Personal Financial Planning Monthly - Editorial Direction LLC

Volume 2 • Number 11 

THE JOURNAL FOR 

FINANCIAL PLANNING 

PROFESSIONALS 

Personal Financial 

Planning Monthly 

FEATURE ARTICLES 

RETIREMENT PLANNING 

Treatment of Growing Annuities in Financial Planning 

By G. Eddy Birrer and Kent Hickman . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 

INVESTMENT STRATEGIES 

Advising the High-Net-Worth Athlete or Entertainer 

By Allen F. Ross . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11 

RISK MANAGEMENT 

Reducing the Wealth Transfer Tax 

By Jeffrey H. Rattiner . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17 

INSURANCE 

Using Private Placement Life Insurance 

By Lewis J. Sarat and Lewis D. Solomon . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 

CASE STUDY 

Unexpected Death Complicates Process of Intended IRA Rollover 

By Mark W. McGorry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29 

NOVEMBER 2002 

9900300017



EDITOR-IN-CHIEF 

Jeffrey Rattiner 

CPA, CFP, MBA 

PUBLISHER 

Louis Lucarelli 

ASSOCIATE 

PUBLISHER 

James O’Shea 

EDITORIAL 

DIRECTOR 

Elaine Stattler 

EDITOR 

Nina Festa 

BOARD OF ADVISORS 

Phyllis Bernstein 

Phyllis Bernstein Consulting, Inc. 

New York, NY 

Larry Chambers 

Larry Chambers & Associates 

Ojai, CA 

Steven Drozdeck 

Drozdeck & Associates 

Logan, UT 

John E. Foster II 

HFG Asset Allocation Service 

Scottsdale, AZ 

Gregory H. Friedman 

Friedman & Associates 

San Rafael, CA 

Marilyn Renninger 

AMG Guaranty Trust 

Denver, CO 

Allen F. Ross 

Pinnacle Wealth Group, Ltd. 

Great Neck, NY 

Gideon Rothschild 

Moses & Singer 

New York, NY 

Larry Swedroe 

Buckingham Asset Management 

St. Louis, MO 

Mark Tibergien 

Moss Adams 

Seattle, WA 

Tom Gau, CPA 

Million Dollar Producer 

Ashland, OR 

Jeff Zaluda 

Horwood Marcus & Berk Chartered 

Chicago, IL 

John R. Phillips 

JR Phillips & Associates PC 

Englewood, CO 

Personal Financial Planning Monthly (ISSN 1535-413X) is published monthly by Aspen Publishers, 1185 Avenue of the Americas, 

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© Copyright 2002

PERSONAL FINANCIAL PLANNING MONTHLY 

Editor’s 

Notes 

“Editor’s Notes” offers a brief overview of articles appearing in 

this issue of Personal Financial Planning Monthly. 

The November issue of Personal Financial Planning Monthly 

brings together practitioners and academics from the financial industry 

to describe practical ways to perform financial planning services. Our 

goal is to provide you with the in-depth analysis and advice you need 

to maintain a successful practice and to keep up with advances in the 

financial planning field. 

— Jeffrey H. Rattiner, CPA, CFP, MBA 

Editor-in-Chief, Personal Financial Planning Monthly 

This Month’s Articles 

Retirement Planning 

Assuming fixed payments over time for investments such as 401(k) 

and 529 plans, which are often based on a percentage of salary, can 

cause retirement income projections to be significantly off. Further, 

not taking inflation and cost of living into account when calculating 

planned withdrawals can cause even more severe problems. 

Unfortunately, as professors G. Eddy Birrer and Kent Hickman point 

out in “Treatment of Growing Annuities in Financial Planning,” this is 

how most of these calculations are made in the financial industry. The 

authors present an effective model for accurately projecting the value 

of a growing annuity over time and for determining the effect of periodic 

withdrawals on a portfolio. 

Investment Strategies 

The unique financial situations of athletes and entertainers require 

unique portfolio planning advice. In “Advising the High-Net-Worth 

Athlete or Entertainer,” Dr. Allen F. Ross of Pinnacle Wealth Group 

explains how to avoid undue taxation given the unusual way most athletes 

and entertainers are compensated. Ross uses specific examples 

and detailed charts to explain how to structure these clients’ portfolios. 

Risk Management 

If the transfer of a large estate is not properly planned for, the 

results can be disastrous. Personal Financial Planning Monthly Editorin-Chief 

Jeffrey Rattiner, in “Reducing the Wealth Transfer Tax,” 

offers several strategies for ensuring that clients’ estates are transferred 

November 2002 

1


to beneficiaries in a tax-advantaged manner. 

Rattiner highlights such strategies as using the 

annual gift exclusion, designing special trusts, and 

using the generation-skipping transfer exclusion. 

Insurance 

Private placement life insurance offers certain 

benefits to high-net-worth clients that they would 

not be able to obtain elsewhere. Lewis J. Saret of 

Cohen Mohr LLP and Professor Lewis D. 

Solomon of George Washington University Law 

School outline these benefits in “Using Private 

Placement Life Insurance.” The authors look at 

how private placement life insurance arrangements 

typically work and the practical considerations of 

implementing a policy. 

Case Study 

Can an IRA rollover be performed posthumously 

if it is clear that that is what the deceased client 

intended In “Unexpected Death Complicates 

Process of Intended IRA Rollover,” Attorney Mark 

W. McGorry examines a real-life case where a 

client died before completing an intended consolidation 

of two defined contribution accounts into a 

single IRA. McGorry outlines the case in detail, 

explains how the IRS has ruled in similar cases, and 

explains his recommendations. 

2 November 2002

RETIREMENT PLANNING 

Treatment of Growing Annuities in 

Financial Planning 

By G. Eddy Birrer and Kent Hickman 

Many personal financial planning illustrations 

are limited by their focus on fixed deposit, 

withdrawal, and interest rate data. For 

example, illustrations contained in information presented 

to employees about tax-sheltered annuity 

accumulations, in advertisements for Roth IRA plans, 

in finance textbooks, and in other publications, tend 

to focus on equal periodic cash flows, that is, ordinary 

annuities. Financial calculators on Web sites 

managed by mutual fund companies and other organizations, 

likewise, often are preprogrammed for ordinary 

annuity computations, as are handheld calculators. 

Related sensitivity analysis normally consists of 

simply changing the combinations of amounts, interest 

rates, or projected rates of inflation. 

Amounts invested in 401(k), 529, and other plans 

in many cases are not fixed, however, but instead are a 

percentage of annual earnings. Planned or estimated 

amounts to be withdrawn, likewise, should not be 

fixed, but rather should be adjusted to reflect inflation, 

cost of living, or annual education cost increases. 

Compound interest and discount rates also should be 

adjusted in response to each major change in investment 

portfolio allocations. Appropriately adjusted 

deposits and withdrawals, therefore, are more likely to 

be in the form of growing annuities, based on rates of 

growth in inflation, earnings, or some other factor. 

Financial planning models using growing annuities 

help address limitations inherent in the conventional 

illustrations mentioned above. Decision makers thus 

can better model financial planning problems or cases 

and may develop better computer-based spreadsheets. 

Growing annuities can be defined as cash flows, 

equally spaced in time, which grow at a constant rate 

over the life of the payment stream and end after a 

predetermined number of payment or withdrawal 

periods. Knowledge of the simple mathematics 

underlying present value (PV) and future value (FV) 

calculations, hereafter referred to as PV analysis, 

will improve financial planning and decision making, 

especially in cases involving growing annuities. 

The mathematics, summing a geometric series, is 

basic algebra, yet it is the key to understanding PV 

calculations made on financial calculators and computers. 

An extension of this technique is the constant 

growth stock formula, essentially a growing 

perpetuity formula. Knowledge of PV mathematics 

helps financial planners model decision cases. 

This article presents a simple example illustrating 

the mathematics underlying a growing annuity problem, 

followed by more comprehensive retirement planning 

examples involving growing annuity deposits and 

withdrawals, with changing discount rates. Results in 

the examples are then compared to those obtained 

assuming ordinary, rather than growing annuity, PV 

and FV calculations. In all cases, timelines are used 

to depict timing and amounts of cash flows, and 

whether amounts are to be compounded or are to be 

discounted in the analysis. General forms of the FV 

and PV equations applied to education funding and 

retirement planning cases later in this article appear 

below. (Derivation of the FV equation is presented in 

Appendix A. The PV equation is solved for similarly.) 

FV Equation (Future Value of Growing Annuity) 

Where: 

FV = future accumulation 

x = initial deposit, assuming each deposit is made 

at the end of each period (ordinary annuity) 

November 2002 

3


i = interest rate or yield earned on investment 

g = growth rate of deposits 

n = number of deposits 

PV Equation (Present Value of Growing Annuity) 

Applying the FV equation, the above facts can be 

reduced to the following simple equation that can be 

solved readily on a handheld financial calculator: 

a. Initial deposit = (5%) ($40,000) = $2,000. 

b. Future value = $29,792.24 determined as follows: 

Where: 

PV = present value of accumulation 

x = amount of initial withdrawal, assuming 

each withdrawal is made at the beginning of 

each period (annuity due) 

i = interest rate earned on investment 

g = growth rate of withdrawals 

n = number of withdrawals 

Note the equations are amenable to compounding 

periods other than one year. If deposits are made 

quarterly, for example, both i and g would be onefourth 

of the annual rate assumed for purpose of 

analysis, and n would be four times the number of 

years over which deposits are made. 

Education Funding Case 

The mathematics for PV calculations involving 

growing annuities can perhaps be best understood by 

studying a simple illustration. Consider the following 

example. A client plans to contribute 5% of her annual 

earnings to a state-sponsored 529 college savings 

plan each year for the next ten years. Invested funds 

are expected to yield 6% tax-free. The client wants to 

know how much will have been accumulated by the 

end of year 10. She currently earns $40,000 per year, 

plans to make annual contributions at the end of each 

year, and anticipates her earnings will increase at the 

rate of 3% per year. The timeline below illustrates the 

calculation to be made. 

I I I I vvv l 

0 1 2 3 10 

$2,000 $2,000(1.03) $2,000(1.03) 2 $2,000(1.03) 9 

i = 6% 

FV 

The FV equation applied can also be used to 

solve the initial deposit required to accumulate a 

specific future amount or target accumulation. The 

initial deposit can then be divided by a client’s earnings 

at the start of the accumulation phase to determine 

the percentage of earnings to be saved. The 

target accumulation should represent the present 

value of expected withdrawals, in the form of a 

growing annuity, as based on an assessment of education 

or retirement cost needs (an example of a target 

present value calculation is included in the 

retirement planning cases presented later). In the 

education funding case, assume the target accumulation 

required by a client is $60,000. Because, the 

future value is given, the initial deposit is the 

unknown to be determined. Given the same variables 

in the FV equation presented in the education 

funding case, but solving for the deposit, x, instead 

of the FV, the required initial deposit is calculated 

to be $4,028. (See Appendix B, E1.) This deposit is 

approximately 10 percent of the first year’s earnings 

of $40,000 ($4,028 divided by $40,000). 

