United States: The Dynasty Annuity – Achieving Tax Deferral For High Net Worth Families In Family Trusts Using Variable Annuities

Last Updated: October 15 2014
Article by Gerald Nowotny

I Overview

The expiration of the Bush tax cuts on December 31, 2012 resulted in an increase in the top marginal income tax bracket to 39.6 percent. Additionally, a new Medicare tax related to new federal healthcare provisions added an additional 3.8 percent tax on unearned income in excess of $250,000. The long term capital gain rate increased to 20 percent. Dividends are taxed at twenty percent for federal tax purposes. When you add the impact of state taxes, pretty soon the numbers add up!

Since the mid-1990's, estate planners have employed a series of planning techniques to transfer taxpayer wealth outside of a taxpayer's taxable estate. These strategies focused primarily on the estate tax consequences of taxpayers. The use of grantor trusts proliferated allowing an asset to be transferred outside of the taxpayer's estate for estate tax purposes while allowing the taxpayer to remain the owner of trust assets for income tax purposes. This planning allowed the taxpayer as settlor of the trust to pay the income taxes associated with trust income without depleting trust assets to pay the tax liability, and without the payment of income taxes considered as an additional gift to the trust.

The increase in personal marginal tax rates makes grantor trusts more onerous to trust settlors. In my personal experience, trust settlors groan every step of the way regardless of the planning logic and sense of grantor trust planning. In either event, the payment of taxes by the grantor of the trust is still an erosion of family wealth whether the income generating asset is inside or outside of the taxpayer's estate. No taxpayer is content with the idea that the taxing authorities have only part of his personal wealth when additional taxation could have been minimized.

Since 1981, the unlimited marital deduction became part of the federal estate tax. Marital trust planning became the norm in will and trust planning. Inevitably, all grantor trusts become non-grantor trusts. The lesser known tax problem is the income tax treatment of non-grantor trusts ("NGTs"). NGTs hit the top marginal tax bracket at only $11,200 of annual income. The top marginal federal bracket for trusts is 39.6 percent. Marital trusts, credit shelters, and dynasty trusts are taxed as NGTs. Income tax planning for NGTs is rarely much of a planning topic discussed by estate planners.

This article addresses the use of private placement variable deferred annuities (PPVA) as a vehicle to maximize tax deferral of trust assets. Due to the unique rules regarding trust-owned annuities, an excellent planning opportunity exists for taxpayers to maximize and extend tax deferral on trust assets for multiple generations. This issue has become increasingly important as wealthy individuals and family offices have allocated a larger percentage of family investment assets to hedge fund strategies which primarily generate short term capital gain income taxed at ordinary rates. The author refers to this type of arrangement as a "Dynasty Annuity".

II What is a Variable Deferred Annuity?

The author is not certain "when" and "why" variable deferred annuities garnered such a bad reputation with the financial press. When did tax deferral become such a bad thing? Most likely this negative sentiment is due to variable annuity product pricing and sales loads. It is rare in the author's experience to find an ultra-high net worth client owing a variable annuity contract.

In spite of volatile public equity markets, the retail variable annuity marketplace according to The Annuity Fact Book has $1.5 trillion of assets under management. These products are sold on an after tax basis to individuals as well as retirement plans – 401(k) and 403(b). The variable annuity industry has competed ferociously with the mutual fund industry. In the face of market volatility in recent years, the variable annuity industry has responded with strong contractual guarantees for policyholders. The result of these product features is strong sales of $158 billion in 2011.

A variable deferred annuity contract is an insurance contract that provides for the payment of an annuity in the future. The assets supporting the future annuity payments are tied to the investment performance of investment funds held in the insurance company's separate or segregated account. These investments are not part of the insurer's general account assets which are subject to the claims of the insurer's creditors. The investment performance is a direct pass-through to the policyholder. The typical retail variable annuity has 5-8 years of declining surrender charges and compensates the agent through his broker-dealer, four-six percent of contract premiums.

