(Click here for Blog Archive)
(Click here for Blog Index)

(Presentations in this blog were created using the InsMark® Illustration System)

Specimen implementation documents for the Dual Security Plan are now available in InsMark’s Cloud-Based Documents on a Disk in the Business Owner Benefit Plans section.

We had an exceptionally positive reaction at the recent InsMark Symposium for our new Dual Security Plan, and I want to introduce you to the specifics of it.  Bear with me while I explore some tax facts – it will be well worth your time when you get to the Case Study.  I debated getting to the tax issues later in the Blog, but I think you need to know them in advance; otherwise, “too good to be true” may overwhelm you.  It is fact-based once you understand the moving parts.

If you want to read details about the plan first, skip down to the Case Study and then return here to review the analysis involving uncomplicated sections of the Internal Revenue Code.

Tax Analysis

The tax issue involves cash value life insurance owned by a Partnership, LLP, or LLC on the life of a partner or member for buy-sell and/or indemnification purposes.  If the policy is transferred to the insured partner or member at retirement, what are the income tax consequences to both parties?

Each of the three entities noted above can elect taxation as a partnership, an S corporation, or a C corporation.  Virtually all of them choose partnership taxation.  The Dual Security Plan as outlined below only works for LLCs, LLPs, and Partnerships that make the partnership election.

The Internal Revenue Code (IRC) sections governing partnership distributions is different from the one governing corporations.  When a C or S corporation distributes a life insurance policy to an employee, the corporation recognizes gain as if it sold the policy for its fair market value.  When partnership taxation is involved, the general rule is one of deferral, i.e., no gain is recognized (IRC Sec. 731(b)).

The partner (or member) receiving the policy recognizes no gain (IRC Sec. 731(a)).  Instead, any gain is recognized only if the partner (or member) surrenders, lapses, or sells the policy.

In other words, the Partnership’s (or LLC’s or LLP’s) basis is transferred to the partner (or member), and the transfer has no tax consequences to either party.¹

¹The partner’s (or member’s) basis in the policy cannot exceed the adjusted basis of his/her interest in the business (IRC Sec. 732(a)).  Post-retirement cash flow activity by the partner (or member) typically involves policy loans which are not taxable events and do not affect basis, so the transferred policy’s basis is generally of no consequence unless it is surrendered, lapsed, or sold in a life settlement transaction.

There is no income tax due on the death proceeds of the life insurance.  The foundation for this special treatment is IRC Sec. 101(a)(1).  This statute provides that the proceeds of life insurance maturing as a death claim are exempt from federal income tax.  This exemption applies to the full death benefit, including any cash value component whether loans exist or not.

Modern life insurance policies are designed to last until age 120 or the prior death of the insured.  The avoidance of income tax entirely is the secret sauce to the effectiveness of the Dual Security Plan – based on the following steps:

• The Partnership, LLP, or LLC purchases life insurance on selected partners (or members) for needed buy-sell purposes.  With some plans, the death benefit is exclusively allocated to indemnify the business against the loss of the member (or partner); some arrangements use both strategies;
• Maximum-funded cash value life insurance is paid for by the Partnership, LLP, or LLC;
• No premiums are scheduled after retirement;
• Policy ownership is transferred to each partner (or member) by way of a K-1 distribution at retirement (or at a different date or event if agreeable to all parties to the transaction);
• Each partner (or member) uses secured policy loans in post-retirement years to produce tax free retirement cash flow;
• Each partner (or member) keeps the policy in force until death.

Case Study

Roger Bartlett, age 45, is one of the key members of McLean Auto Group, LLC.  The firm has decided that a Dual Security Plan is appropriate for several members.

Below is a flow chart of Roger’s transaction:

Image 1

Flow Chart

Source: Dual Security Plan module in the InsMark Illustration System.

Below are the LLC’s values during Roger’s pre-retirement years.

Image 2

LLC’s Values

Source: Dual Security Plan module in the InsMark Illustration System.

Below are Roger’s personally-owned, illustrated values beginning at his age 65.

Image 3

Roger’s Retirement Values

Source: Dual Security Plan module in the InsMark Illustration System.

Click here to see the full illustration.

Conclusion

Most of you have access to Partnership, LLP, and LLC clients and prospects who will want to take advantage of this buy-sell / retirement plan combination.  Many such pass-through firms will realize an increase in net profits starting in 2018.  This increase arises from the Section 199A deduction contained in the Tax Cuts & Jobs Act of 2017 which may conveniently provide a steady source of funds for installing Dual Security Plans for multiple partners and members.

As you locate potential firms for the Dual Security Plan, be sure to inquire initially as to their selected method of taxation.  Occasionally you will find a few that have elected C or S corporation tax status, and you need to know this before you spend time presenting a Dual Security Plan that won’t work.²  In addition, if partnership taxation applies, the firm’s CPA is the best source to advise you if the Partnership, LLP, or LLC is eligible for the Section 199A deduction contained in the Tax Cuts & Jobs Act of 2017.

The Dual Security Plan illustration module is available on the Executive Benefits tab in the InsMark Illustration System.  Also included in the same location is a module for Composite illustrations for multiple lives.  Sample Illustrations in the System includes examples for both.

²An alternate solution for owner-employees of C and S corporations and non-owner key employees of any business entity is Executive Trifecta® also available in the InsMark Illustration System.

Specimen Documents

InsMark’s Cloud-Based Documents On A Disk™ (“DOD”) has specimen documents for the Dual Security Plan in the Business Owner Benefit Plans section.  DOD also has several buy-sell specimen document sets for use by LLCs, LLPs, and Partnerships.  When using the policies created by a Dual Security Plan to fund the purchase of a partner’s or member’s interest, you may want to consider use of the Entity Buy-Sell variations particularly if multiple partners or members are included.  In any event, you must always make certain to obtain the approval of a client’s legal and tax advisers regarding the implementation or modification of this plan as well as the applicability and consequences of new cases, rulings, or legislation upon existing or impending plans.

