Washington Report

---

Leadership for Advanced Life Underwriting

R

Washington Report

The trusted source of actionable technical and marketplace knowledge for AALU members - the nation’s most advanced life insurance professionals.

The Washington The AALU AALU Washington Report is published by Report is published by AALUniversity, a AALUniversity, a knowledge serviceofofthe the knowledge service AALU. The AALU. The trusted trustedsource source of actionable actionable technical of technicaland and marketplace knowledge forfor marketplace knowledge AALU members—the members—the nation’ AALU na- s most advanced life insurance tion’s most advanced life professionals. insurance professionals. The AALU Washington

The AALU Washington Report is prepared by the Report is prepared by the AALU staff and Greenberg AALU staff and Greenberg Traurig, one of the nation’s leading law in tax ands Traurig, onefirms of the nation’ wealth management. leading law firms in tax and wealth management. Greenberg Traurig LLP Jonathan M. Forster Greenberg Traurig LLP Martin Kalb Jonathan M. Forster Richard A. Sirus Martin StevenKalb B. Lapidus Richard Sirus RebeccaA. Manicone

Steven B. Lapidus Rebecca Manicone Counsel Emeritus

Gerald H. Sherman 1932-2012 Stuart Lewis 1945-2012 Counsel Emeritus Gerald H. Sherman 1932-2012 Stuart Lewis 1945-2012

Topic: Funding Trust-Owned Life Insurance – Selecting the Best Option. Washington Report 13-37 MARKET TREND: Although a higher federal estate tax exemption means fewer Topic: “Top-Hat Plan” Exemption Compliance for Deferred Compensation families will face federal estate tax exposure, the use of trusts in life insurance Arrangements plans will continue to serve numerous practical and tax planning needs.

MARKET TREND: As key executives continue to seek options for deferring SYNOPSIS: Planning with trust-owned life insurance (“TOLI”) must consider the receipt and taxation of current income, there likely will be a corresponding the funding of premiums into the trust. Numerous funding methods exist, increase in inquiries from employers as to how to structure nonqualified including: (1) annual exclusion gifts, (2) lump-sum gifts of gift and GST tax deferred compensation plans to meet the “top-hat plan” exemption from many exemption, (3) split-dollar arrangements, (4) installment sales to ILITs or (5) ERISA requirements. a combination thereof, with each method varying in terms of administrative complexity and tax-efficiency.

SYNOPSIS: Nonqualified deferred compensation plans generally are considered pension plans within the meaning of ERISA and are subject to TAKE AWAYS: TOLI is beneficial for creditor and beneficiary protection rules regarding plan design and administration, including funding, vesting purposes, wealth management, state estate tax planning, and income tax and fiduciary duties. These rules, however, do not apply to an unfunded plan planning. The selection of the best premium funding method will depend on each maintained by an employer primarily for the purpose of providing deferred family’s particular circumstances and goals, and the level of on-going support compensation for a select group of management or highly compensated they will have from their insurance, tax, and legal advisors (including policy and employees (i.e., “top-hat”annual plan).exclusion While there is no clear-cut funding reviews). aGenerally, or lump sum gifts areguidance the most defining what constitutes a “select group of management or highly compensated efficient approach for individuals with estates closer to the $5 million federal employees” for purposes ofestates, a top-hat plan, several cases havefrom considered the estate tax exemption. Larger however, will benefit greatly combining issue and have provided parameters that should be considered in establishing these gifts with more advanced funding methods, such as loans or installment such plan. sales, aparticularly given the current, low interest environment. TAKE As 13-08; corporate interest in 12-22 deferred compensation plans PRIORAWAY: REPORTS: 12-41; 12-28; increases, advisors can offer significant value to clients who are contemplating the establishment of changes, such plans by guiding them through a top-hat analysis Prior to recent tax law holding life insurance through an irrevocable trust that ensures (1) only a relatively small percentage of the workforce is invited was standard protocol for estate planning, and it continues to serve many practical to participate, (2) the plan participants have executive or managerial employment purposes. Individuals, however, must consider the practicalities of trust funding duties, (3) there is significant disparity in the average compensation levels in order to select the most suitable and tax-effective premium funding method for between plan participants and nonparticipants, and (4) the language of plan TOLI policies. documents limits participation to a select group of management or highly compensated employees. WHY CONTINUE TO USE TOLI Prior Reports: 2013-30. Before 2013, most individuals placed life insurance into an irrevocable life insurance trust (“ILIT”) in order to prevent taxation of the life insurance