The policy has two levels of fees – insurance contract fees and investment fund fees. At the contract level, the life insurer charges a mortality and expense ("M&E") of approximately 125-150 basis points per annum. This load is the primary profit load for most insurers. Most states do not impose a premium tax unless the annuity is "annuitized", i.e. converted to a stream of monthly payments. Each variable sub-account investment option imposes another level of fees for investment expenses. These investments are very similar to mutual funds and impose similar charges based upon the underlying investment strategy.

III What is a Private Placement Variable Deferred Annuity Contract?

Unlike retail product options, PPVA contracts maximize the benefits of tax deferral with institutional pricing and sales loads. The policies have no surrender charges and the contract's investment options may include sophisticated investment options such as hedge funds. The contract also pays the agent through the agent's broker-dealer an asset based asset charge of 25-35 basis points. PPVA contracts with its customized and negotiated sales loads generally are equal to 1-2 percent of premiums. Unlike life insurance where premium taxes are a percentage of each premium payment (1.5-2.5 percent), variable annuities in most states are typically owned and are only paid when the contract is annuitized.

The investment flexibility and range of investment possibilities make PPVA contracts an ideal vehicle for registered investment advisors to utilize as part of the investment planning process. The contract is ideally suited for managing asset classes that generate ordinary income such as interest, dividend, and short-term capital gain income. PPVA contracts may have alternative investments such as hedge funds, commodities and private equity as part of the fund options in the PPVA's private placement offering memorandum (PPM). The PPM may be amended as needed by the insurer in order to add new investment options to the contract.

IV Tax Law Considerations

A. Taxation of Variable Annuities

The taxation of annuity contracts is governed by IRC Sec 72. PPVA contracts are also subject to the same investment diversification and investor control considerations as retail variable life and annuity contracts under IRC Sec 817(h) and Treas. Reg. 1.817-5.

The primary planning benefit of variable deferred annuities is tax deferral. A variable deferred annuity contract has an owner, a beneficiary, and an annuitant. The annuitant is the measuring life for payments in the event the annuity is annuitized. Distributions from the annuity are treated as "amounts not received as an annuity", payments of interest only, or as "annuity" payments.

The term "annuity" includes any periodic payment resulting from the systematic liquidation of a principal sum. The term "annuity" refers not only to payments for the life of the annuitant, but also to installments that do not have a life contingency such as a fixed period of years. Under IRC Sec 72, a portion of each annuity payment is excluded from gross income as a return of the policyholder's cost basis in the contract and the balance is treated as interest earned on the investment taxed at ordinary rates.

The calculation of the exclusion ratio is slightly different than it is for a "fixed" or non-variable annuity. The exclusion ratio for a variable annuity is determined by dividing the investment in the contract (basis) by the number of years of expected payout. The exclusion ratio treats part of each annuity payment as a return of principal. All annuity payments are fully taxable once the investment in the contract is recovered.

Payments consisting of interest only payments are not annuity payments and not taxed under the annuity rules. Periodic payments on a principal amount that are returned intact are interest payments. Any other payment that is not an "annuity" payment or an interest payment is treated as an "amount not received as an annuity". An "amount not received as an annuity" is taxed under the "last in, first out" or LIFO rule is taxed to the extent of investment income within the contract.

Premature distributions from the contract are subject to a ten percent penalty tax. These payments are applicable to payments before the taxpayer becomes age 59 ½. A number of exceptions apply to the ten percent early withdrawal penalty rule including disability; a pension annuity, i.e. owned by a qualified retirement plan; death of the policyholder; an immediate annuity payment that provides for a series of substantially equal period payments, and a structured settlement annuity.

The Non-Natural Person Rule of IRC Sec. 72(u) provides that deferred annuities lose the benefit of tax deferral when the owner of the deferred annuity is a non-natural person. The legislative history of IRC Sec. 72(u) and IRC Sec. 72(u)(1)(B) provide an exception for annuities that are "nominally owned by a non-natural person but beneficially owned by an individual". This rule describes the typical arrangement in a personal trust. The IRS has ruled on this issue with respect to trusts at least eight times in Private Letter Rulings (PLR9204014, PLR199905013, PLR199933033, and PLR199905015 et al) and has ruled favorably for the benefit of the taxpayer in each instance.

