Editor’s Note: Once in a while, Bob will go deeply into an advanced subject on his Blog, and this is one of them. If you have clients who are senior executives with tax exempt organizations like hospitals, colleges and universities, and large charitable organizations, be sure to study this Blog. Otherwise, skip it unless you want to break into this market. If you do see a place for Leveraged Deferred Compensation in your practice, be certain to obtain the approval of a client’s legal and tax advisers regarding its applicability. |
In the last few Blogs (Blog #36, Blog #37, Blog #38, and Blog #39), we have been examining Indexed Universal Life (IUL) in a Case?Study involving Elizabeth Rand, MD, age 40. ?All that has led up to this Blog where she is illustrated using her IUL policy to fund an unusual deferred compensation plan.
Dr. Rand is a Board Certified orthopedic surgeon specializing in sports injuries. ?She is in negotiations with Bay Area Medical Center (“BAMC”) to merge her practice with the hospital. ?Her compensation package is in the high six figures, and she and BAMC are examining ways for her to defer $100,000 a year for five years with the payback in a lump sum at her age 60.
Deferred compensation funded with corporate-owned life insurance is an alternative, but Dr. Rand does not like: 1) its lack of any pre-retirement vesting and 2) that its typical annual retirement benefit is taxed as ordinary income.
InsMark’s Leveraged Deferred Compensation (“LDC”) may provide the answer.
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Dr. Rand will use the loans from the hospital to purchase an indexed universal life policy. ?She is contractually obligated to repay the loans at retirement, and this puts the hospital in a cash flow neutral position as you can see below:
Dr. Rand’s costs include the after tax cost of her payroll reduction plus the net cash flow for the loan interest due to the hospital, as follows:
At the beginning of year 21, BAMC pays Dr. Rand the five years of compensation she has deferred ($500,000) as provided in the severance agreement, and Dr. Rand repay BAMC the outstanding loan balance of $500,000 due on the split dollar arrangement. She is out-of-pocket $225,000 in income tax on the $500,000 severance -- just as she would have been had she received the $100,000 compensation in years one through five.
It has cost her $419,180 over the first 20 years and $225,000 in income tax at the beginning of year 21, a total of $644,180. What has she gained? She now owns the IUL outright and begins accessing its cash values via tax free, participating,?policy loans of $120,000 a year.
Click here to view Dr. Rand’s Leveraged Deferred Compensation illustration. Her net values are illustrated in Columns (5), (6), (7), and (8) on Pages 3 - 5. And note on Page 9 that the arrangement provides her with a pre-tax equivalent rate of return of 15.24%. Be certain also to review Page 14 to see the interplay of bonuses and loan interest that determine her net cash flow relative to loan interest payments. It is assumed that the source of the bonus funds are from an overall annual bonus that Dr. Rand receives. For those wanting to eliminate this bonus arrangement, Dr. Rand may choose to pay the loan interest. ?In this case, her pre-tax equivalent rate of return reduces to a still substantial 13.80%.
Below is a graphic of her overall results:
Note that Dr. Rand is illustrated receiving $4,800,000 in after tax cash flow from age 60 to 100 ($120,000 x 40 years) with residual value in the policy of $6,357,060.
Key question: ?Could she have improved those results by taking the $100,000 of compensation in years one through five, paid her $45,000 in taxes, and invested the resulting $55,000 each year over the first five years?
To calculate this, we need to compare all of Dr. Rand’s costs for the Leveraged Deferred Compensation ($644,180) with just the total of the after tax compensation she could invest if she takes the compensation ($55,000 x 5 = $275,000).
Let’s go to two corners of InsMark Systems that many of you don’t know exist.
Step 1.
Each of our executive-owned benefit plans allows you to export the executive’s share of the benefit plan to InsMark Source Data Storage. ?You can do this by clicking on this icon on the lower right of your benefit module’s Workbook Window while in edit mode:
Step 2.
One of the most popular modules we have for comparing alternatives is “Various Financial Alternatives”, located in the InsMark Illustration System. ?But that won’t work in this case because it only compares equal costs. ?A sister module to Various Financial Alternatives is “Other Investments vs. Your Policy” also located in the InsMark Illustration System.
We will import Dr. Rand’s share of the benefit plan noted in Step 1 into the Other Investments vs. Your Policy module by clicking on this prompt that appears on the lower right of this module’s Workbook Window while in edit mode and selecting the benefit data created in Step 1:
That benefit data will now be resident in the Other Investments vs. Your Policy module which has a very useful prompt in the upper right corner of the Investment Detail tab that allows you to schedule completely different funding costs for the alternative investment:
If Dr. Rand invests the $55,000 in after tax funds in years one through five in an equity account, that account must furnish $120,000 in after tax cash flow from her age 60 to 100 with residual value of roughly $6.3 million at age 100 to compete with the Leveraged Deferred Compensation illustration. So we will use the “Schedule” prompt to input a $55,000 investment for five years with annual after tax withdrawals of $120,000 from age 60 to 100.
