal to the cumulative premiums- $25 million. The loan provisions provide for the accumulation of interest that will be recovered at Brad’s death. The interest rate is equal to the long-term applicable federal rate at that time.

At that point in time, the policy has a net death benefit of $70 million and cash value of $50 million. The trustee of the QSF has an interest in the policy equal to its cumulative premiums- $25 million. The trustee of the family trust has the discretion to access the policy cash value to distribute  income to trust beneficiaries  on a tax-free basis..

At Brad’s death, the QSF will receive a portion of the death benefit equal to the accumulated principal and interest. One half of these payments will be made to Brad’s private foundation in a lump sum. The balance will be paid to a second family trust established for Brad’s grandchildren.

(4)   Structured Settlement Life Insurance – Freeze Life Insurance Partnership

The balance of the QSF proceeds – $22.1 million – is invested into a Freeze Investment Partnership with the family trust. The QSF trustee invests $22.1 million in exchange for the preferred interests in a new partnership. The family trust purchases all of the common equity (non-frozen) interests in the partnership for $500,000.

The partnership invests all of its assets in a Frozen Cash Value life insurance policy. This policy is a specialty private placement life insurance policy that is intentionally designed to violate the U.S. tax law definition of life insurance. The policy provides that the initial premium plus the investment growth on this policy constitute a mortality reserve that is paid on an income tax-free basis at death. The policy’s cumulative premiums are accessible during lifetime on a tax-free basis.

Under the partnership agreement, preferred partners are entitled to a cumulative preferred return of four percent along with a liquidation preference equal to its investment capital – $22 million. The preferred partner also has the voting rights. The common equity partner is entitled to the excess growth above the preferred partner’s interest.

In year 20,the policy has a projected death benefit of $125 million. The preferred partnership interest with its cumulative preference return is valued at $50 million. The excess value of $75 million has accrued for the benefit of the common equity holder – the family trust.

In the event that Brad dies in Year 20, the partnership would be liquidated and the family trust would receive an additional $75 million income and estate tax-free. The QSF would receive $50 million upon liquidation of the partnership. The amount received by the QSF would be paid in a single lump sum to Brad’s estate in order to fund several charitable bequests along with Brad’s private foundation.

Summary

Any day you receive $104 million from the Government after so much pain and suffering, is a blessed day and beautiful thing. Assuming no planning, the initial proceeds after income taxes payable to Brad would have been worth $47 million. Assuming his death 15 years later and growth in his estate of five percent, Brad’s estate would be left with approximately $52 million.

The techniques outlined in this article  provide long-term tax deferral and the conversion of tax-deferred assets into tax-free assets while providing a lifetime income. The benefits of structured settlement annuity and life insurance arrangements (using private placement insurance contracts) provide benefits that produce results that are 5-8 times greater (if not more) than the “Take Your Money and Run” strategy. Only the strategy that was the source of the UBS Whistleblower case is capable of producing similar results (at least until you get caught).

The structured arrangements – life insurance and annuities – are in effect tax deferral plans similar to an IRA or qualified plan but without limits and restrictions. Life insurance due to its special tax consequences is capable of producing even stronger benefits than structured settlement annuity arrangements. Private placement insurance contracts are the “jet fuel” to turbo-charge the results. The next time that you are settling a case, give serious consideration for yourself as well as your client so that you can be whistling Dixie.

                         Structured Settlement Life Insurance – A Tax-Free Pension Plan

 I Overview

This installment is Part 5 of my series on a tax reduction and tax planning strategies for trial attorneys. This installment introduces a completely new concept in the structured settlement industry- structured settlement life insurance. This strategy is designed for high income trial attorneys who represent plaintiffs that earn a contingency fee based on the damages awarded by a jury or settlement.

Part I of this series focused on tax reduction and deferral strategies for trial attorneys with contingent fee income using private placement variable deferred annuities in lieu of fixed annuities for structured settlement payments.

Part 2 of this series focused on the use of closely held insurance companies (aka captive insurance arrangements) to provide tax reduction and deferral of contingency fee income. In Part 2, the captive insurer functions as a multi-line insurer (property and casualty as well as life insurer) that issues the structured settlement annuities for the contingency fee deferrals referenced in Part I of this series.

In Part 3, the trial attorney was able to gain a charitable tax deduction equal to the amount of the contingency fee and invest that money on a tax-deferred basis using PPLI contracts. Part 3 combined several sophisticated planning techniques – a Charitable Lead Annuity Trust with back loaded payments to a charity; a preferred partnership in order to transfer growth in excess of a preferred partnership return to a family trust, and  tax-free treatment on investments within the CLAT using private placement life insurance to create the tax benefits..