MAJOR v. Nationwide Insurance proceeds inREFERENCES: the insured’s estate.Darden The permanent increaseMutual in the federal estate 1 Company, 717toF.$5.25 Supp. 388 (E.D.N.C. 1989);the Demery, v. Extebank tax exemption million, however, raises questionet. of al. whether many Deferred Compensation F.3d 283 (2d Cir. 2000); Bakri v. Venture, families still need ILITs forPlan, estate216 tax planning. 473 F. 3d 677 (6th Cir. 2007); Cramer v. Appalachian Regional Healthcare, Inc., No. remains 5:11-49-KKC (E.D. Oct. 29, 2012); ADaft Advest, Inc., 658 F.3d Yet TOLI beneficial forKy. numerous reasons. trustv.offers creditor 583 (6th Cir. 2011). protection for beneficiaries (as in cases of bankruptcy or divorce) and provides

centralized (and possibly professional) wealth management, particularly for youngertax beneficiaries who are notgenerated prepared toincreased handle large or sudden ascensions Recent rate increases have interest in deferring to wealth. Further, limitthis exposure to state estate taxes innonqualified states with deferred compensation. ToILITs achieve goal effectively, however, separate estate tax systems no only state comply income taxes, which typically have much compensation plans mustornot with the applicable tax laws (see lower exemptions than the federal estate tax exemption amount. discussion in Washington Report No. 2013-30), but also qualify for the

exemption from important substantive provisions of ERISA.

Leadership for Advanced Life Underwriting

R

Washington Report

The trusted source of actionable technical and marketplace knowledge for AALU members - the nation’s most advanced life insurance professionals.

