Benefit Planning For S Corp Owners-the Retirement Nimcrut

TA K E N OT E Recent developments in estate, business and tax planning

April, 2008 (Revised from 2nd Quarter 2006)

INSIDE THIS ISSUE

Benefit Planning for S Corporation Owners: The RETIREMENT NIMCRUT Jerry Weihs, JD, CPA, MBA, CLU, ChFC

Benefit Planning for S Corporation Owners: The RETIREMENT NIMCRUT Advanced Markets Group 800-432-1102 Advanced Markets Attorneys Janice Alexander Forgays, Esq., CLU ext. 1846 [email protected] Jerry Weihs, JD, CPA, MBA, CLU, ChFC ext. 1756 [email protected] Deborah Moon, Esq., CLU ext. 1838 [email protected] Rose Watson, Esq. ext. 7196 [email protected] Advanced Case Design Douglas Bowden, CLU, ChFC ext. 2450 [email protected] Greg Faux ext. 1817 [email protected] ©2008 Sun Life Assurance Company of Canada. All rights reserved. Sun Life Financial and the globe symbol are registered trademarks of Sun Life Assurance Company of Canada. All guarantees are based on the claims-paying ability of Sun Life Assurance Company of Canada (Wellesley Hills, MA), or in New York, Sun Life Insurance and Annuity Company of New York (New York, NY). Not FDIC/NCUA insured. May lose value. No bank/credit union guarantee. Not a deposit. Not insured by any federal government entity.

Apart from qualified plan benefits, there has been very little we could do in the non-qualified benefits area for S Corp. owners. That is till now. If we have an S Corp. owner with a charitable intent, we can do some exciting things in the benefit planning area. The use of a NIMCRUT can provide tax-advantaged retirement benefits. It achieves income deferral while simultaneously providing the owner with an immediate charitable income tax deduction. The tax treatment of fringe benefits in a S Corporation (or S Corp.) is different for owner-employees than for other employees. Most fringe benefits (other than bonus plans, split dollar and non-qualified deferred compensation arrangements) that are paid to S Corp. employees who are not shareholders, or who own two percent or less of the outstanding S Corp. stock, are generally taxfree. These can be excluded from the employee’s taxable wages and are deductible as fringe benefits by the corporation. On the other hand, EmployeeOwners, owning more than two-percent of the S Corp. stock, are treated differently for fringe benefit purposes. These owners are treated in the same manner as partners in a partnership. This generally means that the benefit is includible in income to the employee-owner, S Corp. rules require >2% shareholder/employees be treated as partners for employee benefit purposes. S Corp. owners, taxed as partners, must report and pay taxes on their “distributive share” of the income for the taxable year even if it is not distributed. Many sections of the Internal Revenue Code provide favorable tax treatment of employee benefits only to employees. Qualified retirement plans are a very significant exception to the unfavorable treatment of >2% business owners in S Corps. Qualified plans can cover owners of S Corps. on much the same basis as regular employees.

WHAT ABOUT NON-QUALIFIED DEFERRED COMPENSATION? What can we do for the >2% S Corp. shareholder? We have already determined that qualified plans are a good deal for these owners. What about non-qualified plans? Deferred Compensation does not make sense since the shareholders have elected to be taxed on all current income as it is earned even if it is not distributed. Thus, they are precluded from deferring income. Continued on page 2 FOR PRODUCER USE ONLY. NOT FOR USE WITH THE PUBLIC.

Benefit Planning for S Corporation Owners: The RETIREMENT NIMCRUT Continued from page 1

WHAT ABOUT SPLIT DOLLAR? Split dollar in a S Corp. is economically unfeasible for owners. The income flow through concept will have the shareholders being taxed on the premium contributions. In addition, there is a problem of double taxation. The shareholders are taxed on income used to pay the premium and the insured shareholder employee will also be taxed again on the value of the economic benefit. Therefore, a portion of the premium cost will be taxed twice.

WHAT ABOUT A BONUS PLAN? Since the shareholders have already elected to be taxed currently on all income earned whether it is distributed or not, an executive bonus plan would fit the bill. The S Corp. pays the premium for a personally owned life policy. The owner/employee picks up the premium as current income. The policy would be a permanent policy and could be heavily funded to take advantage of tax-deferred accumulation. It would provide death and/or retirement benefits in a tax-efficient manner.

The RETIREMENT NIMCRUT will invest the contributions, possibly a deferred annuity. The Trustee determines when to distribute income to the S Corp. owner. If a deferred annuity is purchased, this can be delayed until the S Corp. owner is ready to receive retirement income. Income may be distributed for a term of years (not to exceed 20) or over the owner’s lifetime. The balance of the Trust assets will go to charity after the S Corp. owners death. If Life insurance was purchased, the death benefit will replace the value of the assets contributed to the Charitable Trust. This wealth replacement aspect keeps the heirs happy while the charity benefits from the RETIREMENT NIMCRUT.