In Part 4, I focused on the use of Qualified Settlement Funds under IRC Sec 468B as an unlimited pension plan for trial attorneys. QSFs provide for unlimited contributions from a pension plan perspective, and unlimited tax deferral without a need for required minimum distributions and participation as required in pension law.

In Part 5, I focus on the utility of the QSF from an investment funding perspective to illustrate how private placement life insurance can be used in a split dollar life insurance funding format in order to to create a scenario where the trial attorney is able to create a retirement fund that exploits the tax advantages of life insurance – (1) Tax-free inside build up (2) Tax-free lifetime distributions through policy loans and withdrawals. (3) Income and Estate-tax free death benefit.

Generally, most trial attorneys have not utilized structured settlement annuities which are conservative fixed deferred annuity products issued by large life insurers. Apparently, trial attorneys have been content paying taxes at ordinary rates. Why?

II Again and Again – Why Now?

I am beginning to sound like the proverbial “broken record” regarding the impending tax law changes on the horizon.  The tax bugle sounds once again as a “call to action” for trial attorneys and their advisors.

The tax environment for high income tax payers underwent a substantial change. The top federal marginal tax rate is scheduled increased to 39.6 percent in January 2013. High income tax payers will now incur an additional 3.8 percent tax on unearned income for taxpayers with AGI in excess of $250,000. High income tax payers are also subject to a phase out of personal exemptions and itemized deductions which have the effect of increasing the marginal tax rate by 1-2 percent. State marginal tax rates can add another 4-10 percent to the overall tax rate. What this means is that many trial attorneys will have a combined marginal tax rate in excess of 50 percent.

The top marginal estate tax bracket increased to 40 percent. At the same time the exemption equivalent for federal estate and gift taxes is  $5.25 million. The bottom line is that “earned income” as the trial attorney’s largest asset, is more highly taxed much than any other asset class. The combination of income and estate taxes on this windfall income can be as high as 75-80 percent.

III  Qualified Settlement Funds (QSF)- A Quick Review

QSFs are trusts that are designed to resolve litigation and satisfy claims of the litigation even if they are not the subject of litigation. The QSF is authorized and governed by the provisions of IRC Sec 468B. Depending upon the complexity of a case, number of plaintiffs or defendants, and the level of uncertainty regarding distributions, the QSF can last for a few weeks or a few years. The key point here is that no statutory time limit exists within IRC Sec 468B or the treasury regulations in regard how long a QSF may be kept in place.

The QSF has benefits for both plaintiffs and defendants. From a defendant’s perspective, the ability to transfer assets to a QSF can resolve the claim and release the defendant from further liability while achieving an immediate tax deduction regardless of when claimants actually receive distributions. This is a significant tax planning point for the defendant.

The plaintiff is able to achieve numerous benefits. Claimants can use the QSF to time the receipt of their income. Plaintiffs are not taxed until they actually receive distributions from the QSF. The QSF provides the plaintiff and their attorney with the ability to work out the details of their distribution.

In Part 4 of this series, I outlined the legal requirements necessary to create a QSF as well as the operational and administrative guidelines. Please refer to Part 4 for a review of these concepts. One important point regarding taxation is the fact that QSFs are taxed at the maximum level for trusts (39.6%) in 2013. QSFs will also be subject to the new 3.8 percent Medicare tax on investment income as well as state taxation. All in all, we are talking about “all in” tax rates that hover between 43.4 and 53 percent. As a result, tax deferral on investment income is a key component of investment and tax planning for QSFs.

IV Tax Advantages of Life Insurance

Life insurance agents and attorneys have one thing in common. Everybody hates lawyers except their own lawyer. Life insurance agents get clients to take action in an area of their lives that they would rather avoid – their own mortality. The decedent’s family is very grateful after the fact. In Woody Allen’s film “Take the Money and Run”, solitary confinement is made more onerous by having to spend it with a life insurance agent.

Nevertheless, life insurance agents have the best game in town from a tax perspective. Life insurance is the most tax advantaged investment. The inside buildup of the policy’s cash value is tax-free meaning that the policy’s investment earnings within the policy are not taxed. The policyholder also has the ability to access those investment gains from the policy during lifetime on a tax-free basis using low cost policy loans and partial surrenders of the policy cash value. The policy death benefit receives income tax-free treatment and the policy death benefit may receive estate tax-free treatment if owned by a third party such as a family trust. Not bad!

