We have heard more and more over the past few months about a new strategy named Qualified Plan Insurance Partnerships (QPIP). Apparently, large, prestigious law firms are promoting this concept to wealthy clients. The plan purports to do the alchemy of turning the “dross” of IRD-prone, estate tax-prone qualified plan money into the “gold” of income tax free, estate tax free life insurance proceeds.
How is this magic accomplished? It starts with a wealthy client owning a large self-directed qualified plan account or IRA. Next, a limited partnership is established and the client directs his plan account or IRA to purchase an ownership interest in the partnership. Then, the partnership, using the purchase money, enters into a split dollar arrangement with an irrevocable life insurance trust (ILIT). A typical illustration shows the plan or IRA investing $3 or $4 hundred thousand in the partnership and the trust using the money to buy a $3 or $4 million life policy.
It’s suggested this gets large amounts of estate tax free, income tax free money to heirs without current taxation. There’s no estate tax on the death proceeds because the insured had no incidents of ownership in the life policy and there’s no income tax because it’s a life insurance death benefit. What about the plan money being used to purchase directly a limited partnership interest and indirectly life insurance? The theory is there’s no taxable distribution to the plan owner, nor is it a gift – it’s merely a “plan investment.” Of course, the split dollar arrangement between the limited partnership and the ILIT results in minimal tax consequences.
Will it work? Well, it’s apparent on its face that this plan is not for “pikers” or the faint of heart. Only a very large investment could justify the legal costs involved. It’s no wonder it’s being promoted by lawyers. The fees for work on the plan document or IRA, setting up the limited partnership, establishing the ILIT, and writing an opinion letter could run into many thousands of dollars. Our guess is at least $15,000 or $20,000 if done by a large firm.
We are not aware of any IRS ruling (published or private) on this issue and have not heard of any Tax Court case or IRS Estate Tax Audit involving the concept. We do, however, think there are many areas of concern. Naturally, the promoters have an answer for each concern.
Prohibited Transaction Rules Under Code Section 4975
Code section 4975 sets out rules defining a “prohibited transaction” and the penalty for engaging in a prohibited transaction. The penalty is immediate disqualification of the plan or IRA and taxation of all the money therein. Prohibited transactions include:
- Any sale or exchange, leasing, lending of money, extension of credit, furnishing of goods or services or facilities between the plan and a “disqualified person;”
- Transfer of income or assets of the plan to a disqualified person, acts by a disqualified person as a fiduciary who deals with the plan assets for his own account or benefit; and,
- The receipt of consideration by any person who is a fiduciary from any party dealing with the plan in any transaction involving income or assets of the plan.
A “disqualified person” is any person acting as a fiduciary; certain members of his or her family; and corporations, partnerships, trusts, or estates in which 50% or more control is exercised.
A typical limited partnership arrangement would be for the plan or IRA to be a 98% limited partner; the trustee of the ILIT to be a 1% general partner; and the insured to be a 1% general partner (to head off any transfer for value issues). Promoters claim this cannot be a prohibited transaction because the rule requires a “disqualified person” to own more than 50% of the partnership. It’s claimed the plan or IRA itself cannot be a prohibited person and no other party owns anything approaching 50%.
Promoters point to DOL Advisory Opinion 2000-10A as support for the proposition that an IRA can invest in a family limited partnership. In that Opinion, the IRA owner established a self-directed IRA of $500,000 and directed that it be invested in a family limited partnership which was formed for the purpose of buying, selling and owning marketable securities. The IRA would own nearly all of the partnership interest and the IRA owner would receive no salary or other compensation from the partnership. On a very narrow set of facts, the DOL approved the arrangement but went out of its way to point out that any transaction between the partnership and any other party that resulted in a benefit to the IRA owner would be a prohibited transaction. The opinion noted that if there is any transaction in which the participation of the IRA is necessary to benefit the IRA owner, that would be a prohibited transaction.
“Employee Benefit Plan” Rules and “Exclusive Benefit” Rules
Federal law provides that a qualified plan or an IRA must be an “employee benefit” plan for the “exclusive benefit” of the participant/owner. Promoters point to Revenue Ruling 69-494 for criteria and claim their arrangements meet the test.
In brief, Rev. Ruling 69-494 provides that an investment must be liquid, prudent, and provide a “market rate” of return. It’s claimed QPIPs meet these criteria by using a variable life insurance policy. The QPIP will own the cash value of the policy in the variable subaccounts and the ILIT will own the risk portion of the death benefit. According to promoters, this meets the test of “liquid, prudent, market rate of return.”
Unrelated Business Taxable Income (UBTI)
If a tax-exempt trust engages in an unrelated trade or business, it is taxed on income received from those activities. If an unrelated trade or business is regularly carried on by a partnership, of which a tax-exempt trust is a partner, the tax-exempt trust must include its share of the partnership income as UBTI.
We have not seen this issue discussed, but can assume the promoters’ response. Presumably, the position would be that the increase in cash value inside the life insurance policy does not constitute current income, therefore the IRA or plan would not have to pay tax on UBTI until the death of the insured.
One’s view of this strategy may depend upon his or her position on the so-called "form vs. substance" controversy. Is the form of this arrangement OK? Absolutely. Is it in substance merely another “liquid, prudent, market rate” investment by a plan or IRA for the “exclusive benefit” of the participant/owner? Absolutely not. We think the latter conclusion can be demonstrated by the answer to this hypothetical question: If I set up an ILIT with my children as beneficiaries, buy a variable life policy on my life, and offer private investors the right to make the premium payment in return for ownership of the cash value, how many takers would I get?
Of course, one could argue that this arrangement is no more of a sham than, say, Crummey Powers, for instance, and they have been “blessed” by numerous court decisions. Another concern we have is whether the Service would invoke the step-transaction doctrine to find a violation of Code section 408(a)(3) prohibiting investment of IRA funds in life insurance contracts.
Last Updated: 12/15/2002 11:49:00 AM