The assumptions we used for the equity account are (note that, due to the dividend, the overall yield is 100 basis points higher than the IUL):
Growth: ?7.50%
Dividend: 1.00%
Sales Charge: 0%
Mgt. Fee: ?0.75% (unusually low -- most advisers charge 1.00% to 1.50%)
Income Tax: ?45% (including a provision for state capital gains tax)
Capital Gains and Dividend Tax: ?25% (including a provision for state taxes)
Realized Gains That Are Short-Term: ?30% (generous)
Realized Gains That Are Long-Term: 70% (equally generous)
Portfolio Turnover: ?10% (unusually low -- assumes an index-type fund)
Below are the results of the comparison for Dr. Rand. Notice the shortfall in after tax cash flow from the equity account highlighted by the left side arrow due to the equity account running out of gas at her age 68.
Click here to view the full comparison illustration.
Some may say that the comparison should be between what the Leveraged Compensation Plan costs Dr. Rand and how those numbers compare when invested in the same equity account. That’s reasonable, so using the same equity account assumptions as above, those results are below.
Note: This time we selected this prompt:
Again we have a shortfall in after tax cash flow from the equity account highlighted by the left side arrow due to the equity account running out of gas at her age 76.
Click here to view the full comparison illustration.
How can the IUL work out so well? Two reasons:
1. Its participating loans create a significant amount of favorable interest rate arbitrage.
2. If you measure all the factors that can retard the growth of an equity account compared to what retards the growth of an IUL policy (mortality charges and expenses), the IUL will typically come out the winner every time -- except over short term durations where the commission loads of the IUL have not had time to be absorbed.
Final Questions:
Will Leveraged Deferred Compensation work for any executive of a Tax Exempt Organization? ?Yes; however, in my opinion, it works best for senior executives?of tax exempt organizations like hospitals, colleges and universities (think coaches), and other large charitable organizations.
Will Leveraged Deferred Compensation work for non-owner executives of any profit-making entity (C corporation, S corporation, LLC, Partnership, Sole Proprietorship)? ?Yes.
Will Leveraged Deferred Compensation work for owner-executives of C corporations? ?Yes.
Will Leveraged Deferred Compensation work for owner-executives of S corporations or member-executives of LLCs or partners of Partnerships? ?No, there would be no point in using it with a pass-through tax entity.
Tax Authority for Leveraged Deferred Compensation:
The funding mechanism of Leveraged Deferred Compensation is Loan-Based Split Dollar which is authorized by the 2003 Final Split Dollar Regulations (Treas. Reg. §§1.61-22, 1.83(e), 1.83-6(a)(5) and 1.7872-15). The fact that funding of the plan is assisted by an executive’s compensation reduction that is subsequently recovered by way of a valid severance agreement should be irrelevant.
In all cases, the approval of a client’s legal and tax advisers must be secured regarding the implementation or modification of this planning technique as well as the applicability and consequences of new cases, rulings, or legislation upon existing or impending plans.
Specimen Documents:
Specimen documents (including specimen severance agreements) are available for Leveraged Deferred Compensation in Version 21.0 (and higher) of InsMark’s Documents On A Disk™ under Key Employee Benefit Plans (in the Employer-Sponsored Split Dollar Plans section of documents).
For licensing information regarding the Leveraged Compensation System, the InsMark Illustration System, and Documents On A Disk™, 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.
If you are licensed -- or become licensed -- for the Leveraged Compensation System and the InsMark Illustration System and would like to review the data input we used for Dr. Rand’s analysis, please email us at bob@robert-b-ritter-jr.com, and we will get the Case Data files (Workbooks) right out to you. ?Be sure to ask for both Workbooks associated with Blog #40: Leveraged Compensation.
Testimonial:
“Thanks to the genius of Bob Ritter and InsMark, I was able to complete two cases in the last few months using the InsMark Leveraged Compensation System. ?Annual premiums total was over $90,000. Before reaching out to Bob, I struggled with conceptualizing and communicating this new deferred compensation logic to the business owners and their key employees. ?With the InsMark software, the compelling case logic was immediately obvious to everyone. ?In addition, the software is easy to learn and use.”
Glenn A. Main III, InsMark Power Producer®,
The Main Point LP,
Pittsburgh, PA