Had the original calculations been based instead 

on an ordinary annuity, the total accumulation at the 

end of year 10 would have been $26,362 ($2,000 

annuity compounded at 6 percent). The $3,430 

understatement ($29,792 - $26,362) would also 

affect calculation of annual withdrawals for education 

costs. This error is compounded further if withdrawals 

also are treated as an ordinary annuity, 

rather than a growing annuity that reflects the annu- 

4 November 2002


FIGURE 1 

Age: 30 31 32 60 61 62 84 

I I I vvv I I I vvv I 

0 1 2 30 

$3,600 $3,600(1.05) $3,600(1.05) 29 

i =8% 

FV 

0 1 2 24 

x x(1.04) x(1.04) 2 x(1.04) 24 

PV i = 6% 

al rate of increase in education costs. Differences 

between growing annuity and ordinary annuity calculations 

are only somewhat dramatic in the case 

illustrated above because of the relatively short time 

period and the low interest rate assumed. Where 

longer time periods and higher interest rates are 

involved, however, significant differences can result. 

The retirement planning illustration presented below 

highlights this fact. 

Retirement Planning Case 

Retirement planning is based on many assumptions 

requiring preliminary judgments and estimates, 

including projected retirement and mortality ages, 

risk preferences of the client, various resources 

available to help finance retirement, marital status, 

inflation rates, etc. The following example treats 

many of those variables as given to avoid straying 

from the theme of the article. A more detailed case 

is presented in the next section of the article. 

Based on an extensive interview, a financial 

planner may determine that the needs of a 30- 

year-old client are best met by accumulating 

retirement savings over the next 30 years in a 

company 401(k) plan. Contributions to the plan, 

including the employer’s matching share, will be 

12% of earnings per year. First-year earnings are 

$30,000 and are expected to grow at the rate of 

5% per year. The recommended portfolio allocation 

should produce an average annual return of 

8% during the accumulation phase. The client 

plans to begin withdrawals at age 60, with 

amounts withdrawn to increase at the rate of 4% 

November 2002 

per year to adjust for inflation. Portfolio returns 

during retirement should average 6% per year, and 

the client plans to fully deplete the account by age 

84 (25 withdrawals). 

The client wants to know how much can be withdrawn 

at age 60, the beginning of his first year of 

retirement. The accumulation at retirement first 

must be determined, followed by calculation of the 

initial retirement withdrawal. (The example, of 

course, could be modified to reflect a given initial 

withdrawal amount, and then, working backwards, 

computing the required percentage of earnings to be 

contributed to the 401(k) plan each year, using the 

approach discussed in the education funding example 

earlier.) 

The timeline in Figure 1 illustrates the assumptions 

in the planning model for the retirement planning 

case. 

The calculated amount of FV in the upper portion 

of the timeline becomes the PV amount in the lower 

portion of the timeline. Note, as well, the last 

amount in the accumulation phase is raised to the 

29 th power (one less than the year) because deposits 

are made at year-end, whereas in the withdrawal 

phase the final amount is raised to the 24 th power 

(equal to the year) because withdrawals are made at 

the beginning of the year. The following calculations 

complete the analysis. 

First, applying the FV equation, the FV is calculated: 

FV = $688,891 (Appendix B, E2). 

Second, applying the PV equation, the withdrawal, 

x, is calculated: x = $34,308 (Appendix B, E3). 

5


In summary, the client is able to make retirement 

withdrawals that keep pace with 4% inflation, starting 

with an initial withdrawal of $34,308. The 

client may think this amount is sufficient to meet 

living needs during retirement. If, however, the 

client believes the initial amount should be 10% 

higher, then annual deposits to the retirement 

account should be 10% higher, that is, equal to 

13.2% (12% x 1.10) of earnings. Remaining PV 

analysis calculations will result in a 10% greater 

withdrawal. The financial planner can advise the 

client of other options, including acceptance of 

greater risk in the investment portfolio to generate 

higher investment returns, deferring retirement to a 

later age, and increasing contribution percentages in 

later years. All of these changes can be readily 

incorporated into the PV and FV equations used in 

this article. 

Differences in calculations assuming equal periodic 

deposits and withdrawals (ordinary annuities) 

instead of growing annuities were discussed briefly 

in the education funding example presented earlier. 

Consider the different results that would be obtained 

in the retirement planning example. Assuming 

annual deposits of $3,600 (an amount equal to the 

initial deposit) instead of growing deposits, the 

retirement accumulation would be only $407,820 

($3,600 annuity compounded at 8% for 30 periods), 

instead of the $688,891 amount calculated for the 

growing annuity. The difference certainly has 

implications for amounts that can be withdrawn during 

retirement. 

Perhaps more critical is the effect of ignoring 

inflation or some other growth factor in computing 

withdrawals. Assume the retirement fund 

accumulation is $688,891 as determined earlier 

using growing annuity deposits, but equal periodic 

withdrawals are to be made during retirement. 

The withdrawal each year would be $50,839 ($x 

annuity due for 25 periods discounted at 6% = 

$688,891; x = $50,839). Initial withdrawals, 

therefore, will be greater than those calculated in 

the growing annuity withdrawal scenario. This 

short-term benefit has two major disadvantages. 

First, equal withdrawals later in retirement will be 

lower than those calculated for a growing annuity, 

thus not keeping pace with inflation. Second, the 

retirement fund may be depleted prematurely with 

the higher initial withdrawals if portfolio returns 

are less than the projected 6%. 

Table 1 summarizes accumulations and withdrawals 

based on ordinary versus growing annuities 

and highlights differences in results obtained 

by the differing assumptions made in supporting 

calculations. 

Retirement Planning Case Refined 

The power of mathematical modeling, coupled 

with a timeline, is illustrated in the following exam- 

TABLE 1 

RETIREMENT ACCUMULATIONS AND WITHDRAWALS 

Ordinary Versus Growing Annuities 

8% Earnings Rate in Accumulation Phase, 6% Earnings Rate in Withdrawal Phase 

$3,600 Initial Retirement Deposit 

Beginning of Year Withdrawals 

Ordinary Growing Growing 

Annuity Annuity* Annuity* 

Accumulation Each Year Year One Year 25 

Equal periodic deposits $407,820 $30,097 $20,391 $54,359 

Growing annuity deposits $688,891 $50,839 $34,308 $91,458 

*Assumes withdrawals grow at 4% annual rate 

6 November 2002


ple. Assume the retirement planning client discussed 

in the preceding example accepts your 

advice to make more aggressive investments in the 

first 20 years of the accumulation phase. This 

should result in average annual investment returns 

of 10% through age 50, at which time the portfolio 

will be adjusted to a more conservative mix of 

investments to return 8%. Other assumptions 

remain as before. The timeline to depict this case 

appears in Figure 2. 

The first calculation, FV 1 , is the future value of 

the growing annuity for 20 periods at 10% computed 

using the FV equation. FV 1 = $293,342 

(Appendix B, E4). The FV 1 amount is a single 

amount that must be compounded at 8% for the next 

10 years to determine its accumulation at age 60, 

FV 2 or $633,303 (Appendix B, E5). The growing 

annuity deposits made in years 21 through 30 must 

also be compounded to their future value, FV 3 or 

$168,760 (Appendix B, E6). The sum of FV 2 plus 

FV 3 , $802,063 ($633,303 + $168,760), is the total 

accumulation available for withdrawal starting at 

period 30, that is, age 60. Calculation of the withdrawals 

would be made as illustrated in the preceding 

retirement case illustration, with the PV equal to 

$802,063. Using the PV equation, the initial withdrawal 

at age 60 equals $39,944 (Appendix B, E7), 

growing to $102,389 for the twenty-fifth withdrawal 

(Appendix B, E8). 

Conclusions 

In practice, a majority of calculations may be 

computer-based, but an understanding of the underlying 

mathematics provides several benefits, including 

the following: 

1. Clearer understanding of variables in the decision 

process, especially when coupled with 

timelines depicting timing and amounts of 

cash flows, including related compound interest 

or discount rates; 

2. Basis for more sophisticated modeling of decision 

cases using spreadsheet software, including 

improved understanding of computer output; 

3. Enhanced ability to deal with growing annuities 

to reflect changes in retirement, education, 

or other plan contributions based on earnings; 

4. Improved capacity to deal with inflation and 

other growth adjustments in computing fund 

withdrawals; 

5. Ability to incorporate discount rates that 

FIGURE 2 

Age: 30 31 32 50 51 60 61 62 84 

I I I vvv I I vv I I I vvv I 

0 1 2 20 21 

$3,600 $3,600(1.05) $3,600(1.05) 19 

i = 10% 

FV 1 

FV 1 

FV 2 

$3,600(1.05) 29 

$3,600(1.05) 20 FV 3 

i = 8% 

0 1 2 24 

x x(1.04) x(1.04) 2 x(1.04) 24 

PV i = 6% 

November 2002 

7


change over time in response to changes in 

portfolio allocations; 

6. Ability to solve moderately complex problems 

in a relatively short time period, using only a 

handheld calculator; 

7. Improved ability to evaluate usefulness of financial 

calculators included on various websites; 

8. More efficient analysis of planning problems 

in impromptu client advising sessions. 

Financial planners with knowledge of the mathematics 

of PV calculations are better prepared to serve 

the needs of clients. While at first glance the mathematical 

notation and calculations may appear complicated, 

they are based on basic high school algebra 

and can be learned in a short period of time. ■ 

G. Eddy Birrer, Ph.D., CPA, is a professor of 

accounting at Gonzaga University. Kent Hickman, 

Ph.D., is a professor of finance at Gonzaga University. 

