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The Leveraged Benefit Plan Compared Be sure to review Part 1 before reading this article. In Part 1, we compared the Leveraged Benefit Plan (one of the modules in our new InsMark Section 7872 Illustration System) with an Equity Split Dollar Plan. Thanks to IRS Notice 2002-8, new Equity Split Dollar Plan sales have largely ground to a halt; however, they can still serve a useful purpose as a benchmark to measure the effectiveness of alternative strategies. The IRS clearly indicated in IRS Notice 2002-8 that "Regime 2" plans (those characterized by loans) are acceptable and will be governed under the below-market rules of IRC Section 7872 and, where applicable, the Original Issue Discount ("OID") rules of IRC Sections 1271-1275. The InsMark Section 7872 Illustration System is designed to charge a loan interest rate at least equal to the Section 7872 long-term loan interest rate (often referred to as the "Applicable Federal Rate" or "AFR"). By doing so, two major advantages occur: 1) no further loan interest is deemed to occur between the parties and 2) the OID rules become superfluous. A further advantage of charging at least the AFR is that the corporate variation -- the Leveraged Benefit Plan ("LBP") -- can easily be constructed using a variety of bonus techniques to offset the executive's loan interest payments. For illustrative purposes, the LBP illustrations shown in Part 1 reflect a constant 5.60% interest rate on the series of loans extended by the employer to the executive. In reality, the loan interest rate for each new loan will likely be different, and each future loan must bear its own Sec. 7872 loan interest rate that is in effect during the month each new loan is executed. With LBP, there are four ways to deal with unknown future Sec. 7872 loan interest rates:
One of the reasons that we allow a user to input a loan interest rate equal to or greater than the AFR is to provide a comfort zone in the initial illustration for those clients concerned that the AFR might spike over the premium paying years. The AFR rate for March 2002 may seem low at 5.48% to count on for future years, and an analysis of historic Applicable Federal Rates is instructive. Applicable Federal Rates
If a policy with five scheduled premiums had been purchased in 1992, and the loan for each premium had been made at the highest rate that occurred during each of the five years, the average loan interest rate on the composite of all five loans would end up at 7.76%, as shown below:
However, if each loan had been subsequently renegotiated at the lowest rate available over the years in the Table, a far different result would have been produced, as shown below.
As you can see, this example (which may not be representative of interest rates over all durations) reduces the long-range loan interest rate on a regular basis. By the seventh year (1998), it would have been permanently reduced from 7.76% to 5.05%, a 35% reduction -- significant indeed for a series of loans scheduled to stay in force over many years. This strategy should be kept in mind when deciding on an illustrative loan interest rate for new plans. So -- what loan interest rate should we use for a current illustration? Some might select the March 2002 rate of 5.48%. Others might go higher -- maybe 7.5% -- to account for some rate spiking. Let's compromise and use 6.5%, and we will make the same comparison to an Equity Split Dollar Plan we did last month by using identical policy assumptions: $2,500,000 level face amount with five $100,000 premiums (issue age 45). Leveraged Benefit Plan: Employer offsets the executive's loan interest with a gross-up bonus. Equity Split Dollar Plan: Employer offsets the executive's income tax on the plan's economic benefits with a gross-up bonus. The issues to consider with both plans are as follows:
Leveraged Benefit Plan (Marketing Alert #135 -- 5.60% AFR)
*If the arrangement is rolled out. Leveraged Benefit Plan (Marketing Alert #136 -- 6.50% AFR)
*If the arrangement is rolled out. Equity Split Dollar Plan (Marketing Alert #135)
*If the arrangement is rolled out. The revised Leveraged Benefit Plan illustration using the 6.50% AFR can be reviewed by clicking here. We have not included the illustrations for the Leveraged Benefit Plan using the 5.60% AFR or the Equity Split Dollar Plan as both are identical to those that accompanied Part 1. As you can see by comparing Column (1) from all Tables, the cost to the employer is less during the early years with the Equity Split Dollar Plan. This is because the economic benefit of the Equity Split Dollar Plan is less than the loan interest associated with the Leveraged Benefit Plan. In later durations, the reverse is true -- significantly so. Interestingly, the employer's receivable, the executive's cash values, and the executive's death benefits are identical with any of the plans; however, a major advantage of the Leveraged Benefit Plan is the absence of any income tax due by the executive if the plan is rolled out, which, in the case of the Equity Split Dollar Plan, might have to occur -- due to its soaring economic benefit costs and the employer's cost of the bonus needed to eliminate the executive's out-of-pocket cost. An alternative for the Equity Split Dollar Plan would be to terminate the bonus and have the executive pay the income tax on the spiraling economic benefit -- a poor option indeed at advanced ages. The executive could use policy loans to pay the income tax; however, the increasing loans caused by the increasing economic benefit would soon dig a huge hole in the policy cash values ultimately forcing a rollout with taxable income of the gross cash value of the policy. (Policy loans would not reduce the amount taxed at rollout.) Death would be the only clean way out. Note: For Equity Split Dollar Plans entered into during the remaining window for such plans (until final regulations are published later this year), Section 83(b) elections may avoid taxation at rollout. Other than the 83(b) technique, under the new rules, new Equity Split Dollar Plans have no possible way -- other than early death -- to avoid taxation at rollout. Note: IRS Notice 2002-8 offers relief from rollout taxation of Equity Split Dollar Plans entered into prior to January 28, 2002, provided the rollout occurs prior to January 1, 2004. If a seasoned life insurance policy subject to an Equity Split Dollar arrangement can be sustained after a rollout by that date, it would behoove the parties to roll it out. If it cannot be sustained thereafter, it should be converted by that date to a Leveraged Benefit Plan. Note: The Leveraged Benefit Plan module can illustrate the conversion of an in-force Equity Split Dollar Plan to a Leveraged Benefit Plan. (If you have clients with Equity Split Dollar Plans --including reverse split dollar -- you do not want another producer providing this solution.) In the next article of this series, we will explore the conversion of an Equity Split Dollar Plan to a Leveraged Benefit Plan. P.S.: Never use a modified endowment contract ("MEC") with a Section 7872 Plan. When a MEC is assigned as collateral security for a loan, taxable income to the executive is produced to the extent of any gain in the contract. Important Note: In all cases, the approval of a client's legal and tax counsel must be secured before any of the concepts discussed are utilized. Revised: [6-5-02]
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