At the death of the policyholder, the gain in the contract is subject to taxation at ordinary rates. The beneficiary will not be taxed on a lump sum basis if the beneficiary elects within sixty days after the policyholder's death, payment under a life contingency or installment option. If the policyholder dies on or after the annuity start date and the entire contract has yet to be fully distributed, the remaining balance must be distributed at least as rapidly as the method being used at the time of the policyholder's death. If the policyholder dies before the annuity start date, the contract must be fully distributed within five years of the policyholder's death. If the policyholder's spouse is the beneficiary of the contract, the distribution requirements are applied by treating the spouse as the owner.

IRC Sec. 72(s)(6) deals with the distribution requirements of an annuity that is owned by a non-natural person (e.g. a trust). It provides that the death of the primary annuitant is the triggering event for required distributions from the annuity contract. The primary annuitant must be an individual. Distributions must begin within five years following the death of the primary annuitant.

B. Product Taxation of Variable Insurance Contracts

The taxation of variable insurance products is covered in IRC Sec 817(h). Treasury regulations 1.817-5 provide a detailed overview of the investment diversification requirements of variable insurance products. The regulations address a wide range of investment alternatives that are not found in retail variable annuity products such as direct investment in real estate, and commodities. The reason for this is addressed in the author's recent article in this Journal dealing with private placement group variable deferred annuity contracts for institutional investors.

IRC Sec 817(h) provides that investment diversification is tested separately in each fund within the policy. No single investment may represent more than 55 percent of the fund; two investments 70 percent; three investments 80 percent; and four investments 90 percent. Therefore, a fund must have at least five investments in order to meet the diversification requirements. The cliché "the devil is in the details" is a fitting statement to describe the application of the rules.

In an annuity contract, it is the policyholder (owner) that has the ability to control and manage the incidents of ownership associated with the policy. One of the incidents of ownership is the ability to control the investment decisions or fund selection within the policy. Two notions of investor control exist. The first notion is the subject of several rulings and cases dealing with "wrapping" publicly available investments.

The Service has ruled a number of times regarding the ability of a taxpayer to "wrap" investments that are "publicly available", i.e. not limited exclusively to life insurance company separate accounts, and ultimately decided in Christoffersen v. U.S., that the taxpayer and not the insurance company should be taxed on the policy's underlying income.

The second notion of the investor control doctrine is the more sinister problem. It deal with the idea that a policyholder retains so much direct or indirect control over investments that the policyholder is deemed to be in constructive receipt of the underlying investments within the policy. The consequence of this problem is that the policyholder forfeits the substantial tax advantages of life insurance and annuities. The determination of what constitutes investor control for tax purposes is a fact specific determination.

On a certain level the investor control is somewhat of a mystery. It is not a tax issue that has or has not seen much notice. A number of tax practitioners are of the belief that the investment diversification rules of IRC Sec 817(h) and Treasury Regulations, 1.817-5 were designed to replace the investor control doctrine. A number of practitioners would love to litigate the issue but not at the risk of making their clients famous, as the saying goes. The IRS does not agree with this point of view. This discussion is observed in the commentary of Internal Revenue Bulletin 2005-12.

The Service updated these rulings with the issuance of Rev. Rul. 2203-91 and Rev. Rul. 2003-92. These rulings dealt with the issue of non-registered partnerships that were not exclusively limited to investment by insurance company separate accounts and the ability to look-through to the underlying investments of these non-registered for purposes of meeting the diversification requirements. Internal Revenue Bulletin 2005-12 (TD9185) announced a change to Treasury Regulation1.817-5(f)(ii) by removing this section pertaining to non-registered partnerships as well as the example to the rule.

