Thousands of C corporation owners get hit every year with both corporate and ordinary income taxes because they have retained earnings. What options are there to remove those earning from the company so as to mitigate this double tax?
The solution is to leverage a preferred/non-preferred limited liability company. The retained earnings, once invested in the LLC, can be used to purchase a cash value life insurance policy that ultimately will enable most of the retained dollars to pass tax-free to the owner and grow tax-free during retirement. Pre-retirees for whom a life insurance policy would not be cost-effective because of the high premiums can achieve the same result by either making a child or an irrevocable life insurance trust a non-preferred managing member of the LLC.
These options are superior to one with which most clients and advisors are familiar: having the company pay the owners a year-end bonus. That bonus is deductible for the company but 100% taxable income for the employee. Bonusing out retained earnings is painful because the company already paid a sizable corporate tax on the earnings when retained.
A schematic detailing how the LLC works is shown in the chart.
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What happened in the schematic? First, the company invested $1,000,000 of retained earnings in the LLC (1). The company then paid back its $1,000,000 investment, plus a long-term rate of return pegged to the long-term AFR interest rate (using simple interest). The return is guaranteed by a preferred life insurance policy on the employer/owner’s life, which LLC purchased using 15% ($150,000) of the retained earnings invested (2).
Next, the owner invested $850,000 of the $1,000,000 in retained earnings in a cash value life insurance policy on the employer/owner’s life, the purpose of which is to build wealth. The employee/owner, as managing member of the LLC, used the LLC to borrow the money from the life insurance policy income tax-free (usually during retirement (3)). The LLC passed the tax-free borrowed money to the employee/owner through special allocations (3a).
The loan from the life insurance policy is then paid back to the life insurance company at the death of the key employee through a reduction in death benefit (meaning the owner/employee or his estate does not have to repay the loan out of pocket (4)(4a)).
What was accomplished? The owner of the C corporation removed 85 cents on the dollar of retained earnings so the money could grow tax-free and come out of the life insurance policy tax-free when the owner is retired. Without using the above technique, the owner would have had to take the retained earnings home as W-2 income, which could subject that income to 40%-plus income taxes.
Alternatives for Pre-Retirees
A C corporation owner who is already near retirement (i.e., 60 years or older) will have difficulty using life insurance for retirement plan purposes because the costs for the death benefit will be too high. However, the owner still can use the preferred/non-preferred LLC in two ways to remove the retained earnings in a tax-favorable manner.