IMPACT OF ERISA

Topic: Funding Trust-Owned Life Insurance – Selecting the Best The AALU Washington Most nonqualified compensation plans (“NQDPs”) are considered “pension plans” within the Report is publisheddeferred by Option. meaning of ERISA, AALUniversity, a and, as such, are potentially subject to vesting, funding and fiduciary duty requirements. If those requirements it would, in most cases, produce immediate taxation on the amounts knowledge service ofapply the to a NQDP, MARKET TREND: Although a higher federal estate tax exemption means fewer deferred andtrusted subjectsource the employer tofamilies burdensome requirements. Tothe avoid thetrusts immediate taxation AALU. The will facefiduciary federal estate tax exposure, use of in life insurance of actionable deferred amounts, theand NQDP would have to satisfy the qualification rules under the Internal Revenue of technical plans will continue to serve numerous practical and tax planning needs. marketplace Code (“Code”knowledge or “IRC”), for which, most notably, would preclude the NQDP from discriminating in favor of AALU members—the nation’ the employer’s executives. Assa result, it is unlikely any employer would sponsor such an arrangement or SYNOPSIS: Planning with trust-owned life insurance (“TOLI”) must consider most advanced life insurance any employee would participate in one. An exception from these rules applies, however, for plans that are the funding of premiums into the trust. Numerous funding methods exist, professionals. considered top-hat plans. including: (1) annual exclusion gifts, (2) lump-sum gifts of gift and GST tax exemption, (3) split-dollar arrangements, (4) installment sales to ILITs or (5) The AALU Washington TOP-HAT PLANSby GENERALLY a combination thereof, with each method varying in terms of administrative Report is prepared the complexity and tax-efficiency. AALU staff and Greenberg The termone “top-hat is snot used in ERISA. Rather, it is a colloquialism developed to refer concisely to “a Traurig, of theplan” nation’ plan which unfunded an employer purpose of providing deferred leading lawisfirms in tax and andis maintained TAKE by AWAYS: TOLI isprimarily beneficialfor for the creditor and beneficiary protection compensation for a select group of management or highly compensated employees.” A plan that meets wealth management. purposes, wealth management, state estate tax planning, and income tax this description is exempt from the participation fiduciary dutymethod provisions of ERISA. planning.and The vesting, selection funding, of the bestand premium funding will depend on each Greenberg Traurig LLP family’s particular circumstances and goals, and the level of on-going support Jonathan M. Forster The requirements for top-hat plan exemption have been in insurance, ERISA, and unchanged, they will have from their tax,have and remained legal advisors (including since policy and Martin Kalb ERISA was enacted in 1974. In the nearly years since its enactment, the Department of gifts Labor funding40 reviews). Generally, annual exclusion or lump sum are(“DOL”) the most has Richard A. Sirus not provided (and likely will not provide) any official for or specific guidance clarifying a “select efficient approach individuals with estates closerwhat to theconstitutes $5 million federal Steven B. Lapidus group of management or highly compensated employees.” estate tax exemption. Larger estates, however, will benefit greatly from combining Rebecca Manicone these gifts with more advanced funding methods, such as loans or installment RELEVANT CASE LAW sales, particularly given the current, low interest environment. Counsel Emeritus Gerald H. Sherman 1932-2012 Notwithstanding the absence of DOLPRIOR guidance, a handful of court decisions reviewed whether a plan was Stuart Lewis 1945-2012 REPORTS: 13-08; 12-41; 12-28;have 12-22

a top-hat plan and thus provide some guidance for employers to consider in structuring NQDPs for top-hat plan exemption compliance. Prior to recent tax law changes, holding life insurance through an irrevocable trust

was standard protocol for estate planning, and it continues to serve many practical purposes. Individuals, however,717 mustF.consider practicalities trust funding 1. Darden v. Nationwide Mutual Insurance Company, Supp. the 388 (E.D.N.C.of1989). The in order select theplan most suitable (a) andittax-effective premium method for court held that the plan at issue was not to a top-hat because: was offered to morefunding than 18% of the company’s workforce, which the TOLI courtpolicies. did not consider to be a “select group,” and (b) in the court’s opinion,

the differences in the average compensation of plan participants ($31,528) as compared to all non-agent WHY CONTINUE TO USE TOLI was not sufficient to consider the plan employees ($19,121) and all management employees ($24,501) participants “highly compensated” within the meaning of ERISA.

Before 2013, most individuals placed life insurance into an irrevocable life (“ILIT”) in orderPlan, to prevent of the lifeCir. insurance 2. Demery, et. al. v. Extebank insurance Deferredtrust Compensation 216 taxation F.3d 283 (2d 2000). The proceeds the insured’s estate. The15.34% permanent increase in the federal estate court found that a plan was a top-hat planineven though it covered of the employer’s workforce. 1 tax exemption to $5.25atmillion, however, raises the question of whether many The court said that “[w]hile this number is probably or near the upper limit for the acceptable size for a families still need ILITs for estate tax planning. ‘select group,’ we cannot say that it alone made [the plan] too broad to be a top-hat plan....” As did other

courts, the Demery court applied a qualitative and quantitative analysis. The court found the following Yet TOLI beneficial numerous reasons. A trust plan: offers (a) creditor factors favorable to its determination thatremains the plan met thefor requirements for a top-hat that the protection for beneficiaries (as in cases of bankruptcy or divorce) and plan was limited to “highly valued managerial employees,” and (b) the average compensation of provides plan centralized (and compensation possibly professional) particularly for participants was more than double the average of the wealth entire management, workforce. Finally, the court younger beneficiaries who are not prepared to handle large or sudden ascensions noted that the inclusion of two or three employees who were not highly compensated or a select group of wealth. ILITs limit exposure to state in states with management did not prevent thetoplan fromFurther, being maintained “primarily” for estate these taxes employees.

