A Restricted Property Trust (RPT) provides high-income earning business owners the opportunity to reduce income taxes and grow assets with sizable pre-tax contributions. An RPT also allows for tax-deferred accumulation and tax-advantaged distributions.
But, what good is a strategy if it doesn’t make economic sense?
In this post, we’re going to review the economic benefits of the Restricted Property Trust versus a taxable investment.
For those who are unfamiliar with the Restricted Property Trust, it allows for a business to make a 100-percent deductible contribution to the RPT. The participant typically recognizes 30-percent of the total contribution on their individual tax return in the form of an 83(b) election.
Once the contribution is made to the Restricted Property Trust, the trust purchases a whole life insurance policy. The whole life insurance policy is necessary to recognize the deduction. There must be a business purpose for the life insurance death benefit to qualify.
A whole life insurance policy is a conservative, fixed asset class. It is comparable to a Certificate of Deposit (CD), bond portfolio, etc.
“When we compare the RPT to a taxable investment it is important to keep in mind the taxable investment must earn an equivalent rate of return using a conservative, underlying asset class like the abovementioned.”
The whole life insurance policy provides several benefits:
- It allows the plan to recognize the deduction
- Provides tax-deferred growth and tax-advantaged withdrawals
- The death benefit self-completes funding of the plan if death occurs
- Works well in conjunction with buy/sell agreements and key man coverage
- Includes a residual death benefit after all distributions have been made
In general, a unique component of any permanent life insurance policy is its tax efficiency. Permanent life insurance allows for tax-deferred growth, and the ability to access cash flow tax-free. And, in most scenarios, the death benefit is income tax-free.
Restricted Property Trust versus a Taxable Investment
To analyze a Restricted Property Trust versus a taxable investment we need to make a few assumptions:
- 50-year old, male business owner
- Wants to contribute $100,000 per year for 10-years
- 45-percent tax rate
NOTE: The Restricted Property Trust can only be set up by an established business entity: S-Corp, C-Corp, LLC, or LLP (sole proprietors or LLCs taxed as a sole proprietor are not eligible). In addition, in order to establish a plan, the business entity must commit to a minimum annual contribution of $50,000 or more for a period of at least 5-years.
To understand the economics of a Restricted Property Trust versus a Taxable Investment we’re going to break it down into the following three phases:
- Phase 1 – Funding Period
- Phase 2 – Policy Distribution and Deferral
- Phase 3 – Withdrawal Period
Phase 1 – Contribution Period
During Phase 1 the participant is going to contribute $100,000 per year for 10-years to the Restricted Property Trust.
Since the “business owner/participant” is going to recognize $30,000 of income on their personal return it is important to take this into consideration for purposes of our comparison. In order to net the $30,000 taxable amount, the participant will owe taxes of $24,545. Therefore, to net a $100,000 contribution to the Restricted Property Trust, the participant will need to gross $124,545.
Now that this has been established, if the participant makes the decision to not participate in the Restricted Property Trust, and instead chose to pay taxes on $124,545 they would recognize net income of $68,500.
The result is a contribution to the Restricted Property Trust of $100,000 and $68,500 into a taxable investment. The goal of completing this analysis is to determine what rate of return the taxable investment would have to earn to equal the cash flow performance of the Restricted Property Trust.
Here you will see the $100,000 being contributed to the Restricted Property Trust, and $68,500 being contributed to the Taxable Investment Comparison. We have assumed an 8-percent rate of return for the taxable investment comparison.
You will notice the cash value of the Restricted Property Trust whole life insurance policy has $1,089,918 versus the $874,701 in the Taxable Investment Comparison at the end of Year 10. In addition, the Restricted Property Trust provided an initial death benefit of $3,305,650 that grew to $4,288,670 by year 10.
Phase 2 – Policy Distribution and Deferral
In Phase 2 the whole life insurance policy is distributed from the Restricted Property Trust to the participant. At distribution, the participant will recognize income taxes on a portion of the cash value.
We are going to assume taxes owed on the distribution are going to be paid in the form of a distribution from the policy. We are also assuming the participant chooses to defer any additional income from the policy for five more years until they turn age 66.
First, you’ll notice the distribution from the policy in Year 11 for $225,126. This amount represents the taxes that will be owed on the distribution of the policy from the Restricted Property Trust assuming a 45-percent tax rate. This amount is withdrawn from the policy tax-free to the participant.
Second, we have reduced the death benefit of the policy from $4,288,670 in Year 10 to $1,876,524 in Year 11. This allows the cash value of the policy to grow at a faster rate. Cash value growth in a life insurance policy is tax-deferred. You will also notice that as the cash surrender value grows so too does the policy death benefit.
Phase 3 – Withdrawal Period
During the withdrawal period, the participant receives tax-free distributions from the policy. In this example, we have assumed the participant begins withdrawals at age 66. Nothing says the participant must take withdrawals at age 66.
When the policy is distributed from the Restricted Property Trust the participant can choose when they would like to receive distributions. And, unlike a qualified plan, the participant is not required to begin minimum distributions beginning at age 70 1/2.
In this example, beginning at age 66, the participant receives net income of $88,903 per year for 20-years from the Restricted Property Trust for a total of $1,778,060.
Under the taxable investment, assuming an 8-percent rate of return, the participant receives net income of $88,903 for 16-years and $68,816 in year 17. The total net income distributed from the taxable investment is $1,491,264.
Each time income is taken from the policy the death benefit is reduced. But, in addition to the income received, the policy still has a $360,119 death benefit. The remaining death benefit will be paid to the insured’s beneficiary at their death income tax-free.
It is important to keep the life insurance coverage in force after all the withdrawals have been taken to avoid a large portion of the distributions from the policy from becoming taxable.
What’s the Real Rate of Return the Taxable Investment would have needed to earn to keep up with the Restricted Property Trust?
For the taxable investment to have kept up with the cash flow performance of the Restricted Property Trust it would have needed to earn just under 9.17-percent.
For participants in states with high-income taxes, the rate of return needed can exceed 9.17-percent. In some cases, it can be as high as 12 to 13-percent equivalent rate of return. The higher the tax rate the larger the rate of return required for a taxable investment to match the performance of the Restricted Property Trust.
Again, it is also important to remember we are using a conservative, fixed asset class. If your fixed asset portfolio is earning more than 9.17-percent, then it probably makes sense to not participate in a Restricted Property Trust.
But, you should also remember the Restricted Property Trust provides a rather significant death benefit. The value of this should not be overlooked.
What Did the Restricted Property Trust Accomplish that the Taxable Investment did not?
The Restricted Property Trust reduced the participant’s tax rate on plan contributions from 45-percent to 15.4-percent. It also provided a $100,000 annual deduction for the business. In the event death was to occur, RPT provided a death benefit to the participants beneficiary.
Lastly, the Restricted Property Trust provided $1,778,060 of tax-free income to the participant.