WHAT ELSE CAN WE DO?

WHAT HAVE WE ACHIEVED?

Based on the foregoing information, we are quite limited in what type of benefit plans we can provide >2% S Corp. shareholders. Is there anything else we can do for the S Corp. shareholders who have either maxed out in their qualified plan contributions or because of the cost of including all employees in the plan, do not want to go that way?

Tax deductions for contributions made, a substantial income stream on a deferred basis when needed for retirement and an ultimate gift to charity. Finally, the life insurance is used to replace the wealth transferred through the RETIREMENT NIMCRUT. This plan not only provides a financial benefit to the S Corp. owner, but also provides a benefit to the charity of the owner’s choice.

WHAT ABOUT A NIMCRUT? This is a charitable remainder unitrust with a makeup provision which enables the S Corp. owner to accumulate for retirement benefits and take advantage of partial tax deductibility. This deduction is unique to this type of trust plan and provides a tax benefit to the S Corp. owner. Substantial contributions will be made to the RETIREMENT NIMCRUT via distributions from the S Corp. and life insurance should be purchased to replace the contributions made to the charitable trust.

HOW DOES THE CONCEPT WORK? The S Corp. owner gifts income to both the charitable trust (NIMCRUT) and wealth replacement trust (ILIT).

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RETIREMENT NIMCRUT. The deduction will be limited based on the owners age, interest assumptions, and other factors. Essentially the deduction will be based on the valuation of the interest ultimately to be received by the charity.

The S Corp. owner will get an immediate income tax deduction for each contribution to the

TAX/TECHNICAL ISSUES The annual payout is set as a fixed percentage of the underlying trust assets which are valued annually. The fixed percentage cannot be less than 5% nor more than 50%. See I.R.C. Sec. 664(d)(2)(A). Thus, if the trust grows, the payout will grow accordingly. The payout can be limited to actual trust “income” in the accounting sense. If there is no trust accounting income in any one year, there is no required distribution. That income can be “made-up” by distributions in later years. Under the RETIREMENT NIMCRUT, the payout will be limited to the lessor of : 

fixed percentage, or



actual trust income

However, if less than the fixed percentage is

TA K E N OT E distributed in any one year, the “shortfall” may be made up in future years (to the extent income exceeds the fixed percentage.) A deferred annuity can work well within the RETIREMENT NIMCRUT context. The key issue is when the trust recognizes trust income. The trust is not deemed to be in recent of income from the annuity until a distribution from the annuity occurs. Therefore, the trustee can control the amount of income each year for distribution purposes.

AN EXAMPLE OF HOW A RETIREMENT NIMCRUT WORKS Rich is a 50 year old S Corp. owner. He is receiving a significant amount of income from the S Corp. of which he is a 50% owner. He would like to accumulate more retirement benefits but is maxed out in the S Corp’s qualified plan. He is willing to commit $100,000 a year for the next ten years after

which he would like to retire, at age 60. He likes the RETIREMENT NIMCRUT concept and realizes it is effectively his only non-qualified fringe benefit choice and that a wealth replacement trust needs to be an integral part of his planning. Rich will establish a RETIREMENT NIMCRUT for himself with a 6% payout to effectively start after 10 years. He will include a wealth replacement trust in his planning, with approximately 81% of the contribution going to the RETIREMENT NIMCRUT and 19% going to the wealth replacement insurance trust. The RETIREMENT NIMCRUT will purchase a deferred annuity and will not take only distribution until year 11. After that the trustee will withdraw 6% of the trust plus any desired portion of the “makeup”. The funds gifted to the insurance trust will fund a $1,000,000 insurance policy which will replace and preserve the money gifted to the RETIREMENT NIMCRUT.

The RETIREMENT NIMCRUT Sun Universal Protector Plus Client Name: Valued Client Sex/Age/Class: Male/50/Preferred Non-Tobacco

Specified Face Amount:

Wealth Replacement Trust (ILIT) Insurance

NIMCRUT

Total Annual Outlay

End of Year NIMCRUT Available Tax Accumulation 1 Contribution Deduction Value @ 6%

Cumulative Make-Up Account

$1,000,000

Beg of Yr Beg of Year Make-up Distribution/ Account Payout rate @ Distribution2 6%

Beg of Yr Total Distribution

Amount Gifted to ILIT (Insurance Outlay)

Death Benefit (Net to Heirs)