8 November 2002


APPENDIX A 

DERIVATION OF PV AND FV 

FORMULAS 

Finding a common denomination on the left side 

of (E5) we obtain: 

FV Formula – FV of Growing Annuity 

Derivation of the generalized formula for the FV 

of a growing annuity is illustrated by using the data 

presented for the education funding case used in 

this article. The education funding case provides 

for an initial deposit at the end of year one of 

$2,000, growing at a 3% annual rate through year 

10. Deposits earn 6% per year. The following 

equation is used to compute the FV: 

Solved as follows: 

(E1)FV = $2,000(1.06) 9 + $2,000(1.03) 1 (1.06) 8 

+ … + $2,000(1.03) 9 + $2,000(1.03) 10 /(1.06) 1 

The geometric growth factor is 1.03/1.06, that is, 

the factor that when multiplied by one term in the 

geometric series yields a product equal to the next 

term in the series. To sum the geometric series, 

multiply (E1) by the geometric factor, as follows: 

(E2)FV (1.03)/(1.06) = $2,000(1.03) 1 (1.06) 8 + … 

+ $2,000(1.03) 9 + $2,000(1.03) 10 /(1.06) 1 

Subtracting E 2 from E 1 we obtain: 

(E3)FV - FV (1.03)/(1.06) = $2,000(1.06) 9 - 

$2,000(1.03) 10 /(1.06) 1 

Reducing (E3) by factoring FV on the left side of 

the equation, and $2,000 on the right side produces: 

The PV of a growing annuity may be found following 

the five steps just illustrated for the FV equation: 

1. Set the problem up algebraically, 

2. Identify the geometric factor, 

3. Multiply through the original equation using 

the factor, 

4. Subtract the product just obtained from the 

original equation, and 

5. Simplify. 

Generalizing (E4) by substituting g, i, and n for 

their respective values gives: 

November 2002 

9


APPENDIX B 

E1. Percentage of Earnings – Education Funding 

c. accumulation objective = $60,000 

d. required initial deposit = $4,027.90 determined 

as follows: 

E4. Retirement Case – Refined 


FV 2 = $293,342(1.08) 10 = $633,303 


E2. Retirement Case – Accumulation 


E3. Retirement Case – Withdrawal 

The future value accumulation ($688,890.83) is the 

amount available for withdrawal and, therefore, represents 

the present value of the withdrawals. The initial 

withdrawal, x, can then be calculated as follows: 


FV = $39,944(1.04) 24 = $102,389 = last withdrawal 

10 

November 2002

INVESTMENT STRATEGIES 

Advising the High-Net-Worth 

Athlete or Entertainer 

By Allen F. Ross 

Providing long-term financial advice to the 

high-net-worth athlete or entertainer is a complex 

and sometimes frustrating undertaking. 

Their backgrounds usually do not coincide with the 

need for taking a longer term outlook on their financial 

affairs. Nevertheless, their unique situations still 

require a consummate professional advisor that can 

provide the proper guidance. 

Probably one of the most difficult aspects of an 

athlete’s or an entertainer’s financial affairs rests 

with the rather unusual ways in which the individual 

is compensated. Getting a regular salary check, with 

growth, over a period of years, is just not feasible 

for these professionals. Rather, the biggest contracts 

come with large-scale payments over a short period 

of time with no definitive knowledge that these contracts 

will be regularly repeated. This can create 

both the normal investing and planning problems as 

well as some outrageous tax problems. 

Developing strategies that restructure the method 

of payment or the timing of payments can lead to 

significant improvements in the after-tax value to 

the client. These programs would usually be undertaken 

by previously established professionals with 

outside sources of revenue for ongoing expenses. 

The key is to provide long-term reservoirs of funds 

in the most tax-efficient manner. However, each 

client is different and may require different longterm 

solutions, which may include supplemental 

income, retirement income, estate planning, as well 

as the usual financial planning requirements. This 

should not be considered a comprehensive financial 

plan, but rather a dynamic niche of a fully developed 

program. 

Perhaps the best way to begin our analysis is to 

provide an overview of the typical situations confronting 

athletes and entertainers. Then we will construct 

a program to help alleviate the financial and 

tax crisis. Finally, we will show how this type of 

program can be a significant part of the client’s 

long-term planning. 

The Athlete 

Leading athletes have a number of sources of 

income and each type determines the way it can be 

used. For the team athlete in basketball, hockey, 

football, or baseball, the key components are generally 

salaries, signing bonuses, and endorsement programs. 

These constitute the major revenue sources, 

but unfortunately, none have been designed to provide 

any real tax efficiency, nor any other related 

benefits. Team players’ salaries provide an ongoing 

source of funds, but with the way the leagues are 

structured it is all considered W2 income with little 

opportunity for restructure or design. However, the 

other areas, bonuses and endorsement programs, do 

remain an avenue for reconsideration. 

For individual athletes, particularly golf and tennis 

players, there are no significant salaries or 

bonuses, but there is a substantial amount of money 

in the endorsement arena. Thus, for our purposes, 

we will spotlight bonuses and endorsements. 

For the team athlete the periodic signing bonus 

can be a key portion of the long-term well-being of 

the individual. It is above and beyond the normal 

salary and can provide the opportunity for the athlete 

to dramatically increase his or her net worth. 

Unfortunately, whether paid in one lump sum or 

over a period of years, it is not designed to give any 

initial or future tax benefits. In reality, between the 

federal, state, and related tax authorities, usually 43 

to 50 percent of each marginal dollar will be confiscated. 

Furthermore, once the athlete has control of 

the funds, they usually remain in a taxable invest- 

November 2002 11


ment subject to further taxation. These funds are 

usually not needed for living expenses due to the 

existing salary and could be better deployed into a 

more tax-advantaged strategy. 

All high-quality athletes receive endorsements. 

For some it can be the largest portion of their annual 

income. It is usually a multi-year arrangement, 

which can continue even after an athlete’s playing 

days are over. However, it still remains a highly 

taxed program, with little thought given to the net 

dollars to be kept by the athlete. Once again, a more 

highly structured solution can provide the athlete 

with a substantial increase in net long-term value. 

The Entertainer 

The entertainment industry comprises a wide range 

of activities, but at the levels we are concerned about, 

there are no teams or actual salaries. Each individual 

or small group is in direct competition with everyone 

else in the field. Within the music field, whether 

you’re dealing with solo or group acts, the key to 

income is either concert performances or album deals. 

Concerts are done over a short period of time, with 

little opportunity, in most instances, for long-term 

planning. However, with multiple-album contracts 

there may be an opportunity to institute a more taxefficient 

structure. For movie actors it is quite possible 

to restructure studio deals to allow for a more intelligent 

structure of remuneration. Furthermore, for the 

leading actors an endorsement contract can be 

arranged advantageously. For certain producers or 

directors, with large or multi-movie deals, programs 

can also be arranged. In TV the players are usually 

salaried and W2 income would not lend itself to better 

tax planning. Other creative artists, including wellknown 

writers and a few in television, could be in a 

position to restructure certain compensation packages. 

Certainly, we could consider many talented artists 

capable of enhancing their net long-term value. 

Structure 

Whether considered a bonus, endorsement, or 

deal contract, the basic structure will remain quite 

similar. Furthermore, whether the compensation is 

from a team, corporation, or studio, the advantages 

to both sides will also remain consistent. The basic 

design is as follows: 

The initial parameters, in most cases, are similar 

in format to a deferred compensation arrangement. 

The objective is to restructure the method of remuneration 

such that the long-term after-tax value to 

the athlete or entertainer is substantially greater than 

the alternative of paying tax and investing the 

remainder. In addition, the costs to the provider of 

the funds should not be unduly high and in some 

cases may have certain advantages. The second set 

of parameters would be to take any remaining funds 

not used in the first program and assign them to a 

corporation owned and run by the artist. Inside the 

corporation numerous tax-efficient programs can be 

constructed. 

The centerpiece of both these structures is the 

development of a unique, custom-designed insurance 

contract that acts as a special capital transfer 

vehicle in each aspect of the program. This special 

design will allow the funds to be transferred at a 

fraction of the initial tax cost, while creating both a 

future tax-efficient supplemental income and a substantially 

increased net estate value. 

As mentioned above, we begin by creating a custom-tailored 

deferred-compensation contract, probably 

a version of a “rabbi trust.” A portion of the 

funds to be restructured is deposited into the contracts 

inside the trust for a period not exceeding five 

years. Initially the fund provider (team, corporation, 

etc.) will hold the contracts. If necessary, the funding 

of the contracts can be accelerated or set aside 

in the trust, and/or special split-dollar programs on 

the contracts can be established for more artist control. 

However, there must be a type of employment 

contract, with a risk of forfeiture included, such that 

the client does not have control, officially, of the 

money until the program is distributed. This, for 

various tax and design reasons, is done at the end of 

the fifth year. When the contracts are distributed out 

of the trust to the athlete or artist, any outstanding 

taxes would be paid by additional corporate contributions 

or from income-tax-free policy loans from 

the contracts. No out-of-pocket payments by the 

client would be necessary. This is because of the 

very special design of the insurance contracts. The 

amount of money that can be absorbed by this initial 

program is dependent upon the age of the individual 

and may require insuring additional family 

members. The client would still be the owner and 

beneficiary of all policies. 

For that portion of the funds that cannot be 

included in the first program, a corporation would 

12 

November 2002


be established and the client would assign those 

funds to that entity. 

This firm is usually owned by the athlete or 

artist, and it establishes tax-efficient programs for 

appropriate participants, including excess retained 

earnings programs, pension plans, welfare benefit 

plans, regular corporate expenses, and/or charitable 

deductions. 

The result of all this planning is a net tax rate of 

less than 20 percent of the initial requirement and 

probably substantially lower than that. Furthermore, 

the long-term value to the client includes an ability 

to access a supplemental income with no additional 

income taxes and a much larger estate value. 

For the team or corporation, there are also certain 

advantages or disadvantages. Initially, the program 

is in its control, it establishes an employment contract 

with its athlete or entertainer that may give it a 

higher sense of security, it has a key man insurance 

benefit for five years, and it may be able to create 

substantial cash flow advantages. Alternatively, it 

may lose certain tax deductions on transfer, but this 

can be considered in the initial structure. 

Overall, the plan creates significant advantages 

both for the provider of funds and its key participants. 

Example 

To fully understand the dynamics of the program, 

it would be best to consider a specific example. 

Assume we have a young ballplayer or creative 

artist, age 25, who has received an endorsement 

contract for $5 million to be paid out over the next 

five years. This structure is ideal, but one can 

redesign a lump-sum program or other types of payment 

methods. Furthermore, at this young age there 

is a limit to the level of financial underwriting a 

financial institution may be willing to undertake. 

This may require that other members of the client’s 

family be added to the group of insured individuals 

(absorbing the additional remuneration). 

In our example, illustrated in the table on pages 

14 and 15, we will consider the options of the artist 

taking a supplemental income at ages 45, 55, and 

65. In addition, we will assume that the necessary 

taxes to be paid in the sixth year will be paid with 

outside funds, although coverage internal to the program 

can be arranged. 

Looking at the table, we see that annual contributions 

of $1 million are made to the program by the 

corporation or team and probably held in a “rabbi 

trust” under the control of the team. The client pays 

no taxes, unless it is decided that the client would 

be interested in creating a special split-dollar type 

program for the death benefit of more than $50 million. 

The corporation will continue to make annual 

contributions for five years as shown in column 3. 