separate estate tax systems or no state income taxes, which typically have much lower(6th exemptions than theThis federal estate tax exemption amount. 3. Bakri v. Venture, 473 F. 3d 677 Cir. 2007). court articulated essentially a four-part

Leadership for Advanced Life Underwriting

R

Washington Report

The trusted source of actionable technical and marketplace knowledge for AALU members - the nation’s most advanced life insurance professionals.

test for assessing the top-hat status of a plan. Specifically, the court stated: “In determining whether a plan qualifies as a top-hat plan, we consider both qualitative and quantitative factors, including (a) the Topic: Funding Trust-Owned Life Insurance – Selecting the Best The AALU Washington percentage of theby total workforce invited to join the plan (quantitative), (b) the nature of their employment Report is published Option. duties (qualitative), (c) the compensation disparity between top-hat plan members and non-members AALUniversity, a (qualitative), and of the plan agreement (qualitative).” knowledge service of(d) thethe actual language MARKET TREND: Although a higher federal estate tax exemption means fewer

AALU. The trusted source families will face federal estate tax exposure, the use of trusts in life insurance Unlike thetechnical Darden and cases,will thecontinue Bakri case did numerous not give specific about the percentages of of actionable andDemery plans to serve practicaldetails and tax planning needs. marketplace knowledge for employees that participated in the plan or the range of salaries of those eligible and ineligible to participate AALU nation’ s in members—the the plan. Instead, in holding that the planPlanning was not with a top-hat plan, the noted that top-level company SYNOPSIS: trust-owned life court insurance (“TOLI”) must consider mostexecutives advanceddid lifenot insurance participate inthe thefunding plan, certain employees who were promoted to top management of premiums into the trust. Numerous funding methods exist, professionals. ceased to participate in the plan,including: and participation not limited tolump-sum top management orand even high-level (1) annualwas exclusion gifts, (2) gifts of gift GST tax positions (in fact, administrativeexemption, employees(3)and those who did not supervise other employees were split-dollar arrangements, (4) installment sales to ILITs or allowed (5) The AALU Washington to participate). Thus, that the plan at issue not meet varying the selectivity for a combination thereof, withdid each method in termsrequirement of administrative Report is prepared by thethe court felt consideration as a top-hat plan. complexity and tax-efficiency. AALU staff and Greenberg Traurig, one of the nation’s 4. Cramer v. Appalachian Regional Healthcare, No. 5:11-49-KKC Ky.protection Oct. 29, 2012). leading law firms in tax and TAKE AWAYS: TOLI isInc., beneficial for creditor and (E.D. beneficiary Themanagement. court applied the Bakri test purposes, to conclude that a plan was, in fact, a top-hat plan. In this case,tax however, wealth wealth management, state estate tax planning, and income the court articulated its application of each ofselection the elements the Bakri test. Specifically: planning. The of the of best premium funding method will depend on each Greenberg Traurig LLP family’s particular circumstances and goals, and the level of on-going support Jonathan M. Forster of total workforce invited to join the plan: Although the court noted that there is no a. Percentage they will have from their insurance, tax, and legal advisors (including policy and Martin Kalb bright-ine rule specifying what percentage ofGenerally, an employer’s can be covered a the top-hat funding reviews). annualworkforce exclusion or lump sum giftsby are most plan, Richard A. Sirus the plan in Cramer covered only 0.4% of the total workforce, which thecloser courttoweighed in favor of efficient approach for individuals with estates the $5 million federal Steven B. Lapidus meeting the “select group” requirement necessary for top-hat status. estate tax exemption. Larger estates, however, will benefit greatly from combining Rebecca Manicone these gifts with more advanced funding methods, such as loans or installment b. Nature of plan members’sales, employment duties: presented in the case indicated that particularly given the Evidence current, low interest environment. Counsel Emeritus H. some of the participants Gerald Sherman 1932-2012 in the plan did not exercise the authority or control generally associated with Lewis management and executive employees. However, noting the facts in other Stuart 1945-2012 PRIOR REPORTS: 13-08; 12-41; 12-28; 12-22 cases, including Demery, as



