Leveraging the QPIP To Avoid The 70% Tax Trap

An alternative to the stretch IRA, the charitable trust, can receive a gifted individual retirement account or pension plan only upon the clients death. That lets the client avoid estate taxesbut at the childrens expense. While they may draw a salary as trustees, the children will derive little or no residual funds from the IRA.

Yet another technique, dubbed “liquidate and leverage,” has the client withdraw funds from the qualified plan or IRA, pay income tax on the distribution, and buy life insurance to cover the income and estate taxes on the qualified asset. This solution is less than optimal, observes DeFrancesco, because clients have to make large premium payments to an ILIT, which uses up their estate tax credit.

“This strategy is painful, but at least you can put money into a life insurance policy to cover estate taxes,” says DeFrancesco. “Thats better than nothing, but there are superior solutions. Also, the premiums that older clients must gift to an ILIT are so high that they would have a gift tax problem, as they would be using up their unified [estate and gift tax] credit.”

Other popular tax techniquesbuying life insurance inside an employer-sponsored 412(i) qualified plan and pension (or IRA) rescuehave their own drawbacks.

The first, says DeFrancesco, would be subject to both income and estate taxes; and, for a comparable retirement benefit, the method costs double the amount of money of wrapping the 412(i) around an annuity. The second, which leverages a “5-pay sponge policy” (i.e., one with a low cash surrender value that can be removed from a profit-sharing plan at an 80% income tax discount), was killed in February 2004 by IRS 2004-16. The revenue ruling aimed to shut down “abusive” 412(i) plans by restricting how cash values can be calculated.

And so we return to the QPIP. The technique calls for joining the retirement account, the participant (client) and an irrevocable life insurance trust to form a limited liability company.

The participant makes a nominal contribution to the LLC (preferably pegged to a long-term applicable federal rate or AFR) in exchange for a membership interest. The retirement account (IRA or pension plan) provides the majority capitalization, with the ILIT making the balance of contributions.

The LLC invests these contributions, using the earnings (and principal, if necessary) to purchase an insurance contract on the life of the participant, which names the LLC as a beneficiary. Each year, an amount equal to the cost of the contracts death benefit would be charged against the capital account of the trust. The balance of the premium is charged against the capital account of the retirement account.

When the client dies, the IRA will be refunded for premiums it paid to the LLC, plus a minimum rate of return, such as the long-term AFR. The balance of assets in the LLC (the remaining death benefit) will go to the ILIT. That death benefit can then be disbursed to beneficiaries free of income and estate taxes.

“This is the guts of the plan,” says DeFrancesco. “The QPIP is a really neat tool that advisors can leverage to differentiate themselves in the marketplace and help clients avoid a double tax that many dont even know exists.”

Reproduced from National Underwriter Edition, April 15, 2005. Copyright 2005 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.