At the end of that time, the program will be distributed 

to the artist or athlete and the client will be 

responsible for paying taxes on the stated cash value 

or the real taxable value, the interpolated terminal 

reserve, which will be similar (see column 5–fifth 

year). Thus at the end of the fifth year, taxes must 

be paid on $578,893 (with customization this 

amount can be significantly reduced). At the 50 percent 

marginal tax rate, the taxes will be $289,447 

(shown in column 4) and we are assuming that it 

will be paid with other funds. Now the program is 

in the control of the athlete or entertainer and can 

be structured many different ways. 

In this example, we assume that our client has 

substantial funds from other sources and does not 

need the funds growing in the contract. By controlling 

the program, the client has secured a vastly 

increased estate value because of the more than $51 

million death benefit. Thus, the client’s family is 

substantially protected. If the main purpose of the 

program is to create long-term supplemental income 

for the client, then the death benefit will be somewhat 

reduced after the tenth year (see reduction in 

column 6) and the program will be tailored for cash 

flow. The client controls the access to the cash flow 

stated in column 5, but we have created three 

options to be considered. If he or she waits until age 

45 to begin a supplemental income program, the 

client can have $1 million annually income-tax-free 

for the rest of his or her life. Waiting until age 55 

will create a program worth $2.25 million annually 

for life, and waiting until age 65 will increase that 

to almost $5 million per year. Obviously, these illustrations 

show only a small portion of the combinations 

and opportunities available. The amounts 

taken out with these income-tax-free policy loans 

are totally flexible and at the client’s discretion. The 

only restriction is that the policy remain in force 

during the client’s lifetime. Even after decades of 

tax-free cash flow, there will still be a substantial 

November 2002 13


1 2 3 4 5 6 7 8 9 10 11 12 

OPTION I OPTION II OPTION III 

INCOME AT AGE 45 INCOME AT AGE 55 INCOME AT AGE 65 

Corporate Annual Residual Net Annual Residual Net 

Premium Tax-Free Cash Death Tax-Free Cash Death 

Age Year Payment* Income Account Proceeds Income Account Proceeds 

Annual Residual Tax-Free Income Net 

Cash Death 

Account Proceeds 

25 1 1,000,000 51,229,508 51,229,508 51,229,508 

26 2 1,000,000 51,229,508 51,229,508 51,229,508 

27 3 1,000,000 51,229,508 51,229,508 51,229,508 

28 4 1,000,000 245,902 51,229,508 245,902 51,229,508 245,902 51,229,508 

29 5 1,000,000 578,893 51,229,508 578,893 51,229,508 578,893 51,229,508 

30 6 -289,447 1,053,230 51,229,508 -289,447 1,053,230 51,229,508 -289,447 1,053,230 51,229,508 

31 7 2,028,711 51,229,508 2,028,711 51,229,508 2,028,711 51,229,508 

32 8 3,012,653 51,229,508 3,012,653 51,229,508 3,012,653 51,229,508 

33 9 4,005,563 51,229,508 4,005,563 51,229,508 4,005,563 51,229,508 

34 10 5,007,737 51,229,508 5,007,737 51,229,508 5,007,737 51,229,508 

35 11 5,127,532 43,882,080 5,127,532 43,882,080 5,127,532 43,882,080 

36 12 5,592,593 43,882,080 5,592,593 43,882,080 5,592,593 43,882,080 

37 13 6,096,918 43,882,080 6,096,918 43,882,080 6,096,918 43,882,080 

38 14 6,638,670 43,882,080 6,638,670 43,882,080 6,638,670 43,882,080 

39 15 7,224,133 43,882,080 7,224,133 43,882,080 7,224,133 43,882,080 

40 16 7,854,369 43,882,080 7,854,369 43,882,080 7,854,369 43,882,080 

41 17 8,535,338 43,882,080 8,535,338 43,882,080 8,535,338 43,882,080 

42 18 9,267,874 43,882,080 9,267,874 43,882,080 9,267,874 43,882,080 

43 19 10,058,899 43,882,080 10,058,899 43,882,080 10,058,899 43,882,080 

44 20 10,913,324 43,882,080 10,913,324 43,882,080 10,913,324 43,882,080 

45 21 1,000,000 11,836,053 43,882,080 11,836,053 43,882,080 11,836,053 43,882,080 

46 22 1,000,000 11,757,611 42,806,811 12,832,880 43,882,080 12,832,880 43,882,080 

47 23 1,000,000 11,677,600 41,650,608 13,909,072 43,882,080 13,909,072 43,882,080 

48 24 1,000,000 11,596,139 40,407,379 15,070,840 43,882,080 15,070,840 43,882,080 

49 25 1,000,000 11,512,136 39,070,574 16,323,642 43,882,080 16,323,642 43,882,080 

50 26 1,000,000 11,434,137 37,633,148 17,683,068 43,882,080 17,683,068 43,882,080 

51 27 1,000,000 11,317,154 36,087,530 19,111,704 43,882,080 19,111,704 43,882,080 

52 28 1,000,000 11,201,493 34,425,575 20,657,998 43,882,080 20,657,998 43,882,080 

53 29 1,000,000 11,089,488 32,638,526 22,333,042 43,882,080 22,333,042 43,882,080 

54 30 1,000,000 10,982,626 30,716,968 24,147,739 43,882,080 24,147,739 43,882,080 

55 31 1,000,000 10,883,483 28,650,777 2,250,000 26,114,787 43,882,080 26,114,787 43,882,080 

56 32 1,000,000 10,795,260 26,429,066 2,250,000 25,828,919 41,462,725 28,248,274 43,882,080 

57 33 1,000,000 10,721,475 24,040,129 2,250,000 25,542,641 38,861,268 30,563,426 43,882,080 

58 34 1,000,000 10,661,429 23,228,838 2,250,000 25,254,052 37,821,461 33,072,129 45,639,538 

14 November 2002


59 35 1,000,000 10,614,380 22,782,019 2,250,000 24,961,286 37,128,925 35,787,175 47,954,815 

60 36 1,000,000 10,582,317 22,199,849 2,250,000 24,665,012 36,282,544 38,725,108 50,342,640 

61 37 1,000,000 10,569,719 22,303,415 2,250,000 24,368,316 36,102,011 41,906,054 53,639,749 

62 38 1,000,000 10,574,458 22,364,082 2,250,000 24,067,573 35,857,197 45,344,710 57,134,334 

63 39 1,000,000 10,600,522 22,375,679 2,250,000 23,765,161 35,540,319 49,063,158 60,838,316 

64 40 1,000,000 10,650,671 22,329,066 2,250,000 23,462,111 35,140,506 53,083,614 64,762,009 

65 41 1,000,000 10,729,075 22,215,307 2,250,000 23,160,731 34,646,963 4,950,000 57,431,163 68,917,396 

66 42 1,000,000 10,842,168 22,647,768 2,250,000 22,865,454 34,671,054 4,950,000 56,812,156 68,617,756 

67 43 1,000,000 10,987,387 23,086,259 2,250,000 22,571,566 34,670,438 4,950,000 56,170,170 68,269,042 

68 44 1,000,000 11,170,123 23,530,180 2,250,000 22,282,143 34,642,200 4,950,000 55,506,448 67,866,506 

69 45 1,000,000 11,395,053 23,977,160 2,250,000 21,999,376 34,581,482 4,950,000 54,821,209 67,403,316 

70 46 1,000,000 11,665,222 24,421,959 2,250,000 21,723,634 34,480,371 4,950,000 54,112,702 66,869,439 

71 47 1,000,000 11,988,711 23,944,404 2,250,000 21,460,121 33,415,815 4,950,000 53,383,851 65,339,544 

72 48 1,000,000 12,386,621 23,327,211 2,250,000 21,226,847 32,167,437 4,950,000 52,650,212 63,590,802 

73 49 1,000,000 12,878,275 22,560,542 2,250,000 21,039,809 30,722,075 4,950,000 51,825,147 61,607,414 

74 50 1,000,000 13,484,492 21,631,818 2,250,000 20,916,249 29,063,575 4,950,000 51,223,064 59,370,390 

75 51 1,000,000 14,228,787 20,526,564 2,250,000 20,875,837 27,173,614 4,950,000 50,560,585 56,858,362 

76 52 1,000,000 15,146,153 21,964,039 2,250,000 20,949,433 27,767,318 4,950,000 49,965,291 56,783,177 

77 53 1,000,000 16,185,984 23,565,797 2,250,000 21,081,983 28,461,796 4,950,000 49,378,605 56,758,418 

78 54 1,000,000 17,359,650 25,346,464 2,250,000 21,280,079 29,266,894 4,950,000 48,803,329 56,790,143 

79 55 1,000,000 18,673,300 27,315,387 2,250,000 21,544,730 30,186,817 4,950,000 48,236,396 56,878,482 

80 56 1,000,000 20,138,932 29,488,268 2,250,000 21,882,405 31,231,740 4,950,000 47,679,895 57,029,230 

81 57 1,000,000 21,835,777 31,951,640 2,250,000 22,366,393 32,482,256 4,950,000 47,202,404 57,318,267 

82 58 1,000,000 23,724,373 34,667,661 2,250,000 22,950,842 33,894,130 4,950,000 46,753,004 57,696,292 

83 59 1,000,000 25,812,444 37,648,302 2,250,000 23,636,604 35,472,462 4,950,000 46,327,101 58,162,959 

84 60 1,000,000 28,117,754 40,916,368 2,250,000 24,434,055 37,232,669 4,950,000 45,929,213 58,727,827 

85 61 1,000,000 30,650,883 44,487,434 2,250,000 25,345,830 39,182,381 4,950,000 45,555,678 59,392,229 

86 62 1,000,000 33,470,483 48,427,886 2,250,000 26,422,040 41,379,442 4,950,000 45,249,833 60,207,235 

87 63 1,000,000 36,547,766 52,712,658 2,250,000 27,642,708 43,789,600 4,950,000 44,966,421 61,131,313 

88 64 1,000,000 39,877,962 57,342,294 2,250,000 28,939,190 46,403,522 4,950,000 44,682,967 62,147,299 

89 65 1,000,000 43,476,184 62,338,632 2,250,000 30,369,975 49,232,425 4,950,000 44,395,545 63,257,992 

90 66 1,000,000 47,328,344 67,693,297 2,250,000 31,891,563 52,256,516 4,950,000 44,069,592 64,434,545 

91 67 1,000,000 51,451,028 69,034,691 2,250,000 33,508,252 51,091,916 4,950,000 43,699,681 61,283,345 

92 68 1,000,000 56,294,856 70,536,623 2,250,000 35,657,463 49,899,230 4,950,000 43,712,763 57,954,530 

93 69 1,000,000 62,069,181 72,330,580 2,250,000 38,534,350 48,795,749 4,950,000 44,292,737 54,554,136 

94 70 1,000,000 68,996,707 74,546,898 2,250,000 42,346,352 47,896,542 4,950,000 45,634,940 51,185,130 

95 71 1,000,000 77,386,803 77,386,803 2,250,000 47,386,420 47,386,420 4,950,000 48,019,310 48,019,310 

96 72 1,000,000 87,384,308 87,384,308 2,250,000 53,781,746 53,781,746 4,950,000 51,559,047 51,559,047 

97 73 1,000,000 98,575,146 98,575,146 2,250,000 61,099,273 61,099,273 4,950,000 55,806,049 55,806,049 

98 74 1,000,000 111,086,170 111,086,170 2,250,000 69,445,446 69,445,446 4,950,000 60,850,581 60,850,581 

99 75 1,000,000 125,056,887 125,056,887 2,250,000 78,937,829 78,937,829 4,950,000 66,792,814 66,792,814 

TOTALS 55,000,000 101,250,000 173,250,000 

November 2002 

15


death benefit for the beneficiaries. Thus, the program 

will provide both a substantial supplemental 

income and a significant estate value. 