Private placement life insurance is a state of the art institutionally priced variable universal life insurance policy that allows for customized investment options including a wide range of investment options such as hedge funds and private equity funds. The policy is effectively a low load or no load life insurance policy making it very efficient but also the primary reason why it isn’t sold more.

V Structured Settlement Life Insurance

The thrust of the structured settlement life insurance strategy is use of the QSF as a source of funds to invest in a PPLI contracted owned by the trial lawyer’s family trust using a split dollar life insurance arrangement. Split dollar life insurance is a funding technique that has traditionally been used as a funding technique used by an employer to provide life insurance coverage for key executives. The earliest reference to split dollar is Rev. Rul 55-713. Hence, split dollar is older than I am.

Specifically, this arrangement calls for the use of a split dollar technique known as Switch Dollar. Switch dollar starts out as a traditional split dollar arrangement using the economic benefit regime under the final split dollar regulations promulgated in September 2003. As the economic benefit tax cost to the trial attorney increases, the arrangement is switched to a split dollar arrangement under the loan regime.

The four stages of the arrangement:

1. Economic Benefit Phase – the QSF funds the entire policy premium. The trial attorney has a tax cost equal to the value of the economic benefit (term insurance cost) for the trial attorney’s (Family Trust) interest in the policy.
2. Switch – The split dollar agreement terminates. The Family Trust issues a promissory note to the QSF. The initial premium is equal to the cumulative premiums. The note has no interest rate and is a demand note. The trial attorney has reportable income equal to the long-term applicable rate.
3. Loan Phase – The loan interest accrues and is added to the principal of the loan. The family trusts owns the policy in its entirely. The trustee of the is able to take a partial surrender of the cash value and policy loans and make tax-free payments each year to the trial attorney or his spouse.
4. The End – The loan and any accrued interest is repaid at the trial attorney’s death to the QSF. The trustee of the QSF uses the repaid loan proceeds to make the payments on a taxable basis to the trial attorney’s estate or beneficiaries. 

1. Split Dollar Overview

Split dollar life is a contractual arrangement between two parties to share the benefits of a life insurance contract. In a corporate setting, split dollar life insurance has been used for 55 years as a fringe benefit for business owners and corporate executives. Generally speaking, two forms of classical split dollar arrangements exist, the endorsement method and collateral assignment method.

The IRS issued final split dollar regulation in September 2003. These regulations were intended to terminate the use of a technique known as equity split dollar. The consequence of these regulations is to categorize into two separate regimes – the economic benefit regime or the loan regime.

2.

• Split Dollar under the Economic Regime

Under the economic benefit regime, the employee or taxpayer is taxed on the “economic benefit” of the coverage paid by the employer. The tax cost is not the premium but the term insurance cost of the death benefit payable to the taxpayer. The economic benefit regime usually uses the endorsement method but may also use the collateral assignment method.

In the endorsement method within a corporate setting, the corporation is the applicant, owner and beneficiary of the life insurance policy insuring a corporate executive. The company is the applicant, owner, and beneficiary of the life insurance policy. The company pays all or most of the policy’s premium. The company has in interest in the policy cash value and death benefit equal to the greater of the policy’s premiums or cash value. The company contractually endorses the excess death benefit (the amount of death benefit in excess of the cash value) to the employee who is authorized to select a beneficiary for this portion of the death benefit.

The economic benefit is measured using the lower of the Table 2001 term costs or the insurance company’s cost for annual renewable term insurance. This measure is the measure for both income and gift tax purposes. Depending upon the age of the taxpayer, the economic benefit tax cost is a very small percentage of the actual premium paid into the policy -1-3 percent.

3. Split Dollar Under the Loan Regime

The loan regime follows the rules specified in IRC Sec 7872. Under IRC Sec 7872 for split dollar arrangements, the employer’s premium payments are treated as loans to the employee. If the interest payable by the employee is less than the applicable federal rate, the forgone interest payments are taxable to the employee annually.  In the event the policy is owned by an irrevocable trust, any forgone interest (less than the AFR) would be treated as gift imputed by the employee to the trust. The loan is non-recourse. The lender and borrower (employer and employee respectively) are required to file a Non-Recourse Notice with their tax returns each year (Treas Reg. 1. 7872-15(d) stating that representing that a reasonable person would conclude under all the relevant facts that the loan will be paid in full.