well as the DOL’s position in an earlier advisory opinion that provided that the fact that not all employees eligible to participate in a top-hat needholding to be management or highly employees, Prior to recent tax lawplan changes, life insurance through anpaid irrevocable trust the court found that this factor weighed in favor of finding the plan be a top-hat plan. wasalso standard protocol for estate planning, and itto continues to serve many practical

c.

order to select most suitableand and tax-effective premium funding method for Compensation disparity in between planthe participants nonparticipants: The court stated TOLI that qualification as a top-hat planpolicies. requires a significant disparity between the average compensation of plan participants and the average compensation of non-covered employees. Over the two years WHYW-2 CONTINUE TO USEofTOLI the court evaluated, the average compensation plan participants was more than 4.5 or 5 times the averages for nonparticipants. The court also noted that the compensation for the lowest paid plan Before 2013, mostfor individuals placed life insurance an irrevocable life participant was more than twice the average nonparticipants. The courtinto found that both of insurance trust (“ILIT”) in order to prevent taxation of the life insurance these facts supported treatment of the plan as a top-hat plan.

d.

1 tax exemption to $5.25 however,contained raises the question ofthat whether many Actual language of the plan document: Themillion, plan document language properly families still need ILITs for estate tax planning. restricted the group of employees eligible to participate, but the court noted that, notwithstanding the language of the Bakri test, a plan will not satisfy this criterion if the plan does not follow its Yet TOLI remains beneficial for numerous reasons. A trust offers creditor eligibility language in operation.

purposes. Individuals, however, must consider the practicalities of trust funding

proceeds in the insured’s estate. The permanent increase in the federal estate

protection for beneficiaries (as in cases of bankruptcy or divorce) and provides (and possibly professional) wealth management, In light of the foregoing factors, the centralized court concluded the plan was a top-hat plan within the particularly meaning offor ERISA. younger beneficiaries who are not prepared to handle large or sudden ascensions wealth. ILITs limit exposure statenot estate taxes in states withof 5. Daft v. Advest, Inc., 658 to F.3d 583Further, (6th Cir. 2011). Finally,to while providing the kind separate estate tax systems or no state income taxes, which typically have detailed analysis found in the Cramer case, the ruling in this case showed the court’s continued supportmuch for the lower exemptions than the federal estate tax exemption amount. Bakri test.

Leadership for Advanced Life Underwriting

R

Washington Report

The trusted source of actionable technical and marketplace knowledge for AALU members - the nation’s most advanced life

TAKE-AWAY insurance professionals.

Despite the lack of formal agency guidance top-hatTrust-Owned exemption qualification, the foregoing decisions Topic:on Funding Life Insurance – Selecting the Best The AALU Washington provide a framework for evaluating whether a NQDP qualifies as a top-hat plan exempt from most ERISA Report is published by Option. requirements. can offer significant value to clients who are contemplating the establishment of a AALUniversity,Advisors a knowledge service of the NQDP by guiding them through a top-hat analysis that consider following factors: MARKET TREND: Althoughthe a higher federal estate tax exemption means fewer AALU. The trusted source

families will face federal estate tax exposure, the use of trusts in life insurance

of actionable technical and 1. Percentage of Workforce Invited to Participate: a relatively small the plans will continue to serveOnly numerous practical and percentage tax planningof needs. marketplace knowledge for employer’s workforce should be eligible to participate in the plan.