Additional Considerations 

When constructing this system, it is imperative to 

account for the myriad opportunities. If the corporation 

is expected to provide more than the amount that 

can be underwritten by the related financial institution, 

then additional family members should be added 

to the list of those to be insured. These will eventually 

give the client contracts on the closest loved ones, and 

various alternative beneficiary designations could be 

considered. If additional payments are still available, 

it would be best to arrange that they be assigned to the 

client’s corporation. Once inside the client’s operating 

firm, various new programs can be initiated for the 

benefit of those so chosen. Initially, salaries can be 

provided and then appropriate pension plans, excess 

retained earnings programs, welfare benefit plans, and 

regular corporate expenses and/or charitable deductions 

can be added. 

Instituting all the above-mentioned opportunities 

will drastically reduce the tremendous original tax 

burden and provide the client with a wealth of additional 

long-term benefits. 

The Advisor 

Implementing this dynamic strategy requires a 

general understanding of the various components of 

the program and the inclusion in the new structuring 

of all of the parties. This program can be advantageous 

for everyone involved, but it will certainly 

require that all parties be engaged in its design. 

The client and the advisors, as well as members 

of the corporate team, must be willing to work 

together to construct a proper program. The advisor 

must consider the appropriateness of the program 

for the client as well as the alternatives. 

A knowledgeable advisor will provide the client 

with a tremendous value enhancement. 

Summary 

For athletes and entertainers, this strategy will 

dramatically reduce income tax burdens and greatly 

enhance the net value of their estates. In the proper 

circumstances, this well-designed strategy will also 

significantly enhance almost any comprehensive 

business, tax, financial, or estate plan. Large corporations, 

family businesses, wealthy individuals interested 

in wealth transfer, and even those involved in 

the not-for-profit arena can implement various versions 

of the strategy. ■ 

Dr. Allen F. Ross holds a Ph.D. in economics from 

Columbia University and is the chief business strategist 

for Pinnacle Wealth Group, LTD. His more than 

40 articles have been featured in numerous national 

legal, accounting, and financial journals. 

Additional information regarding tax strategies 

and articles can be viewed and downloaded from 

www.pinnaclewealth.net. Allen can be reached at 

allen@pinnaclewealth.net and at (516) 829-3000. 

16 

November 2002

RISK MANAGEMENT 

Reducing the Wealth Transfer Tax 

By Jeffrey H. Rattiner 

Editor’s Note: This is the last part of a four-part 

series dealing with risk management issues concerning 

high-net-worth clients. 

As planners, a key objective is to help 

clients reduce their wealth transfer tax. 

There are five general strategies for 

reducing this tax: 

1. Inheritance planning; 

2. Reducing the valuation of estate assets; 

3. Using the $11,000 annual gift exclusion; 

4. Designing special trusts, such as personal residence 

GRITs, GRATs, or GRUTs; and 

5. Using the $1,090,000 generation-skipping 

transfer exclusion. 

Inheritance Planning 

Those who expect to inherit a significant estate 

should ask their benefactor to create a trust for their 

benefit, preferably a spendthrift trust. A trust fund 

set up for an individual is a private transaction that 

can protect the principal from creditors (and from 

those of his or her descendants), from creditors of 

his or her estate, and from becoming marital property 

available for a divorce settlement arrangement. 

Moreover, parents, grandparents, and ancestors can 

bequeath up to $1,090,000 sheltered from future 

transfer taxes in the beneficiary’s estate and that of 

other descendants. Those who expect to inherit substantial 

bequests can even be trustee of these types 

of trusts as long as they do not have unlimited discretion 

to make distributions of trust principal to 

themselves. 

Reducing the Valuation of Estate Assets 

Another way to preserve wealth for one’s family 

is to fractionalize the ownership of business assets 

or real estate to take advantage of valuation discounts. 

This is best done through a family limited 

partnership (FLP) in which the high-net-worth individual 

and his or her spouse are general partners 

and their descendants are limited partners. 

The principal advantage of this technique is that 

it facilitates the gifting of limited partnership interests 

from parents to children and other family members 

without divesting control from the parents. 

In other cases, an FLP will be used to ensure 

continuous ownership of assets within the family 

unit for several generations. 

Begin by obtaining a valid appraisal of the 

client’s estate and then creating the family partnership 

under which a minority interest is gifted to the 

descendants. The minority interest will be subject to 

a valuation discount for lack of marketability as 

well as a minority interest discount due to inability 

to influence decisions, compel distributions, or force 

a liquidation. The majority interest owned by the 

high-net-worth individual and his or her spouse may 

be gradually gifted or bequeathed so that it is converted 

to a minority interest and therefore subject to 

valuation discounts at the death of the second 

spouse. It is, of course, not automatic that the IRS 

will accept this type of planning. Care must be used 

in establishing such family partnerships. 

Some of the circumstances in which an FLP 

would be an appropriate device are as follows: 

1. To reduce the value of an estate for transfer 

tax purposes 

2. To shift the income tax burden from a parent 

in a high tax bracket to child or other relative 

in a lower income tax bracket 

3. To conduct a family business in a form other 

than a sole proprietorship (because placing it 

into trust may result in the trust being taxable 

by the IRS as a corporation, usually a very bad 

November 2002 17


result) or in a corporate form (C corporations 

are subject to personal holding company, accumulated 

earnings, and unreasonable compensation 

problems, while S corporations are 

restricted as to who and how many persons 

may be shareholders.) 

4. To enable a parent to maintain control over 

assets that will be transferred to future generations 

through gifts of limited partner interests 

5. To protect assets from creditors of the partners 

6. To allow retention of ownership of assets within 

the family unit when desired 

7. To enable a parent to protect assets that are to 

be transferred to younger generations from 

being dissipated through mismanagement or 

divorce 

8. To provide flexibility in establishing the rules 

for managing property 

9. To simplify ownership of assets 

10. To ease the distribution of assets at death 

among family members without having to 

remove the assets from the partnership 

11. To avoid out-of-state probate costs 

12. To discourage family members from fighting 

over FLP assets and to provide a forum for the 

resolution of disputes among family members 

when such disputes arise 

Using the $11,000 Annual Gift Exclusion 

Many planners underestimate the power of making 

annual gifts up to $11,000 each. By making 

$22,000 gifts, with the spouse joining in the gifts 

per donee, assuming the gifts are invested at 8 percent 

over the next 20 years, over $1 million of 

estate growth can be shifted to others per donee. 

GRITs, GRATs, GRUTs, and Private 

Annuities 

Personal residences, tangible personal property, 

grazing land, and investment income property can 

be transferred to family members by using grantorretained 

trusts. As their name implies, these are 

irrevocable trusts into which the grantor places 

assets and retains an interest for a fixed period of 

years. Principal, at the end of the specified period of 

years, will pass to a noncharitable beneficiary, 

such as a child or grandchild of the grantor. With 

most GRITs (grantor-retained income trusts), a 

grantor is treated as making a gift of the entire 

property transferred to trust (rather than a gift of 

the discounted value of the remainder). A GRIT 

holding a personal residence is a notable exception 

to this rule. 

A house GRIT is a powerful tool for transferring 

high value appreciating personal residences to 

descendants, but it contains certain drawbacks. 

First, if one uses it for a second home residence, it 

must be used for the greater of 14 days a year or 

10 percent of the days during the year it is rented 

at full value. Second, the donor must survive until 

the GRIT expires; otherwise, the heirs will have to 

pay estate taxes on the full inherited value of the 

residence, minus the original gift value. This can 

be protected by using life insurance. Third, 

although a house GRIT helps with transfer taxes, it 

may increase the beneficiary’s income taxes upon 

the sale of the residence. Use of a house GRIT 

will not result in a stepped-up basis upon the 

donor’s death after the GRIT expires. Finally, the 

donor may outlive the life of the GRIT and want to 

continue to live in the house. If the beneficiaries 

agree, the donor could continue the trust and 

develop a rental agreement that permits a life right 

to the property. 

Not only personal residences can be transferred 

by using a GRIT. The future value of tangible personal 

and real property, such as artwork, jewelry, or 

even hunting and grazing land, can be transferred 

by use of a GRIT. 

Future income-producing assets that provide the 

owner with an income stream for a period of years 

can be set up in a GRAT (grantor-retained annuity 

trust) or GRUT (grantor-retained unitrust). Under 

this approach, the owner retains a specific income 

amount or a fixed percentage of future value. If the 

grantor does not survive the selected period, only a 

portion (unlike the house or personal property 

GRITs) of the full value of the investments will be 

included in the donor’s taxable estate. 

Grantor-retained trusts are particularly useful in 

the following situations: 

1. The client is single and has a substantial estate 

upon which federal estate taxes are certain to 

18 

November 2002


be paid. Wealthy widows or widowers, or 

divorced individuals can use such a trust as a 

“marital deduction substitute.” 

2. A married couple has an estate in excess of the 

couple’s combined unified credit equivalent to 

eliminate or reduce taxes on the death of the 

second spouse to die. The larger and more rapidly 

appreciating these estates are, the more 

effective such a trust would be. 

3. Income-producing property is located in more 

than one state, and unification and probate 

savings are desired. 

4. There is the possibility of a will contest, public 

scrutiny, or an election against the will if 

the grantor survives the trust term. 

5. Aclient wants to purchase certain tangible 

assets, such as a work of art, and retain the 

right to display it in his or her home but be 

sure it will pass to a specified person immediately 

and without probate at death. (Note: If 

the grantor is unable to establish the value of 

the retained interest through comparable 

rentals, the gift of the transferred remainder 

will be valued at 100 percent of the transferred 

property.) 

6. As an alternative to a recapitalization or other 

freezing technique, a grantor-retained trust has 

the added advantages of gift tax leverage and 

possible estate tax savings. 

7. The client is young enough to have a high 

probability of outliving the trust term that is 

needed to obtain a low present value gift to the 

remainderman. 

