Today marks the one-year anniversary of my Dad's (Willy Wolfgang Nowotny) passing on November, 17, 2019. My instinct is to be sad, but I choose to remain happy remembering his life with fondness by focusing on where he started and where he ended up.
My Dad was from a small town in the former East Germany about a mile from the Polish and Czech borders on the edge of the former Sudetenland. He came to the U.S. in 1952 as an eighteen-year-old as a refugee sponsored by a former Army Chaplain. My grandmother was widowed with two small children after the war. After watching the guards at the border for two weeks, he made his escape to West Germany and freedom swimming across a river. Of course, he forgot important identification papers and had to retrace his steps and do it a second time.
He was drafted into Uncle Sam's Army in 1953. This was not "Easy Street" right after World War II with his thick German accent and World War II veteran NC0 as his platoon sergeant. He met my mother through her half-brother who played in the same immigrant soccer league before the rest of America knew what soccer was. After the Army, he worked for the federal government and applied for a job in the Panama Canal Zone where he had a fine career as a civil servant. By my age, he was comfortably retired and traveling the World. He managed to visit every continent. While he never liked to talk about his experiences growing up during the War or East Germany after the War, he made up for it later in life become a world class storyteller for the benefit of his grandchildren.
He was another American Dream success story which is something only made in America, never to be stolen by the CCP or USSR or replicated by anyone else. Like many immigrants, he had the courage to risk his life and leave behind everything he knew and loved, for the potential of a better life. This is the life that only eagles dare!
My soccer-playing German father loved American baseball. He was fond of saying when he critiqued my performance and that of my older brother Willy by saying, “I never played the game, but….” The same propensity for giving fatherly advice extended to tax playing by saying “I have no idea what you are talking about but….” This one is for you Pops!
This article addresses the combination of a Malta Pension Plan and the Loan Method Split Dollar Arrangement. Some readers might say, what do these two strategies have to do with each other? Malta Split Dollar is the tax combination of a tax deferral strategy that migrates deferred dollars into tax-free dollars through the Loan Method of Split Dollar using the Leveraged Split dollar Rollout on the backend to terminate the arrangement at a significant discount. Watch, listen and learn!
The Malta Pension Plan
I have written extensively on Malta Pension Plans ("Plan"). The Plan has many similarities to a Roth IRA except that the Plan has no contribution limits and is not restricted to cash contributions. A high net worth taxpayer can contribute appreciated assets to the Plan without triggering taxation on the contribution. The investment advisor within the Plan can sell appreciated capital assets within the Plan without taxation. The investment earnings within the Plan can be reinvested within the Plan and accrue on a tax-deferred basis.
The Plan offers the participant various methods of distributing tax-deferred benefits on a mostly tax-free basis like a Roth IRA. The Plan offers a participant who is at least age 50 to distribute up to 30 percent of the account value on a tax-free basis. The Plan offers the participant the ability to take additional lump sum distributions up to 50 percent of the account value, three years after the lump sum distribution and every year thereafter. The Plan may always make taxable distributions to the participant.
The inevitable tax problem of a deferred compensation asset is that it is ultimately subject to income and estate taxation where applicable. In the Plan, appreciated assets at the time of the participant's death are subject to a one-time mark-to-market tax under IRC Sec 684 at the participant’s death. The tax basis of Plan assets is increased by the amount of taxes paid under IRC Sec 684. The Plan death benefit to beneficiaries receives tax-free treatment. A participant subject to estate taxation also has this tax to deal with.
The combination of both taxes should get the client's attention. The other obvious problem is that the law today may not be the law tomorrow. Consequently, it is difficult to leave all the eggs in one planning basket. The planning consideration is to identify an exit strategy to migrate assets from the Plan tax efficiently. Combining MPP planning with split dollar life insurance creates an opportunity to convert tax deferred dollars into tax-free dollars with respect to income and future estate taxation.
