Outlook 2013: Expect more tax-wise advanced markets sales

Enactment of the American Taxpayer Relief Act, legislation signed by President Obama on January 2 to avert the fiscal cliff, drew fire aplenty for supposed shortcomings from commentators on both the left and right of the political spectrum. But for insurance and financial service professionals, the new law has one indisputable plus in its favor: It brings permanency to a federal tax code that, for more than a decade, has essentially been in limbo because of Bush-era tax cuts that came with an expiration date.

By easing planning, say experts, the law’s now set-in-stone tax provisions should help boost sales for advisors active in advanced markets, including such fields as investment planning, executive benefits and exit planning, wealth management and estate planning. Tax increases the legislation calls for on the high net worth, among them hikes in rates levied on income, estates, capital gains and dividends, will also heighten advisors’ focus on making the planning more advantageous from a tax perspective.

“There will be a greater focus among advisors and clients on investing in a tax-efficient manner, says Paul Lapiana, a senior vice president at New York-based MetLife. “Tax-qualified retirement plans and deductions will continue to be important. But now you’ll start to see more tax-efficient investing, whether through individual retirement accounts, fee-based managed accounts, annuities or life insurance.”

The last, say experts, will be valued more than ever for the product’s longstanding tax-favored treatment. Life insurance boasts income tax-free payout of death benefits, tax-deferred accumulation of cash values and, when owned by an irrevocable life insurance trust, estate-tax free distributions.

Life insurance, among other tax-favored vehicles, will also increasingly appeal to investors looking for higher yields in the current low interest rate environment. The internal rate of return of insurance at life expectancy, observes Lapiana, is now superior to the returns offered by alternative fixed income vehicles — a result of  the product’s tax treatment.

Laurence Greenberg, president of Louisville, Ky.-based Jefferson National, agrees, adding that the ability to accumulate a retirement nest egg on a tax-deferred basis also contributes to the often superior yields of variable annuities relative to alternative investment products.

“Because of current low interest rates and the certainty of rising taxes, solutions that offer tax-deferral are more meaningful than ever to advisors,” he adds. “We’ve done studies that show tax-deferral can add as much as 100 basis points annually to a vehicle’s performance.”

Tax-advantaged business planning

These advantages help to explain the growing demand for tax-favored solutions among high net worth clients who value the products for both personal and competitive reasons: small and mid-size business owners. Market-watchers say they anticipate gains in 2013 for life insurance-funded business solutions — key person insurance, executive compensation arrangements, exit planning, plus retirement, tax and estate planning needs of business owners — and associated tax advantages are expected to spur sales.

But only in part. Steve Parrish, national advanced solutions director of Principal Financial Group, Des Moines, Iowa, says that life insurance sales for business applications should also be strong in 2013 because owners have more money to spend.

“The small and mid-size business market is really a bright spot in the current economy,” he says. “The ability of business owners to fund the range of planning needs they have is high. I can confirm anecdotally that many are sitting on a lot of cash.”

The cash hoard, he adds, has materialized in large measure because of three factors: (1) the weak economic recovery since the 2007-2009 recession; (2) questions as to the tax liability under the Affordable Care Act; and (3) Washington’s failure (until January) to bring permanency to the tax code amid the ongoing struggle over the nation’s finances. Uncertain as to the direction of the economy and of fiscal policy, small and mid-size companies deferred strategic operational decisions, including capital investments, expansion plans and rank-and-file hiring.

However, the funding of plans to recruit, reward and retain executive talent remains, as in prior past years, a top priority for many small businesses. Hence the need for life insurance-funded non-qualified deferred compensation plans, supplemental executive retirement arrangements and other pay packages for senior managers.

Among the various offerings, Internal Revenue Code Section 162 executive bonus arrangements are particularly popular now, observers say, in part because of their simplicity. Employees purchase and own a life insurance policy on their lives; and the employer funds the tax-deductible premium payments. Bonus plans also are not subject to the myriad of rules respecting the timing of deferrals and distributions required of non-qualified deferred comp plans under IRC Section 409(A).

Should the employer want to impose golden handcuffs on the supplemental comp, they can, alternatively, set up a restrictive endorsement bonus arrangement or REBA, a version of which might establish a five-year vesting schedule for the employer contributions to the plan. The employer can also set up “double bonus” arrangement to cover the income tax owed on the premium payments, which plan participants must report on their tax returns as income.

Exiting the business

For a key demographic with the business community, baby boomers, the need to establish and fund tax-favored financial plans to provide for the continuity of their businesses and post-retirement needs grows more urgent. The eldest of more than 78 million boomers began turning 65 in 2011 — and 10,000 more of them are crossing the retirement age threshold daily. The pent-up needs of those owners who have yet to engage an advisor is, experts say, huge.

See also: Infographic: What boomers want from agents

This is especially true in the area of exit planning. While cash accumulations have boosted their liquidity, company principals looking to make a graceful exit frequently confront a challenge: depressed business valuations resulting from a dearth of potential outside buyers or less-than-optimal credit markets for third-party acquisitions.  To fund retirement plans that hinge on the sale of the firms, say experts, many business owners are looking internally for the next generation of management.

Thus, the growing interest in employee stock ownership plans: tax-qualified retirement plans that let employee-owners accumulate shares of a company as part of their compensation. ESOPs, say experts, are fast becoming a favored vehicle among owners of S-Corps for transitioning control of their firms to key employees or family members, and for securing retirement money on a tax-advantaged basis.

Because the business is 100% owned by an ESOP trust and because the S-Corp. is a pass-through entity, the business can pass through profits to a non-taxable entity: the ESOP trust. Also, state economic development councils recognize that ESOPs are advantageous in terms of keeping home-grown companies from moving out-of-state. For example, Iowa’s governor has signed a law — the first of its kind — that provide incentives to business owners to use ESOPs to keep businesses in the state.

“In Iowa, if you sell at least 30% of your business to an ESOP, you get a 50% exemption from the state’s 8.9% capital gains tax,” says Jerry Ripperger, director-consulting of Principal Financial. “So by selling to an ESOP, you can add 4.4% to the value of your business. Indiana, Ohio and Vermont offer similar tax incentives.”

Beyond offering the ability to defer tax on capital gains and deduct dividends paid on ESOP-held stock, ESOPs also let participating employees avoid tax on the stock allocated to their accounts or on earnings until distributed. Companies that sponsor ESOPs can also deduct plan contributions.