8. The client’s assets are so substantial that a significant 

portion can be committed to a remainderman 

without compromising his or her own 

personal financial security. 

9. The client has a high risk-taking propensity 

and strong incentive to achieve gift and estate 

tax savings (rather than taking a safer but 

more costly approach of making an immediate 

gift). 

Another related technique is the use of a private 

annuity where an asset, particularly land, is sold 

to children subject to lifetime installment payments. 

This device can be useful in the following 

situations: 

1. When a client would like to “spread” gains 

over several tax years, particularly in light of 

the decline of the attractiveness of installment 

sales; 

2. When a client wishes to retire and shift control 

of a business to a family member or key 

employee; 

3. When a client desires to remove a sizable 

asset, such as a business, from his or her estate 

for estate tax purposes; 

4. When a client wishes to obtain a fixed retirement 

income, especially when his or her 

business does not provide pension, profitsharing, 

or nonqualified deferred compensation 

benefits; 

5. When a client owns a large parcel of nonincome-producing 

property but wants to make 

it income producing; 

6. When a client’s estate is very large and the 

major or sole heir is a grandchild (or other 

individual two or more generations below that 

of the client) because the private annuity is a 

sale, not a gift, and therefore is not subject to 

the GST tax; and 

7. Where the purchaser’s objective is to bar others 

from obtaining the property in question, 

but he or she cannot afford to pay for the asset 

in a lump-sum outright purchase. 

Preferably the property transferred in a private 

annuity transaction will be income producing, rapidly 

appreciating, and not subject to depreciation or 

investment credit recapture or to indebtedness. This 

technique suffers from the inability of the donor to 

secure the annual payments, the nondeductibility of 

payments, and the taxability of payments received. 

Furthermore, if the donor lives too long, the payments 

will far exceed the original value of the asset. 

Use of the $1,090,000 GST Exclusion 

Use of the $1,090,000 generation-skipping transfer 

(GST) exclusion can also substantially reduce 

the overall wealth transfer tax. The GST was traditionally 

used as a device to save federal gift and 

November 2002 

19


estate tax by keeping property out of the taxable 

estates of the members of the intermediate generation. 

The beneficiary could be trustee, have all the 

income, invade the principal for needs, and control 

the distribution of the property as long as the beneficiary 

did not have a general power of appointment. 

Now, the GST tax considerations of such transfers 

must also be considered. 

There are three situations where GST techniques 

are useful. First, where a client stands to inherit a 

substantial estate from a parent and already has a 

substantial estate of his or her own, a generationskipping 

trust would be set up for the parent’s property 

for the benefit of the client. Such a trust would 

allow the client-beneficiary the use and enjoyment 

of the inherited property, together with protection 

against creditors, divorce courts, or bankruptcy. The 

amount subject to the $1,090,000 GST exemption 

will also be excluded from the beneficiary’s already 

substantial estate. Although the client’s parent may 

pay gift or estate tax, the client does not pay estate 

tax or GST tax on the exempt inherited property at 

death. Furthermore, it is possible that no estate tax 

or GST tax will be paid by the client’s children or 

future issue, depending on the term allowed for the 

trust. 

Second, a generation-skipping trust may be used 

where parents wish to minimize transfer taxes in a 

child’s estate but still give the child the use and benefit 

of the property, or where the parents wish to 

protect the property from a spendthrift child, or 

from being subject to loss through a child’s divorce 

or bankruptcy. In these situations, a generation-skipping 

trust would be set up to provide income to the 

child for life, but with the principal being preserved 

for subsequent distribution to grandchildren. The 

trust can continue through the grandchildren’s lives 

(and for great-grandchildren as well), avoiding 

transfer tax in each generation, subject only to the 

limitation on the maximum life of a trust under state 

law. In the case of many estates, however, the generation 

skip occurs as a result of the death of a member 

of the intermediate generation before such 

member receives full ownership of the gift or inheritance, 

as when a trust is provided for a child until 

he or she attains age 30, and that child dies before 

attaining age 30, leaving grandchildren surviving. 

Third, a client may wish to make direct transfers 

to a grandchild or other skip person for the beneficiary’s 

education, support, or enjoyment, or in order 

to avoid tax in the estate of the intervening generation. 

Gifts that immediately benefit grandchildren 

will generally be subject to the GST tax unless they 

qualify for the $1,090,000 per donor generationskipping 

exemption or the $11,000 per donor per 

donee annual exclusion. 

If combined with a “family bank” or “dynasty 

trust,” the GST is the most valuable planning concept 

currently available for passing assets to future 

generations. Generally, a trust fund is established by 

current gift or eventual bequest that will continue 

for selected beneficiaries—usually children, grandchildren, 

great-grandchildren, and spouses. During 

the life of the trust, the beneficiaries’ shares will not 

be subject to the wealth transfer tax. The trust can 

also be designed to freeze distributions to creditors 

or divorcing spouses. 

Any gift or estate taxes which become due are 

paid, and $1,090,000 or less is transferred in trust to 

establish a generation-skipping plan. If the donor’s 

spouse consents, as much as $2,180,000 may be 

transferred in this fashion. The funds are accumulated 

by the trustee and paid to or for the benefit of all 

of the donor’s descendants. The effect is to defer for 

a considerable amount of time (often well over 100 

years) the payment of transfer taxes. 

A generation-skipping trust plan designed as a 

dynasty trust can permit the trustee to make payments 

of income and principal to any member of the 

family who needs them. The trust itself is usually 

funded with appreciating assets (which can be 

leased to beneficiaries at a low rent). Also, the trust 

may make tax-free loans to descendants. In these 

ways, there can be more accumulation and tax 

deferral to benefit future generations. 

While such a plan is in place, beneficiaries 

should “spend down” other personal assets owned 

outside the dynasty trust. Once they deplete their 

assets, they can look to the dynasty trust for help. In 

this way, they will consume property that would 

otherwise be taxable in their estates at their deaths, 

which also would be subject to their creditors and, 

possibly, the claims of former spouses. Meanwhile 

the protected trust fund grows, and their exposed 

personal taxable estates get smaller. 

Such trusts should not permit any descendant 

who is trustee to have the absolute, unfettered 

20 November 2002


power to distribute principal amounts, as this power 

could cause tax benefits and creditor protection to 

be forfeited. It is better to name someone who is not 

a beneficiary as trustee or co-trustee. He, she, or 

they should have authority to make payments to 

beneficiaries. 

Leveraging the Wealth Transfer Tax 

This strategy involves spending relatively little on 

insurance premiums to gain substantial savings in 

estate taxes. The life insurance proceeds can be 

directed to a generation-skipping trust designed as a 

dynasty trust (or family bank) for the benefit of the 

donor’s grandchildren. 

There are three ways to make such gifts, which 

end up as life insurance premiums. 

1. Make a one-time $1,000,000 tax-free gift now, 

or even a portion of it, if the client can afford 

to do so. The funds are then used for life 

insurance premiums to leverage the amount 

payable to beneficiaries upon the client’s 

death. The best asset to gift for this purpose is 

income tax-paid cash or near cash. 

2. Make “special gifts” of $11,000 each to a 

Crummey trust on behalf of as many relatives 

as the client likes. The favored relatives are 

then given a limited amount of time, say 30 

days, during which they can withdraw their 

gifts. This provides them with a present interest 

to assure that the gift will be tax-free. If 

they fail to withdraw their gifts, the funds are 

used to purchase a large life insurance policy. 

3. Make a taxable transfer to family members 

now by using the proceeds to purchase life 

insurance on the donor’s life. If the donor lives 

at least three years after making the gift, these 

assets will be removed from his or her estate. 

Of course, the insurance policy would be held 

by an irrevocable trust or group of beneficiaries. 

It is best to set up the trust first and have 

the trust pay the premium. Also, each child or 

grandchild should be permitted to withdraw 

from the trust annually the greater of $5,000 or 

5 percent of the trust value with an overall 

limit equal to the maximum annual exclusion 

gift per donee. 

Eliminating the Wealth Transfer Tax 

This strategy involves the use of charitable giving 

combined with life insurance in a “wealth replacement 

trust.” There are three approaches that can be 

used. 

The first involves making annual exclusion gifts 

to a Crummey withdrawal trust for each descendant. 

This would not be a generation-skipping trust 

and would probably end after the deaths of the highnet-worth 

individual and his or her spouse. The 

Crummey trust purchases a life insurance policy for 

the taxable estate value less the $2 million in 

exemptions. For example, for a $6 million taxable 

estate, a $4.8 million life insurance policy would be 

purchased. The life insurance proceeds would be 

received by the trust and then transferred to the 

estate of the second to die in exchange for $4.8 million 

in estate assets. The estate would then donate 

the $4.8 million in cash to a selected charity. The 

beneficiaries still receive the $6 million in estate 

assets while a charity receives a $4.8 million gift, 

and there are no transfer taxes payable. 

A second approach uses the so-called “vested 

trust” concept under which trusts are established for 

grandchildren only. The value of these trusts would 

not be taxed at the childrens’ deaths but would be 

taxed upon the deaths of each grandchild. 

Accordingly, these are not “family bank” trusts as 

discussed earlier. Annual gifts of $22,000 would be 

made to a vested trust for each grandchild and additional 

annual gifts of $22,000 would be made for 

each child to Crummey withdrawal trusts. Using the 

same size taxable estate as in the first approach and 

assuming there are two children and four grandchildren 

involved, life insurance for $4 million would 

be purchased in the vested trusts and $2 million in 

the Crummey withdrawal trusts. Again, $4.8 million 

would be gifted to charity upon the second death 

with bequests of $1.2 million to the family and, 

again, no transfer taxes. 

The third approach is to establish an insurance 

trust and arrange the annual gifts so that only 

$5,000 or 5 percent of principal, if greater, can be 

withdrawn from the trust by each beneficiary. 

Annual gifts of $22,000 per donee would be made 

to a Crummey withdrawal trust designed as a generation-skipping 

family bank. Again, using the same 

taxable estate as in the first two approaches, $6 mil- 

November 2002 

21


lion of life insurance would be purchased by the 

trust. Again, $4.8 million is gifted to charity with 

$1.2 million in bequests to the family (reduced by 

gifts that must be allocated to the $1,000,000 exemptions). 

No transfer taxes would be due under this 

approach, either. 

Under any of the three approaches and depending 

on exactly how the trust is arranged, it will either 

terminate in favor of children, continue for grandchildren, 

or possibly continue for 100 years or so as 

a generation-skipping dynasty trust or family bank. 

Of course, charitable gifting can be accomplished 

through charitable remainder trusts or other vehicles, 

and it is not the purpose of this article to explore this 

very broad subject area of charitable gifts. To set any 

of these strategies up, you should consult an attorney 

or other estate planning expert. ■ 

Personal Financial Planning Monthly Editor-in- 

Chief Jeffrey Rattiner is the owner of JR Financial 

Group in Englewood, Colo. 