The Loan Method of Split Dollar Life Insurance
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. The Malta Split Dollar technique in the article envisions a Loan Method Split Dollar Arrangement between an investment holding company structured as a Limited Liability Company (LLC) or Limited Partnership (LP) that is wholly owned by the MPP. Additionally, LLC owned within the LLC is the sponsor and lender to the Dynasty Trust. The Loan Method uses the Collateral Assignment Method of Split Dollar. In the Collateral Assignment Method, the Trust (in our case) is the applicant, owner, and beneficiary of the policy. The MPP LLC makes a one-time loan using the long term applicable federal rate which is 1.31% in December 2020. This rate is fixed for the term of the loan.
The loan proceeds of the Dynasty Trust are used to pay life insurance premiums in a Private Placement Life Insurance policy (PPLI) on a Non-MEC basis to preserve tax-favored treatment on loans and withdrawals from the policy for Dynasty Trust beneficiaries. The LLC within the MPP LLC retains an interest in the policy’s cash value and death benefit equal to the value of the loan plus any accrued interest. The Dynasty Trust collaterally assigns an interest in the policy to MPP LLC for its contributions and interest in the policy.
The Malta Split Dollar technique envisions underwriting life insurance on members of the second or third generation in the family. The Dynasty Trust retains the excess cash value and death benefit is paid to the Dynasty Trust during the arrangement. The technique also uses a restricted collateral assignment.
Restricted collateral assignment is the classical form of Split Dollar arrangement utilized by the majority shareholder of a closely held business. Under restricted Collateral Assignment Split Dollar, a restriction is added to the Split Dollar agreement which “restricts” the company’s access in the policy under the Split Dollar arrangement (greater of cash value or premium). The “restriction” limits the company’s access until the earlier of the death of the insured, termination of the Split Dollar agreement, or surrender of the policy.
Overview of the Leveraged Split Dollar Rollout
The Leveraged Split Dollar Rollout™ is a method to terminate an existing Loan Regime Split Dollar™ arrangement at a significant discount from the value of the collateral assignment interest. In the Loan Regime, the business is the lender, and receives a restricted collateral assignment interest in the life insurance policy's cash value and death benefit equal to the value of the loan plus any accrued interest. The collateral assignment interest is restricted until the earlier of the insured's death, termination of the Split Dollar arrangement or surrender of the underlying policy.
The value of the collateral assignment note is potentially discounted due to this restriction. Since the business’s collateral interest is restricted for several years until the death of insured, there is a present value calculation to determine the current value. At some point, the policyholder may decide to terminate the Split Dollar arrangement by purchasing the lender’s restricted collateral assignment interest in the policy. A valuation specialist values the note receivable for valuation purchases. The valuation specialist takes into consideration the life expectancy of the policy’s insured life as well as a discount rate. Due to the restriction, the receivable is likely to be discounted. Following the purchase of the Split Dollar receivable from the lender, the Split Dollar agreement is terminated. The policyholder may use a tax-free policy loan or withdrawal to purchase the note from the lender.
A decent amount has been written in the last several years about Intergenerational Split Dollar life insurance following recent Tax Court litigation in the Cahill, Morrisette, and Cahill cases which used Collateral Assignment Non-Equity Split Dollar and the Economic Benefit Method. These arrangements were private Split Dollar arrangements typically designed to transfer large amounts of value from the taxpayer’s estate at large discounts. I am personally aware of exceptionally large transactions having taken place at obscene (in a good way!) discounts. Supreme Court Justice Potter Stewart in determining a threshold test for obscenity is famously known to have said, “ I shall not today attempt further to define the kinds of material I understand to be embraced within that shorthand description ["hard-core pornography"], and perhaps I could never succeed in intelligibly doing so. But I know it when I see it, and the motion picture involved in this case is not that.”
In Cahill, the taxpayer claimed a 98 percent discount. Come on! How could anyone think that this level of discount wouldn't be challenged by IRS on principle alone? These cases were ultimately about valuation issues versus whether the arrangements were valid Split Dollar arrangements. The cases were largely settled based on horse trading versus legal issues. The Court in each case ruled that the arrangements were valid Split Dollar arrangements. None of these arrangements used the Loan Regime Method of Split Dollar™. The use of the Loan Regime Method of Split Dollar in an employer-employee context is significantly different than the transactions in recent tax court cases involving Intergenerational Split Dollar. First, the use of restricted collateral assignment in the context of business-sponsored split dollar has existed for over fifty years.