Note: If you are not licensed for DOD, the link in this section will take you to the DOD product site.  If you are licensed for DOD, go to www.insmark.com and select “My InsMark” from the home page for access to the full version of DOD.

Licensing InsMark Systems

To license the InsMark Illustration System or Cloud-Based Documents On A Disk, visit us online or contact Julie Nayeri at Julien@insmark.com or 888-InsMark (467-6275).  Institutional inquiries should be directed to David Grant, Senior Vice President — Sales, at dag@insmark.com or (925) 543-0513.

Creating Similar Presentations

If you would like some help creating customized versions of the presentations in this Blog for your clients, watch the video below on how to download and use InsMark’s Digital Workbook Files.

Files For This Blog

Before downloading and reviewing any files, be certain you have installed the most current update to your InsMark Systems.  Do this using Live Update available under Help on the main menu bar of the System or this icon on the main menu bar: Note:  If you are viewing this on a cell phone or tablet, the downloaded Workbook file won’t launch in your InsMark Systems.  Please forward the Workbook where you can launch it on your PC where your InsMark System(s) are installed.

If you obtain the digital workbook for Blog #174, Click here for a guide to its content.

For those not licensed for the InsMark Illustration System who would like to review the case-specific, digital workbook files used for this Blog #174, we will be pleased to provide you with a complimentary 30-day installation for the software along with the applicable, digital workbook file for Roger Bartlett’s illustration.  Contact Julie Nayeri at julien@insmark.com or 888-InsMark (467-6275) for details.  (This offer applies to any digital workbook file discussed in any of my Blogs.)

Testimonials

“InsMark is the Picasso of the financial services world — their marketing savvy never fails to amaze me.”
Doug Peete, Past President, Top of the Table, InsMark Silver Power Producer®, Overland Park, KS

“The reason I use InsMark products is because they are so good at explaining financial concepts to all three parties: 1) the producer trying to explain the idea; 2) the computer technician trying to illustrate it; 3) the customer trying to understand it.”
Rich Linsday, CLU, AEP, ChFC, InsMark Power Producer®, Top of the Table, International Forum, Pasadena, CA

“I really thought I knew all the sales techniques that affect my business, but I do now, thanks to InsMark.”
Sam Keck, MBA, CLU, CFP, LUTCF, InsMark Platinum Power Producer®, Financial Planner, Denver, CO

“InsMark has created without question the best suite of software for our industry that has ever existed.  I personally have been using their software for almost 30 years, and it changed my career.  This unique and user friendly software will add many thousands to your income for as long as you’re in business.  InsMark makes me look good, and it will you as well.”
Simon Singer, CFP®, CAP®, RFC®, Past President International Forum, InsMark Platinum Power Producer®, Encino, CA

“InsMark” and “Executive Trifecta” are registered trademarks of InsMark, Inc.

“Documents On A Disk” is a trademark of InsMark, Inc.

 

Important Note #1:  The hypothetical values associated with this Blog assume the nonguaranteed values shown continue in all years.  This is not likely, and actual results may be more or less favorable.  Life insurance illustrations are not valid unless accompanied by a basic illustration from the issuing life insurance company.

Important Note #2:  The information in this Blog is for educational purposes only.  In all cases, the approval of a client’s legal and tax advisers must be secured regarding the implementation or modification of any planning technique as well as the applicability and consequences of new cases, rulings, or legislation upon existing or impending plans.

Important Note #3:  Many of you are rightly concerned about the potential tax bomb in life insurance that can accidentally be triggered by a careless policyowner when policy loans are present and net cash values are so low that the income tax on the gain on surrender (calculated using gross cash values less basis) is more – often significantly more – than the net cash surrender value.

This lurking tax bomb can be present in all forms of whole life and universal life where policy loans of any type are utilized.  It can be avoided, and you, the producer, are key to making sure your clients are aware of how to sidestep it.

A tax bomb can be avoided if the policy is neither surrendered nor allowed to lapse, since the policy death benefit wipes away the income tax liability.  The foundation of this special treatment is IRC Section 101.  This statute provides that the proceeds of life insurance maturing as a death claim are exempt from federal income tax.  This applies to the full death benefit, including any cash value component whether loans exist or not.

Note: It is best if you design the policy with no premiums scheduled after retirement if loans are anticipated in retirement years.  This may require higher premiums during pre-retirement years, but a policy with no premiums scheduled is much more tolerable at advanced ages than one with continuous premiums.

Can your clients remember these facts years into the future?  If they are incapacitated, will family members understand the issues?  It is probably best to file a short note with the policy – something like this (although your compliance officer will likely have preferred language):

If/when you take policy loans on this policy, be sure to talk to your financial adviser before surrendering or lapsing the policy in order to anticipate unexpected tax consequences that may otherwise be avoided.

Does this note make it harder or easier to deliver the policy?  It’s harder if you haven’t discussed it with your client; easier if you have.  And that’s the point – you should discuss it.

Some life insurance companies have concierge units that monitor loan status at the point of lapse or surrender, and you would be well-advised to select an insurance company with this capacity.  To be effective regarding the tax bomb, such carriers need to be proactive in their client relationships, not merely reactive to client inquiries.  I hope that ultimately the policyholder service division of all life insurance companies will bring this potential liability to the attention of those surrendering or lapsing policies, particularly those policies with 50% or more of the gross cash value subject to outstanding loans.