Split dollar under the loan regime generally uses the collateral assignment method of split dollar. In a corporate split dollar arrangement under the loan regime, the employee or a family trust is the applicant, owner, and beneficiary of the policy. The employer loans the premiums in exchange for a promissory note in the policy cash value and death benefit equal to its premiums plus any interest that accrues on the loan. The promissory note can provide for repayment of the cumulative premiums and accrued interest at the death of the employee.

Switch dollar is a method of split dollar life insurance that commences using the economic benefit method and then converts to the loan regime when the economic benefit costs become too high.

IV   Strategy Example

 A.     The Facts

Joe Smith, age 50, is a partner is a plaintiff’s law firm. The firm’s partnership agreement provides that the partner who wins a trial gets a 60 percent compensation credit on the contingency fee with the remaining partners getting a 20 percent compensation credit. The firm allocates the remaining 20 percent to cover the firm’s fixed expenses and to fund future cases. His combined marginal tax bracket for federal, state and city purposes is 40 percent.

Joe recently settled a product liability case with a $60 million settlement. The fee agreement provides for a $19.8 million contingency fee to the firm. Joe receives a compensation credit equal to $11.88 million.

Solution

During the course of settlement discussions, the firm, claimant, and defendant agree to create a QSF. The defendant likes the fact that it can take a deduction for its transfer of insurance proceeds to the QSF rather than taking a deduction as the claimant receives payment. The firm petitions the probate court in the firm’s hometown to issue an order authorizing the creation of the QSF.

The Smith Family Trust is an irrevocable trust designed to provide multi-generational benefits to Joe’s wife, children and grandchildren. The trustee of the family trust is the applicant, owner, and beneficiary of a private placement life insurance policy insuring Joe’s life. The policy will have premiums of $2.5 million per year for 4 years for a total of $10 million. The policy will have a death benefit of $40 million.

The policy will be funded by the trustee of the QSF. The trustee of the QSF enters into a collateral assignment split dollar arrangement with the trustee of the Smith Family Trust. During the first ten years of the arrangement, the split agreement will use the economic benefit arrangement and then switch to the loan regime. The average annual economic benefit (tax) cost during the first ten years of to Joe is $50,000. This is the cost for both income and gift tax purposes each year. During that time, the QSF has an interest in the policy cash value and death benefit equal to the greater of the policy premiums or cash value.

At the end of Year 10, the trustees agree to switch to the loan regime. The trustees terminate the collateral assignment agreement in exchange for a promissory note equal to the cumulative premiums paid to date, $10 million. The cash value in the policy at the end of Year 10 is $20 million. The interest rate on the loan is the long-term AFR which is 2.34 percent per year. The interest is capitalized and added to the promissory note.  The annual interest charge added to the policy is $234,000 in year. Ultimately, a portion of the death benefit equal to the accumulate principal and interest will be repaid to the QSF. This repayment will be paid to Joe’s wife and family in a lump sum or on installments.

The trustee of the Smith Family Trust takes a tax-free policy loan of $1 million per year beginning in Year 10 and distributes the proceeds to Mrs. Smith who is a discretionary beneficiary of the Trust. The distribution is also tax-free.

In the event of Joe’s death, the death proceeds ($40 million) are income and estate tax-free. At death, the trustee of the Family Trust will reimburse the trustee of the QSF in amount equal to $10 million (cumulative premium) plus any accrued interest. Lastly, Joe’s estate will be paid $10 million in a lump sum as payment for the original compensation paid to the SQF, the contingency fee. This payment is taxable income to the estate.

Summary

The ability to use QSFs as a funding vehicle for other trust investments that provide tax-free benefits for trial attorneys is more than compelling. The results dramatically exceed those found in a typical structured settlement annuity arrangement for trial attorneys.

This article focuses on one version of a new concept- structured settlement life insurance for trial attorneys. The technique uses an investment by the trustee of the QSF to fund a split dollar arrangement with the trustee of the trial attorney’s family trust. The arrangement funds a PPLI contract.

This strategy uses an executive benefits strategy- split dollar life insurance that has been used by virtually every Fortune 1000 company in the Land. The program provides tax-free retirement income,’ tax-deferral and a substantial income and estate tax free death benefit for the trial attorney and his family. On top of those substantial benefits, the trial attorney’s family receives a final lump sum (equal to the original contingency fee benefit) from the QSF when the trial attorney dies.

The next installment (Part 6) will focus on a few different versions of structured settlement life insurance for trial attorneys. Stay tuned!