V Taxation of Non-Grantor Trusts

Trusts that are not taxed as grantor trusts are taxed as separate taxable entities. In general, marital trusts and most testamentary trusts are non-grantor trusts. Most asset protection trusts are also non-grantor trusts for income tax purposes. Unfortunately, it takes very little investment income to push a non-grantor trust into the top marginal tax bracket - $12,150.

Many wealthy families have generation-skipping trusts that are taxed as non-grantor trusts. A non-grantor trust is a trust that does not fall within any of the provisions of IRC Sec 671-679. The necessary trust provisions in order to classify a trust as a NGT is retention of a power by the settlor to name new trust beneficiaries or to change the interest of trust beneficiaries except as limited by a special power of appointment (ascertainable standard). The settlor's transfer to a trust with this power renders the transfer an incomplete gift for gift tax purposes. The second method to avoid grantor trust treatment is to require the consent of an adverse party on any trust distributions.

The major focus of this article is tax-advantaged wealth accumulation across multiple generations. Many wealthy families and family offices have multi-generational planning as a component of their tax planning. It makes a lot of sense to reduce the "drag" of income taxation along with the avoidance of future estate and generation skipping transfer taxation.

VI Introducing the Dynasty Annuity

The Dynasty Annuity involves the purchase of a PPVA contract by the trustee of the Family Trust. The trustee selects young annuitants (grandchildren or great grandchildren) as the measuring lives of the annuity in order to maximize tax deferral within the PPVA contract. This structure maximizes tax deferral for the over the lifetime of the PPVA's young annuitant(s). In the case of a three year old grandchild, tax deferral could be accomplished for more than eighty years before a distribution is required.

As mentioned in an earlier part of this article, it is the death of the annuitant which triggers the requirement to distribute tax deferred income within five years of the death of the annuitant or over the lifetime of the beneficiary.

The steps of the transaction can be summarized as follows:

A. Purchase of a PPVA Contract - The trustee of the Family Dynasty Trust is the applicant, owner, and beneficiary of a PPVA contract(s).

B. Selection of Young Annuitants - The critical element in the maximization of tax deferral is the selection of a young annuitant(s) with the greatest potential of outliving their normal life expectancy(ies) for each separate PPVA contract. The trustee may purchase multiple policies with different individual annuitants to "hedge" against the possibility of exposing the trust to a tax burden as a result of distribution requirement caused by the pre-mature death of the annuitant.

All of the investment income and gains from the PPVA will accrue within the contract on a tax deferred basis. At any time prior to the death of the annuitant, the trustee may request a distribution from the life insurer in order to make a distribution to a trust beneficiary. At the death of the annuitant, the trustee will be required to make a distribution of the annuity based upon the life expectancy of trust beneficiaries over the life expectancy of trust beneficiaries (presumably the surviving Doe Children).

The approximate cost of the PPVA contract is 40 bps per year. The PPVA contract has the investment flexibility to add investment options to the contract. The Customized Account provides an open architecture allowing the investment advisor to manage based upon its asset allocation model and changes to the model. The PPVA contract is ideally suited to manage trust assets that generate ordinary income.

A ten million dollar single premium invested into a PPVA contract earning eight percent per year over an 80 year period grows to $2.5 billion in the 80th year. This small example illustrates the power of tax deferral compounding over a long time period.

VII Strategy Example

A. Facts

The Jones Family Office was established by Pierre Jones, age 72, following the sale of his technology company to Peachtree Computers for $100 million. Pierre was able to transfer stock to the Jones Family Trust early on before the price of the company was worth much. Southern Trust is the trustee of this trust. The trust is a grantor trust. The trust has $50 million of corpus that is invested in a diversified portfolio. Pierrre's children and grandchildren are beneficiaries of the trust.

Pierre is a resident of New York City. Following the expiration of the Bush tax cuts at the end of 2012, he will be in a combined marginal income tax bracket of 53.4%. The trustee has invested $10 million in a diversified hedge fund portfolio. The portfolio has consistently been returning ten percent net of all fees. The investment income is all short term capital gain income taxed at ordinary rates.