22 November 2002

INSURANCE 

Using Private Placement 

Life Insurance 

By Lewis J. Saret and Lewis D. Solomon 

Private placement life insurance (PPLI) has 

become a hot topic because it offers significant 

benefits to high-net-worth individuals 

that they cannot easily obtain elsewhere. PPLI is 

particularly beneficial for three categories of individuals: 

1. Those with high amounts of passive income, 

such as hedge fund owners; 

2. Those with assets expected to significantly 

appreciate, such as closely held corporate 

stock expected to be acquired or go public in 

an initial public offering; and 

3. Those concerned with asset protection. 

PPLI serves primarily as an investment vehicle 

rather than as a method of providing a death benefit. 

The reason is that PPLI allows policy owners to 

choose “friendly” investment managers to control 

the assets in which the PPLI invests. That PPLI 

structure contrasts with standard life insurance 

policies in which the owners are limited to certain 

mutual funds provided by the insurer. 

This article discusses the following issues: 

• What is PPLI 

• What benefits does PPLI offer your clients 

• How do PPLI arrangements typically work 

• What PPLI design issues must you consider 

to ensure life insurance treatment for tax purposes 

• What practical matters must you consider 

Definition of PPLI 

When clients purchase life insurance, they typically 

enter into a standard contract or policy 

with the insurer. In contrast, when clients purchase 

PPLI, the clients enter into a custom-written 

life insurance contract with the insurer, 

which can be either a U.S. insurer or an offshore 

insurer. Such an arrangement gives the clients 

benefits that they cannot obtain in standard contracts. 

One of the most significant of those benefits 

is the owner’s ability to designate the investment 

manager. 

Insurers will not enter into a PPLI contract unless 

they receive a commitment for a significant amount 

of insurance premiums from the client because the 

contracts are custom written. To illustrate, a minimum 

required premium commitment of $3 million 

is not unusual, that is $3 million in total premium 

payments, not the coverage. 

Benefits of PPLI 

PPLI can benefit your clients in the following ways: 

Investment Vehicle for Wealth Accumulation 

PPLI serves primarily as an investment vehicle 

for the policy owner’s lifetime wealth accumulation 

rather than as a method of providing a significant 

death benefit. The client’s objective is to maximize 

the tax-free buildup of the PPLI policy’s internal 

cash value. The client generally wants to minimize 

the death benefit and its associated cost. However, 

PPLI must provide a death benefit to qualify the 

life insurance risk for tax purposes. Most planners 

try to minimize the death benefit because of the 

associated cost, after taking into account federal tax 

requirements. 

Tax Benefits 

Life insurance receives special tax treatment, 

November 2002 

23


FIGURE 1 

COMPARISON OF HARRY’S AND GWENNETH’S HEDGE FUND INVESTMENTS 

$450,000,000 

$400,000,000 

$350,000,000 

$300,000,000 

$250,000,000 

Dollar Values 

$200,000,000 

$150,000,000 

■ 

$100,000,000 

■ 

■ 

$50,000,000 

■ 

■ 

■ 

■ 

■ 

■ 

■ 

● ● ● ● ● ● ● ● ● ● ● ● 

■ ■ ■ 

■ 

■ 

● 

● 

● 

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 

Year 

● 

■ 

Harry’s Hedge Fund Investment 

Gwenneth’s Hedge Fund Investment 

Harry’s Hedge Fund 

Year Beginning of Year Income Generated Taxes on Income End of Year 

Hedge Fund Investment on Fund Generated Hedge F 

Investment 

2000 $10,000,000 $2,000,000 $900,000 $11,100,000 

2001 $11,100,000 $2,220,000 $999,000 $12,321,000 

2018 $65,435,529 $13,087,106 $5,889,198 $72,633,437 

2019 $72,633,437 $14,526,687 $6,537,009 $80,623,115 

Gwenneth’s Hedge Fund 

Year Beginning of Year Income Generated Taxes on Income End of Year 

Hedge Fund Investment on Fund Generated Hedge F 

Investment 

2000 $10,000,000 $2,000,000 $0 $12,000,000 

2001 $12,000,000 $2,400,000 $0 $14,400,000 

2018 $266,233,333 $53,246,667 $0 $319,479,999 

2019 $319,479,999 $63,896,000 $0 $383,375,999 

24 November 2002


which is the driving force behind PPLI’s popularity. 

Those benefits include ... 

• Cash deferral. Earnings on PPLI cash values, 

including interest, dividends, and capital gains, 

are tax deferred as long as values remain in the 

policy. 1 Consequently, the cash value grows 

much more rapidly than that of a taxable 

investment portfolio. 

• Tax-free withdrawals and loans. During the 

insured’s life, the policy owner may withdraw 

cash and obtain policy loans against cash value 

on an income-tax-free basis, as long as the 

policy is not a modified endowment contract 

(MEC). 

• Tax-free death benefits. Death benefit proceeds 

payable at the insured’s death are 

excluded from the insured’s gross income. 2 

With proper planning, the death benefits may 

also be excluded from the insured’s taxable 

estate. 3 

Product Pricing 

The death benefit life insurance may be less 

expensive for offshore PPLI than for domestic 

insurance. That lower price results from lower overhead 

costs for offshore life insurance and the 

absence of a state premium tax. Foreign issuers who 

do not make an IRC § 953(d) election to be taxed as 

a domestic corporation may avoid the federal 

deferred acquisition cost (DAC) tax that might otherwise 

apply. 

Asset Protection 

A substantial benefit of PPLI is that it protects 

the PPLI assets while allowing the insured to access 

such assets. That availability plus protection results 

because most states exempt life insurance from 

creditors’ claims. In contrast, other asset protection 

techniques generally limit the client’s ability to 

access protected assets. In addition, planners frequently 

place PPLI into an irrevocable life insurance 

trust (ILIT), which also provides the asset protection 

benefits of an irrevocable trust. Finally, if 

offshore PPLI is used along with a foreign ILIT, 

clients may obtain the benefit of a foreign asset protection 

trust. 

Typical Use of PPLI 

The following examples illustrate how PPLI typically 

works in practice: 

Example 1: Harry, a successful author, invests 

$10 million in the Magical Hedge Fund (MH Fund) 

on January 1, 2000. The MH Fund generates a 20 

percent annual return, all of which is taxable to 

Harry at his marginal combined federal and state 

income tax rate of 45 percent. Harry’s sister, 

Gwenneth, an actress who also has a marginal combined 

federal and state income tax rate of 45 percent, 

also invests $10 million in the MH Fund on 

January 1, 2000. However, Gwenneth invests in the 

fund through a PPLI policy. 

Between 2000 and 2020, Harry’s investment in the 

MH Fund grows from $10 million to over $80 million. 

However, during that same period, Gwenneth’s 

investment in the MH Fund grows from $10 million 

to over $383 million. That difference results from the 

income tax deferral on Gwenneth’s investment, 

ignoring the death benefit cost. The difference can be 

seen graphically in Figure 1. 

Example 2: The facts are the same as in example 

1, except that Gwenneth’s PPLI policy is held by an 

ILIT, and Gwenneth dies in 2020. Here, the full 

PPLI death benefit is excluded from Gwenneth’s 

taxable estate for federal estate tax purposes, and 

the tax deferral on the inside cash buildup becomes 

permanent. [This example ignores, for the sake of 

convenience, the problem of how to place $10 million 

into an ILIT without causing gift tax consequences. 

There are various ways of doing that, but 

they must be tailored to the client’s particular circumstances.] 

Planning pointer: One technique planners often 

use in conjunction with offshore PPLI is to form a 

company wholly owned by the PPLI arrangement. 

The company purchases a highly appreciated asset 

(e.g., low basis, pre-IPO stock) from the client in 

exchange for a deferred private annuity. The company 

subsequently sells the highly appreciated asset. 

That technique allows the client to defer the gain on 

the sale of the asset to the PPLI arrangement over 

the client’s life (or the lives of the client and his 

spouse in the case of a joint and survivor private 

annuity). Moreover, the wholly owned company can 

sell the asset that it owns without any gain recogni- 

November 2002 

25


FIGURE 2 

USING A WHOLLY OWNED COMPANY IN CONJUNCTION WITH AN OFFSHORE PPLI 

Client 

Step 1 - Client creates OPPLI arrangement. 

OPPLI 

Step 2 - Client sells highly appreciated 

asset to wholly owned company 

in exchange for deferred private 

annuity. 

Wholly 

Owned 

Company 

Step 3 - Wholly owned company 

sells the highly appreciated asset 

to a third party in a tax-free 

transaction because internal 

buildup of OPPLI is tax deferred. 

Third 

Party 

tion. That arrangement is graphically represented in 

Figure 2. 

PPLI Policy Design Issues 

The primary issue in designing PPLI policies is 

ensuring that such policies qualify as “life insurance” 

for U.S. federal tax purposes in order to 

obtain the favorable tax treatment that U.S. federal 

tax law confers upon life insurance. Although a 

detailed discussion of the requirements for life 

insurance treatment exceeds the scope of this article, 

the key issues that planners must examine when 

designing PPLI arrangements include ... 

• IRC § 7702 definition of life insurance. 

Generally, IRC § 7702(a) defines a life insurance 

contract as a contract under the applicable 

law, but only if such contract satisfies certain 

mechanical tests, which IRC § 7702 sets forth. 

26 November 2002


TABLE 1 

PPLI: PRACTICAL 

CONSIDERATIONS 

There are several practical and nontax considerations 

that planners must also consider when 

establishing PPLI arrangements, including the 

following: 

• Planners need to ensure that they operate 

within the appropriate parameters regarding 

solicitation of the PPLI policy. 

• Planners need to determine what steps 

must be taken as part of the underwriting 

of the PPLI policy. 

• For offshore PPLI policies, planners must 

guide the client in selecting the jurisdiction 

and insurer that they will use for the PPLI 

policy. 

• Because offshore PPLI is subject to less 

regulation than domestic life insurance, the 

involvement of reputable and knowledgeable 

professionals is critical to minimize 

the client’s risk exposure. At a minimum, 

offshore PPLI arrangements require the 

involvement of a knowledgeable attorney 

and insurance broker. However, other professionals, 

such as accountants and financial 

planners, should also be involved. 