AALU members—the nation’s SYNOPSIS: Planning with trust-owned life insurance (“TOLI”) must consider most advanced life insurance 2. Nature of Participants’ Employment Most, nottrust. all, of the eligible employees should the fundingDuties: of premiums intoifthe Numerous funding methods exist, work professionals. in positions that provide them with executive management authority. including: (1) or annual exclusion gifts, (2) lump-sum gifts of gift and GST tax exemption, (3) split-dollar arrangements, (4) installment sales to ILITs or (5) The AALU Washington 3. Compensation Disparity between Participants and Nonparticipants: Nonparticipants: a combination thereof, with each method varying in terms of administrative Report is prepared by the should replaced with the following language: There should be a significant disparity in the average complexity and tax-efficiency. AALU staffbe and Greenberg Traurig, one of the s compensation ofnation’ employees eligible to participate in the plan and the average compensation of ineligible leading law firms in tax and TAKE AWAYS: TOLI is beneficial for creditor and beneficiary protection employees. wealth management. purposes, wealth management, state estate tax planning, and income tax 4. planning. TheOperation. selection of the bestapplicable premium funding method will depend on each 5. Language of Plan’s Documents & Plan The plan documents should contain Greenberg Traurig LLP goals, and the level of on-going support language limiting participation tofamily’s a selectparticular group ofcircumstances managementand or highly compensated employees, and the Jonathan M. Forster willstandard. have from their insurance, tax, and legal advisors (including policy and plan’s operation should conform they to that Martin Kalb funding reviews). Generally, annual exclusion or lump sum gifts are the most Richard A. Sirus efficient approach forby individuals estates closer to the million federal In order comply with requirements imposed the IRS with which may apply to$5 the Washington Steven B.to Lapidus estate tax exemption. Larger estates, however, will benefit greatly from combining Report distributed or as re-circulated by our members, please be advised of the following: RebeccaasManicone these gifts with more advanced funding methods, such as loans or installment particularly given the current, lowBE interest environment. Counsel Emeritus THE ABOVE ADVICE WAS NOTsales, INTENDED OR WRITTEN TO USED, AND IT CANNOT BE Gerald H. 1932-2012 USED, BYSherman YOU FOR THE PURPOSES OF AVOIDING ANY PENALTY THAT MAY BE IMPOSED Stuart Lewis 1945-2012REVENUE SERVICE. PRIOR REPORTS: 13-08; 12-41; 12-28; 12-22 BY THE INTERNAL Prior to recent lawconsidered changes, holding lifeainsurance through an irrevocable trust In the event that this Washington Report is tax also to be “marketed opinion” within was standard protocol forby estate and itbe continues to serve manyof practical the meaning of the IRS guidance, then, as required theplanning, IRS, please further advised the purposes. Individuals, however, must consider the practicalities of trust funding following: in order to select the most suitable and tax-effective premium funding method for policies. TO SUPPORT THE PROMOTIONS OR MARKETING THE ABOVE ADVICE WAS NOTTOLI WRITTEN

OF THE TRANSACTIONS OR MATTERS ADDRESSED BY THE WRITTEN ADVICE, AND, WHY CONTINUE TO USE TOLI BASED ON THE PARTICULAR CIRCUMSTANCES, YOU SHOULD SEEK ADVICE FROM AN INDEPENDENT TAX ADVISOR.

Before 2013, most individuals placed life insurance into an irrevocable life insurance trust (“ILIT”) in order to prevent taxation of the life insurance proceeds in the insured’s estate. The permanent increase in the federal estate tax exemption to $5.25 million,1 however, raises the question of whether many families still need ILITs for estate tax planning. Yet TOLI remains beneficial for numerous reasons. A trust offers creditor protection for beneficiaries (as in cases of bankruptcy or divorce) and provides centralized (and possibly professional) wealth management, particularly for younger beneficiaries who are not prepared to handle large or sudden ascensions to wealth. Further, ILITs limit exposure to state estate taxes in states with separate estate tax systems or no state income taxes, which typically have much lower exemptions than the federal estate tax exemption amount.