The trustee would like to manage this alternative asset class with a tax-advantaged structure on a long-term basis. The balance of the portfolio is able to generate income for trust beneficiaries.

B. Strategy

(1) PPVA

Southern as trustee of the Jones Family Trust is the applicant, owner, and beneficiary of four PPVA contracts. Each contract is funded with a $2.5 million single premium. The underlying investment within the contracts is a customized insurance dedicated fund managed by the family's investment advisor. The IDF is a customized portfolio that has invested $1 million with ten different fund-of-funds and single strategy hedge funds.

Each annuity contract has a different annuitant. The Jones grandchildren are each named the annuitants of each contract. The ages of each annuitant are 2, 4, 6 and 8 respectively. The annuitant is strictly a measuring life and has no control over contract assets.

Over an eighty year period, the chart illustrates the powerful effect of tax-deferred compounding versus a taxable account. At the death of each annuitant on each separate PPVA contract, the trustee has several choices.

The trustee can take a lump sum distribution resulting in a very substantial taxable event at ordinary rates. Alternatively, the trustee can annuitize the contract and achieve an extended deferral by paying out the account balance over the life of the trust beneficiary(ies). Distributions during lifetime are treated as taxable income and are taxed at ordinary rates. The trust may take a deduction as part of its Distributable Net Income (DNI) and the beneficiary(ies) is taxed on the trust distribution.

The after-tax column reflects the income taxation of the grantor based the combined marginal tax rate.

Male Age 50 - $10.0 Million
PPVA HYPOTHETICAL ILLUSTRATION
Year Net Taxable
Investment

Value @ 53.4%
PPVA End of
Year Policy

Cash Value
PPVA
Death Benefit
Net Taxable
Investment

IRR
Death
Benefit

IRR
1 10,466,000 10,950,000 10,950,000 4.66% 9.5%
10 15,769,141 25,009.530 25,009.530 4.66% 9.5%
20 24,866,497 61,461,121 61,461,121 4.66% 9.6%
30 39,212,263 152,203,127 152,203,127 4.66% 9.7%
40 61,834,267 377,193,992 377,193,992 4.66% 9.7%
50 61,834,267 1,024,074,091 1,024,074,091 4.66% 9.7%
60 97,507,163 2,584,625,676 2,584,625,676 4.66% 9.7%
80 382,347,656 16,463,804,711 16,463,804,711 4.66% 9.7%

VIII Summary

The wealth accumulation potential of the Dynasty Annuity concept is immense. The power of compounding of the tax savings along with the time value of money produces a long-term result that is five –ten times more powerful than its taxable equivalent. The grantor trust has been a sophisticated solution, but the erosion of family wealth due to the payment of income taxes by the grantor has reduced family wealth. In the case of a New York or California resident, the income tax consequences are more onerous than the estate tax consequences currently. Tax-advantaged accumulation produces a much better long-term result. The author submits that a wealthy family will be a lot wealthier if it does not have to pay taxes on certain investment income over several decades.

The non-grantor trust is the taxpayer with the greatest propensity for being heavily taxed. The top marginal tax bracket is reached at only $12,150 of taxable income. How many marital trusts, credit shelter, asset protection trusts and Dynasty Trust face this problem currently?

The reality is that this strategy can be executed with $500,000 of trust principal or $50 million. The Dynasty Trust can perpetuate family wealth from an income, estate, and generation skipping transfer tax standpoint. Inevitably, trustees as part of their asset allocation model will have a reasonable allocation to investment asset classes that are taxed as ordinary income. The flexible investment structure of PPVA provides a platform for customizing investment options on an ongoing basis. The example in this article demonstrates the significant advantage for tax-deferred compounding over a long period of time.

Tax and estate planners have been familiar with the tax advantages of insurance contracts for some time but unfortunately have been limited to fully commissionable insurance contracts suffering from a lack of investment flexibility. Private placement insurance contracts are more than a viable solution to the problem.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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