Exotic Stuff

By Jason Watson, CPA
Posted Saturday, November 5, 2023

We don’t want to go too far down this road, but you should be aware of this option. It is usually reserved for highly compensated employees such as executives who can set aside more money, and it might allow a non-qualified deferral to help a qualified plan, such as a 401k plan, to conform to plan testing. 401k plans with profit sharing and defined benefits pension piggybacks usually eliminate the need for this.

Exotic Stuff

There are all kinds of exotic stuff out there. Be careful. If it sounds too good to be true, check it out. Do your research. Talk to us. Yes, there are several legitimate yet exotic plans out there. A lot of them use life insurance as the vehicle. Life insurance has many unknowns and can prove difficult to tease out the problems or issues. With life insurance there must be an insurable interest by the policy owner, and some of the life insurance-based plans cannot be used in a pass-through entity such as S corporations and disregarded entities such as single-member LLCs.

Here are some things that might be a good fit for you and your business-

Self-Directed 401k Plans

Self-directed 401k plans allow you to invest into non-traditional investments such as rentals, other businesses, etc. This is very similar to self-directed IRAs. However, similarly to self-directed IRAs, self-directed 401k plans have several pitfalls such as unrelated business taxable income (UBTI) and unrelated debt financed income (UDFI).

Please visit our website for more information-

wcginc.com/sdira

You can also review our previous chapters. Be careful with self-directed IRAs and 401k plans. Not always a bad thing, but being unaware can leave you with expensive lessons.

Employee Stock Ownership Plans

You can also set up an employee stock ownership plan (ESOP) where employees can purchase business stock over time, and the stock is held in trust. A cool feature is the tax deferral of this system- the employee-owned portion of the business profit’s is added to the ESOP’s overall asset balance, and is only taxed when the employee makes withdrawals similar to an IRA. Check out the National Center of Employee Ownership here-

wcginc.com/6110

Section 79

Internal Revenue Code Section 79 offers huge deductions of policy premiums and instant tax savings. A Section 79 plan is where life insurance is offered as a group policy, but employees are able to obtain more benefits that are taxable as income. However, there is cash value to the policies that allow for borrowing in the future. There is one inherent problem- when a life insurance policy for a business under ten employees is underwritten, no medical exam is necessary which means the policy has high risk. And to balance that, the policy will have poor cash accumulation. Short-term gains, potentially long-term failures. Are all Section 79 plans bad? No. Just do your homework and ask those pointed questions.

Captive Insurance Company

If you have high property and casualty insurance needs, you can create another corporation that is essentially in the insurance business by collecting premiums from your primary business and investing those premiums into quality investments. The primary business gets a massive tax deduction since insurance premiums are an expense, and if the premiums are less than $1.2 million per year, the captive insurance company only has to pay taxes on the investment income.

Read that again. The captive insurance company does not pick up any taxable income directly from the premiums paid. Eventually the money is returned to you at dividend tax rates.

Tax savings is difference between ordinary income tax rates and capital gains tax rates.

The use of a captive insurance company is disclosed on your tax returns as well. At present, WCG has about 30 clients who leverage this arrangement, and with recent tax court and federal court decisions, captive insurance is under severe scrutiny and is being lumped with other abusive tax shelters.

Controlled Executive Benefits and Endorsement Split-Dollar

These programs are similar in the sense that life insurance is used to retain key employees by controlling the access to the cash value. The tax deferral or tax savings might not be available with type of arrangement, and depending on how it is setup, the payout to the beneficiary might be taxable as well. This is very complicated, and your garden variety financial planner might not be comfortable with these. Your best bet is to speak directly to an advisor who works for a life insurance business such as Transamerica, Northwestern Mutual, New York Life, etc. Or at the very least get a second opinion.

Again, do your homework and ask around before jumping into a life insurance-based product. They have their place, and they can provide huge tax savings especially during high marginal rate tax years. But not all products and plans are the same.