For a detailed discussion of the practical considerations 

involved in the use of PPLI, see Leslie C. Giordani and 

Derry W. Swanger, Offshore Life Insurance Planning for 

U.S. Clients, 26 ACTEC Notes 70, 78 (2000). 

a PPLI owner overfunds the policy, it will constitute 

a MEC. MEC status causes the IRS to 

tax the policy owner at ordinary income tax 

rates on certain policy distributions, including 

policy loans. That structure eliminates one of 

the key advantages of PPLI, namely the ability 

to access cash placed into the PPLI policy on a 

tax-free basis. 4 

Holding Structure 

As with other life insurance, the most popular 

holding structure for PPLI is an ILIT. ILITs are 

popular because they offer significant tax and asset 

protection advantages. To illustrate, the transfer of 

a PPLI policy into a properly structured ILIT 

avoids estate tax on the insured’s death. In addition, 

by placing PPLI into an ILIT, the planner 

gains the asset protection advantages of an irrevocable 

trust. 

Planning pointer: Planners also frequently use 

PPLI policies as part of a private split-dollar 

arrangement to leverage gift tax payments and generation-skipping 

transfer (GST) tax exemptions, 

while excluding the policy owner’s share of the 

death benefit from the insured’s estate. 5 

Conclusion 

Although complex, PPLI offers significant benefits 

to clients, including the ability to effectively 

place their taxable investments into a tax-free wrapper, 

thereby effectively converting such assets into 

nontaxable assets. PPLI works particularly well for 

individuals planning to sell their closely held businesses 

and those with high amounts of passive 

investment income. ■ 

• IRC § 817 diversification requirements. 

Generally, IRC § 817 sets forth certain diversification 

requirements that variable life insurance, 

such as PPLI, must satisfy to constitute 

life insurance for tax purposes. In addition, 

there are related owner-control issues, which 

planners must address. 

• Modified endowment contract (MEC) status. If 

Lewis J. Saret is of counsel to Cohen Mohr LLP. 

He can be contacted by telephone at (202) 342- 

2550 or by e-mail at lsaret@cohenmohr.com. 

Lewis D. Solomon is the Theodore Rinehart 

Professor of Business Law at the George 

Washington University Law School. He can be contacted 

by telephone at (202) 994-6753 or by e-mail 

at lsolomon@main.nlc.gwu.edu. 

November 2002 

27


1. IRC §§ 72(e)(5), 7702(g)(1)(A). 

2. IRC § 101(a)(1). 

3. IRC § 2042; Treas. Reg. § 20.2042-1(c)(1). 

4. For a more detailed discussion of the above requirements, see Lewis D. 

Solomon and Lewis J. Saret, Asset Protection Strategies: Tax and Legal 

Aspects § 8.03[G], 2nd Ed. 2001 & Supp. 2002, Aspen Publishers, Inc. 

5. See Anthony M. Sardis and Jeffrey J. Jenei, Creating a Life 

Insurance Private Pension via Split-Dollar, 25 Est. Plan. 51 (Feb. 

1998); Robert J. Adler, Private Split-Dollar Provides Transfer Tax 

Savings, Tax’n for Law. 196 (Sept./Oct. 1998); Gerald R. 

Nowotny, The Use of Private Placement Life Insurance and Split 

Dollar to Transfer Post-Mortem Appreciation, 140 Tr. & Est. 62 

(Feb. 1, 2001). 

28 

November 2002

CASE STUDY 

Unexpected Death Complicates 

Process of Intended IRA Rollover 

By Mark W. McGorry 

This case involves the sudden unexpected 

death of a female in her late 50s, who was 

previously thought to be in relatively good 

health. This summer she had accepted her employer’s 

offer of an early retirement package, which was 

part of that company’s cost-cutting efforts and 

restructuring necessitated by falling profits. She in 

fact had been in the same “job” for more than 30 

years, but through the process of corporate acquisitions, 

she actually had three employers during the 

course of this job. 

This woman’s financial needs had been relatively 

modest. She had never married, nor had she taken 

on the higher expenses often associated with raising 

a family. She had been a tenant in an apartment in 

one of New York City’s outer boroughs most of her 

adult life and subsequently had a relatively low rent 

under that city’s rent control laws. Therefore, she 

was in the position of enjoying a very modest housing 

expense for the foreseeable future. As a result, 

her living expenses were low and her biggest 

nonessential budget items were for travel, which 

was also typically done on a low cost basis. 

The early retirement offer included a cash settlement, 

which would supply her with enough cash to 

meet her expenses for several years until she 

reached the earliest Social Security retirement age 

of 62. At that point, the reduced benefit from Social 

Security in addition to a small defined benefit pension 

that she was entitled to from her employer 

would meet her cash flow needs. In addition, she 

was entitled to benefits from two defined contribution 

plans, as outlined below, which would be available 

to meet her future cash needs. She also planned 

to work, on a part-time basis, at the very least until 

age 62 and thereafter at a level that would not 

reduce her Social Security benefits. Her goals in 

working part-time were to remain active and to 

build up her personal savings before she stopped 

working entirely. 

As noted above, for more than 30 years she had 

held the same job, but eventually it was for three different 

employers. Her very first job was with a firm 

(Employer 1) that provided her with a modest defined 

benefit pension, which she could begin to draw down 

at age 62. Her second position was at a business 

(Employer 2) that was then privately owned by several 

members of a family who were the children of the 

founder. These owners sold the division she worked 

for to a fast growing private firm (Employer 3), which 

in turn sold it to a large, publicly held listed company 

(Employer 4). It was Employer 4’s offer of a cash settlement 

in return for early retirement that prompted 

her to begin to look at all of her retirement accounts. 

As part of this review, she considered whether it 

would be best if she moved the defined contribution 

accounts that she had at Employers 2 and 4 into IRAs. 

Objectives 

Her key objective was to consolidate her two 

defined contribution accounts into a single IRA. She 

was looking for several things: 

1. To have these assets in a single account that 

she could have direct control over; 

2. To have a full array of investment choices 

available and not be limited to only those that 

these two plans’ administrators offered; and 

3. To have the ability to allow these tax deferred 

accounts to continue for the benefit of her 

family in the event of her death. 

Recommendations 

This appeared to be a simple task of creating a 

new IRA, with the beneficiary arrangements as the 

November 2002 29


client wanted them, and then contacting each of the 

plan administrators to begin the paperwork to effect 

a rollover to the IRA. It was determined that she 

would do these as direct transfers from the plans to 

her newly established IRA to avoid being subject to 

the 20 percent federal withholding requirement that 

would apply if she had received a distribution and 

then rolled it over within 60 days. 

The administrators for Employer 2 acted very 

quickly, faxing paperwork to the client that she 

immediately executed and returned in order to effect 

the rollover of these assets. The new IRA custodian 

received the check several days before this woman 

suffered a fatal heart attack. The paperwork and this 

rollover of assets had been completed, but her attorney, 

who was also a relative of the client and the 

intended beneficiary, did not know where the paperwork 

stood on the rollover from the plan under 

Employer 4. A search of the woman’s papers in her 

apartment indicated that this employer had been 

considerably slower than the other in getting the 

paper work started. The woman had apparently 

received the forms to begin the distribution and 

rollover a day or two before her death, but she had 

not yet begun the task of filling them out. 

Her attorney looked into the possibility that the 

client’s telephone conversation and subsequent fax 

detailing her desire to roll over her account balance 

into a specific IRA, providing all the necessary 

information, might have been sufficient to let the 

rollover be complete. In the fax that the client had 

sent, she had provided all the detail as to the IRA, 

including the name and address of the custodian, the 

IRA account number, and a direction to liquidate all 

investments and send a check payable to the new 

custodian. 

PLR 200204038, dated October 31, 2001, 

involved a very similar situation: the plan participant 

had not yet reached his required beginning date 

(RBD) despite the fact that he was 87 years old, 

because he was not a 5 percent shareholder in the 

employer sponsoring the plan and he continued to be 

actively employed. He also had established a 

rollover IRA and directed the plan administrator to 

roll over his account balance into this IRA. In fact, 

he had completed and submitted to the plan administrator 

all the necessary forms, including instructions 

to liquidate all investments and forward the proceeds 

to his new IRA. Most of the investments had been 

liquidated, and the plan administrator was within 

days of completing the administrative details and 

forwarding the funds when this man passed away. 

Before completing the rollover, one of the beneficiaries 

of the intended rollover requested a PLR asking 

the IRS to confirm that this would be a tax-free 

rollover. The IRS responded that this was not a valid 

rollover and offered the following explanation: 

“Although not explicitly stated in either Code 

section 402(c), Code section 401(a)(31), or the 

regulations promulgated hereunder, a valid 

rollover, even if intended to be accomplished 

as a direct transfer as that term is defined in 

Code section 401(a)(31), necessitates the actual 

transfer of plan assets occur during the lifetime 

of the employee for whose benefit the 

plan account is maintained and for whose benefit 

the IRA is established.” 

Many commentators have opined that the IRS is 

wrong in its position in this PLR. In addition, the 

PLR involved a set of facts that occurred in 1999, 

before the softer position that the IRS has taken in 

two sets of proposed regulations and the final regulations 

on distributions issued earlier this year, as 

well as some changes under the Economic Growth 

and Tax Relief Reconciliation Act (EGTRRA), 

which grant the IRS the authority to use greater discretion 

in rollovers not completed by the time of the 

death of a participant. The question that these advisors 

are contemplating is whether even the most liberal 

interpretation of the rules governing distributions 

will allow the completion of the rollover based 

merely on the directions of the participant’s fax, 

absent her completing the forms that were mailed to 

her shortly before her death. In addition, even if the 

advisors feel they have a comfort level with that 

position, they would still need to convince the plan 

to distribute the account balance to the IRA when 

the request did not follow the normal procedure of 

filing the plan’s own forms to formalize the request. 

At this point, the advisors are viewing this as an 

uphill battle with very little likelihood of success 

with either the plan administrator or the IRS. 

Results 

The beneficiaries will at least have the benefit of 

the tax deferrals available under the one successful 

rollover. The distribution of the other defined contri- 

30 

November 2002


bution plan account from Employer 4, as well as the 

lump-sum payment available from Employer 1’s 

defined benefit plan’s death benefit, will both have 

to be paid under the “five year rule” by December 

31, 2007, as outlined under the relevant sections of 

the terms of those plans, as allowed by the final 

401(a)(9) regulations. 

Conclusion 

This case reminds us that it is often beneficial to 

roll over benefits from qualified plans as soon as 

permissible. The exceptions to this might be when a 

plan contains potentially valuable features, such as 

loan availability or net unrealized appreciation 

(NUA), with its special tax treatment. The need to 

consider a rollover is even greater if the intended 

beneficiary is not a spouse and therefore does not 

have the many distribution options available to a 

surviving spouse. ■ 

Mark W. McGorry, JD, MSFS, CFP, CPC, CLU, 

ChFC, CMFC, AEP, is a financial consultant specializing 

in estate, tax, pension, insurance, and 

business planning with Braunstein McGorry & 

Company, Ltd., an independent financial services 

and planning firm. 

November 2002 

31

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