The use of private split dollar and particularly the insertion of a restriction in the collateral assignment interest is far more recent. In the early days of Split Dollar life insurance, planners did not realize the valuation planning opportunities created by the restriction in the collateral assignment interest. Valuation in tax planning became much more mainstream in the decade of the 1980’s and 1990’s in the realm of closely hold business interests and family limited partnerships. Second, the tax audit exposure in Intergenerational Split Dollar using private Split Dollar in large estates was almost 100 percent. The audit rate for regular corporations and LLCs that sponsor Split Dollar arrangements is negligible at best (between 0.2-0.5 percent). Third, business Split Dollar has enjoyed significant non-business purposes ranging from employee benefit planning to business succession planning, et al, unlike the Intergenerational Split Dollar transaction which was heavily tax motivated. The IRS has seen and ruled favorably on the use of restricted collateral assignments for controlling shareholders in the employer-employee context for at least five decades for these non-tax driven purposes. Lastly, the Tax Court cases mentioned above were exclusively used the Economic Benefit Method of Split Dollar instead of the Loan Regime.
Strategy Example Using Malta Split Dollar
Hector Heathcoat (Heathcoat), age 51, is the majority shareholder in Acme Technology (Acme Tech), LLC, Acme is a privately held limited liability company. Heathcoat formed a Malta Pension Plan in 2019. He created and assigned a Delaware LLC, Acme Investment Holdings (Acme Holdings) to the MPP. Bob Smith, his CPA, is the manager of Acme. Acme opens an investment account at TD Ameritrade. Acme Technology is being sold and Hector transfers his entire interest in Acme Tech to Acme Holdings which is wholly owned by the MPP. The company is sold for $40 million in an all cash sale. Acme Tech distributes the proceeds to Acme Holdings. Since the sale occurs within the MPP, not one dollar of the sale is subject to federal or state level taxation.
Acme Holdings is the sponsor of a Split Dollar arrangement between Heathcoat Family Trust, a Nevada Dynasty Trust, which is structured by Holly Heathcoat. The Trust features Hector as income beneficiary during his lifetime. The trustee is the applicant, owner, and beneficiary of a group PPLI policy with premiums of $3.25 million per year for four years. The average age of the policy’s insured lives is age 40. The policy is using Option B, the increasing death benefit option. Each life is insured for $300,000 on a guaranteed basis. The policy is funded as a non-MEC.
Acme Holdings adopts a corporate resolution authorizing the Company’s participation in a Split Dollar arrangement and enters a Loan Method Split Dollar arrangement with the trustee of the Heathcoat Family Trust. Acme Holdings will hold a restricted collateral assignment interest in the policy cash value and death benefit equal to the amount of the loan plus any accrued interest on the loan. Its interest is restricted until the earlier of the death of Heathcoat, surrender of the policy or termination of the split dollar arrangement. The Trust will own the excess cash value and death benefit.
In Year 5 the projected cash value is $25 million. The trustee enters into an agreement to purchase the Split Dollar receivable from Acme for $3.2 million, an eighty percent discount based upon the valuation report of a specialist. The trustee takes a tax-free loan from the policy to purchase the Split Dollar receivable. At that juncture, the Split Dollar agreement has been terminated and the policy is owned within the Trust with no encumbrances. The Trust owns the policy in its entirety accumulating on an income and estate tax-free basis beyond the reach of creditors. The trustee has the discretion to tax tax-free loans to distribute to Hector during his lifetime. The policy was able to strip and distribute $12 million and the growth of those assets with minimal or no taxation.
The Malta Pension Plan is an excellent planning strategy that provides Roth-like benefits without a contribution limit and the restriction to make contributions in cash. The continuation of the U.S.-Malta Income Tax Treaty like life itself is uncertain. The planning suggestion is to convert tax-deferred dollars into tax-free dollars by adding a Split Dollar arrangement into the planning. Tax deferred dollars are extended to the client's family trust as a loan using the Loan Method Split Dollar arrangement to purchase Private Placement Life Insurance (PPLI) with the Leveraged Split Dollar Rollout™ technique. The repositioned assets will grow income and estate tax-free outside of the reach of personal and business creditors with the participant as an income beneficiary of the Trust during his lifetime. This is the next building block in Malta Pension Planning.