Year

Age

1 2 3 4 5

50 51 52 53 54

$100,000 $100,000 $100,000 $100,000 $100,000

$81,302 $81,302 $81,302 $81,302 $81,302

$17,994 $18,810 $19,654 $20,520 $21,412

$86,180 $177,531 $274,363 $377,005 $485,805

$4,878 $14,927 $30,457 $51,797 $79,295

$0 $0 $0 $0 $0

$0 $0 $0 $0 $0

$0 $0 $0 $0 $0

$18,698 $18,698 $18,698 $18,698 $18,698

$1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000

6 7 8 9 10

55 56 57 58 59

$100,000 $100,000 $100,000 $100,000 $100,000

$81,302 $81,302 $81,302 $81,302 $81,302

$22,328 $23,269 $24,234 $25,221 $26,226

$601,134 $723,382 $852,965 $990,323 $1,135,922

$113,322 $154,268 $202,549 $258,605 $322,902

$0 $0 $0 $0 $0

$0 $0 $0 $0 $0

$0 $0 $0 $0 $0

$18,698 $18,698 $18,698 $18,698 $18,698

$1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000

11 12 13 14 15

60 61 62 63 64

$0 $0 $0 $0 $0

$0 $0 $0 $0 $0

$0 $0 $0 $0 $0

$1,097,499 $1,059,214 $1,021,067 $983,057 $945,185

$290,512 $258,121 $225,731 $193,340 $160,950

$68,155 $65,850 $63,553 $61,264 $58,983

$32,391 $32,391 $32,391 $32,391 $32,391

$100,546 $98,240 $95,943 $93,655 $91,374

$0 $0 $0 $0 $0

$1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000

16 17 18 19 20 25 30

65 66 67 68 69 74 79

$0 $0 $0 $0 $0 $0 $0

$0 $0 $0 $0 $0 $0 $0

$0 $0 $0 $0 $0 $0 $0

$907,448 $869,847 $832,382 $795,051 $758,918 $745,355 $732,035

$128,559 $96,169 $63,778 $31,388 $0 $0 $0

$56,711 $54,447 $52,191 $49,943 $47,703 $44,883 $44,081

$32,391 $32,391 $32,391 $32,391 $31,388 $0 $0

$89,102 $86,837 $84,581 $82,333 $79,091 $44,883 $44,081

$0 $0 $0 $0 $0 $0 $0

$1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000

1. The available income tax deduction is derived from the actuarial value of the remainder interest received by the charity using the February 2008 Sec. 7520 rate of 4.2% and is based on the owners age, interest assumptions and other factors. Please consult your financial or tax advisor to review your specific situation. 2. The Make-Up Account Distribution is specified at $32390.5 per year beginning in year 11 until the account is depleted. This illustration assumes that the currently illustrated nonguaranteed elements of interest rates, COI charges and expense charges will continue unchanged for all years shown. This will not occur and actual results will be more or less favorable than illustrated. The nonguaranteed elements will change over time and are dependent on the company's investment, mortality and expense experience. This illustration must be accompanied by a basic illustration with the same date and premium outlay as this illustration. Please refer to the basic illustration for additional information, including guaranteed policy values. These materials are not a contract and will not become part of any policy issued by Sun Life Assurance Company of Canada.

Continued on page 4

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TA K E N OT E Benefit Planning for S Corporation Owners: The RETIREMENT NIMCRUT Continued from page 3 The chart demonstrates how the RETIREMENT NIMCRUT with a defened annuity works. In year 11, 6% of the Trust plus $32,391 from the make-up account will be distributed from the deferred annuity. This is continued for 10 years or until the cumulative make-up account is drained. Of course, the amount of the payout also depends on the account value of the deferred annuity. The operational rule at Payout (line 4) calls for the lesser of the Fixed % (Line 1) or Actual Income (Line 2), plus the cumulative make-up account. However, the payout cannot exceed Actual Income (Line 2) which is controlled by distributions from the deferred annuity.

NIMCRUT PAYOUT EXAMPLE Year 11

Year 12

Year 13

Year 14

$68,155

$65,850

$63,553

$61,264

2. Actual Income (Line 1 + $32,391)

$100,546

$98,240

$95,943

$93,655

3. Cumulative Make-Up Account

$290,512

$258,121

$225,731

$193,340

4. Payout (< of 1 or 2 plus 3, but cannot exceed 2)

$100,546

$98,240

$95,943

$93,655

1. Fixed % (6%)

SUMMARY 

A charitable income tax deduction partially offsets the income received from the S Corp. distribution.  Retirement income accumulates for 10 years tax deferred in the RETIREMENT NIMCRUT.  Income payout starts in year 11 when Rich is age 60, and continues for his lifetime.



The total contributions made to the RETIREMENT NIMCRUT ($100,000 for 10 years) are recovered for the children on Rich’s death via the $1,000,000 wealth replacement policy.  The remainder interest in the trust is distributed directly to a charity at Rich’s death.

TAKE NOTE is a quarterly publication of Sun Life Financial’s Advanced Markets Group. This information is intended to be of a general education nature. Sun Life Financial and its independent distributors do not give legal, tax or accounting advice. For specific tax or legal advice seek and rely on a qualified tax advisor or attorney. Sun Life Financial and its distributors specifically disclaim any liability or loss which is incurred as a consequence, directly or indirectly, of the use of this publication.

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SLPC 19244 08/08 Exp. Date 08/09

FOR PRODUCER USE ONLY. NOT FOR USE WITH THE PUBLIC.