Most of you know by now that I grew up in the Panama Canal Zone which no longer exists as of 1999. In that respect, the transition left me as a man without a country. My father (of blessed memory) when referring to kids raised in the Canal Zone, always said that it was the only country that we ever knew. In the case of my own family, we rarely came to the United States because we were active in competitive sports during the summers of our youth.
I have previously posted that Zonians celebrate this connection to the Canal Zone with a reunion every year. This may be the only country that we knew growing up, but it does not mean that we weren’t patriotic Americans.
This patriotism is best demonstrated than military service. I have surmised in my quirky ways that the Canal Zone high schools – Balboa High School on the Pacific Ocean side of the Canal Zone and Cristobal High School on the Atlantic Ocean side of the Canal Zone – sent the largest numbers of students to the U.S. service academies of any American high school on the Planet. I went to Balboa High School up to the 10th grade before I transferred to Culver Military Academy. My football team had five students who went to various service academies. I estimate the number of service academy appointments as 12-15 in the time period 1976-1978. Not bad!
Recently I wrote about Family Owned Life Insurance™ (or Family Office Life Insurance™) or FOLI™ as a planning solution for ultra-high net worth investors to structure investments tax efficiently on an inter-generational basis. The benefits are quite simple and compelling. Investment assets accumulate tax-free and may be distributed to beneficiaries tax-free. Policy death benefits can be paid to generation skipping trusts income and estate tax-free.
This segment focuses on a companion solution to FOLI™ called FOLA™ or Family Office Life Annuity™. The solution utilizes a private placement group variable deferred annuity which provides for tax deferral. I have written previously about the concept of a Dynasty Annuity, e.g., a deferred annuity that could allow a family trust to accumulate investment income on a tax deferred basis for generations.
The concept is relatively straight-forward. A multi-generational trust may own a deferred annuity without violating the tax rule regarding ownership by a non-natural person, i.e., a trust. Since the trust has individual beneficiaries, the non-natural person rule of IRC Sec 72(u) is not violated, allowing for tax deferral within the Trust.
The FOLA™ annuity is a group annuity issued to the Trust. The FOLA™ has a large group of annuitants (measuring lives). The annuitants do not have any rights under the Policy. In my view, the insurable interest rules of life insurance do not apply to annuities. In a trust-owned annuity, the death of an annuitant triggers the need for a distribution of the annuity under IRC Sec 72(s). If a policy had ten annuitants, the death of a single annuitant would necessitate the need to distribute ten percent of the account value in a lump sum within five years of the annuitant’s death or over the life expectancy of the oldest beneficiary of the Trust.
The Policy allows for customized investment options. The combination of institutional policy pricing, and investment flexibility and tax deferral across the lives of many annuitants, provides for favorable tax deferral for many decades.
Like PPLI, PPVA is an institutionally priced variable deferred annuity that is offered exclusively to accredited investors and qualified purchasers. PPVAs also provide for tax-deferred accumulation, with the proviso that withdrawals are treated as income (as compared to return-of-principal) first and that there is a 10% penalty tax on withdrawals prior to age 591/2 (subject to certain exceptions). There are no policy loans and death benefits are not income tax free.
Many wealthy families have been successful accumulating wealth in multi-generational trusts such as Dynasty or generation skipping trusts. These trusts are very efficient for wealth transfer tax purposes but not necessarily for wealth accumulation purposes. For example, the level of trust investment income required to trigger the top marginal income tax bracket is quite low, $9,300. Therefore, tax efficient let alone tax advantaged wealth accumulation is a planning objective for Dynasty Trusts particularly as trustees continue to make larger allocations to hedge funds.
The application of the FOLA™ strategy is readily available considering the large amount of wealth transferred to irrevocable trusts through such techniques such as Sale to an Intentionally Defective Trust and Charitable Lead Annuity Trusts that revert to irrevocable trusts.
Retail Deferred Annuities versus PPVAs
The domestic retail market for variable deferred annuities currently has $2.1 trillion of assets under management. According to the National Association of Variable Annuities, the average annual cost of a deferred annuity is approximately 140 basis points not counting fund expenses.
The average annual cost of a PPVA with a $1 million account balance is approximately 50 basis points.
The greater difference between retail variable annuities and PPVAs is the degree of investment flexibility. Retail annuities almost exclusively feature registered funds that are very similar to mutual funds. PPVA contracts may feature alternative investments- real estate, hedge funds, LBO, and private equity.
Most states have relaxed the investment liquidity requirements of PPVA contracts to accommodate less liquid investment strategies. PPVAs may also incorporate registered funds on a customized basis as well to provide a complete array of investment options.
PPVA and Tax Considerations
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) age 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 reviewed this issue with respect to trusts at least eight times in Private Letter Rulings (PLR9204014, PLR199905013, PLR199933033, PLR199905015) has ruled favorably for the benefit of the taxpayer in each instance.
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 for the trust-owned annuity. At death, the annuity account balance may be paid out over the life expectancy of the beneficiary providing additional deferral.
The Solution – FOLA™
The solution to the problem of accommodating the problem of medical underwriting and the lack of reinsurance availability for PPLI is the FOLA™. The FOLA™ involves the purchase of a group PPVA contract by the Trustee of the Family Trust. The trustee selects young annuitants 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. The steps of the transaction can be summarized as follows:
1. Purchase of a PPVA Contract. The trustee of the Family Dynasty Trust is the applicant, owner, and beneficiary of a PPVA contract(s).
2. 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 living to normal life expectancy 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.
FOLA™ Strategy Example for John Doe Children’s Trust
The trustee of the children’s trust is the applicant, owner, and beneficiary of a group PPVA contract for each of the Doe children. The group PPVA contract features twenty five annuitants comprised of all of the family members and family office employees. No annuitant has any of the policy rights or benefits under the Policy. The death of an annuitant will only impact approximately four percent of the account value for the payment of a death benefit under the Policy. The Policy provides for the discretion to distribute and recontribute the death benefit to the Policy.
The PPVA contract issued by Acme Life Assurance Company (Acme) will feature at least two different investment options within its Private Placement Memorandum (PPM) – (1) Acme Money Market Account and (2) Customized Investment Account (“Customized Account”). An independent investment advisor that manages funds for the Doe Family will manage a diversified portfolio within the PPVA contract. The Customized Account will be structured as an insurance dedicated fund.
All of the investment income and gains from the Customized Account will accrue within the contract on a tax deferred basis. Prior to the death of the annuitant, the trustee may request a distribution from PFLAC 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 ownership of PPVA contracts is a powerful wealth accumulation technique. In the present case, the trust is taxed as a grantor trust. Upon the death of the grantor, the trust will be taxed based on trust brackets. The income threshold for the top bracket is very low- $9,3000. The PPVA is an institutionally priced variable deferred annuity contract that provides investment flexibility in a manner that is not available. The ability to structure the trust owned PPVA contract based upon the life of the annuitant using a young life with a long life expectancy is a powerful wealth accumulation mechanism as a result of achieving tax deferral for up to 60-80 years in the present case.
While it can be argued that life insurance under tax rules provides the best tax treatment, variable deferred annuities are no “slouch” when it comes to tax benefits. FOLA™ provides a tax structuring set up for decades of tax deferral within Dynasty Trusts.