Q.
I am a Texas physician grossing around $500,000 per year (39.6% bracket). I anticipate cutting back to 1/2-2/3rds of that income in about 8 years when I hit 50. I plan to save around $150K per year toward retirement until that time, more than I can put into my available tax-protected retirement accounts. My tax accountant is suggesting a scheme where I use a C Corporation plus whole life insurance for a tax deduction. The plan is very complicated, building my skepticism. It seems to run like this:
I am an independent contractor running a PLLC taxed as an S-corp. I then also start a C-corp management company. A C-corp is taxed at 15% up to $50K and 25% for the next $25K. The effective tax rate for $75K
profit in the C-corp is 18.33% or $61,250. If I am at the 39.6% tax bracket that becomes $12,900 tax savings if I divert that money to the C-corp.
Normally the C-corp profits would go back to me and then I would have to pay personal income tax on that. Instead that money in the C-Corp after taxes ($61,250) is used to purchase whole life insurance and over fund it. This money is now in a qualified vehicle that can be invested and grow tax free and can be taken out at any time without a penalty. There is a cost to buy the life insurance I believe the cost is ~3K. I would then somehow borrow the money from the C corporation to avoid taxation or I'd have to use it to buy a second insurance policy. The accountant estimated returns at 5% and annual insurance expenses at $3K/year.
My question now is, have you ever heard of anything like this, and does it make sense?
A.
I'm always very skeptical of complicated schemes. As a general rule, complexity favors the issuer/advisor, and not the client. I'm also very skeptical when I see extremely creative schemes that use financial products in ways that they really aren't designed for. Mixing insurance and investing is a good example. C Corporations also don't generally make sense for physicians due to the double taxation issue – it's either taxed first at the corporate tax rate, then taxed at your personal dividend rate or it is paid to you as salary on which you pay your full marginal tax rate (and applicable payroll taxes.) Now you're talking about a scheme that combines both of these products and somehow morphs the combination into an extra retirement account for you.
Taxable Accounts Aren't That Bad
The first thing to keep in mind when considering schemes like this is that you're always comparing it to a taxable investing account. A taxable account has it's downsides, no doubt, including taxes and less asset protection than many other financial products. However, it also has many positives. You can dip into it at any time and for any purpose. Taxes can be minimized through tax-loss harvesting, the step-up in basis at death, donating appreciated shares to charity, and using only tax-efficient investments such as index funds and municipal bond funds. You should also wait a year prior to taking any gains so you're only paying at the lower long-term capital gains rates. Many people pay hardly any taxes at all on their taxable investing accounts (mine actually saves me taxes.) Advisors like to make it sound like some boogey-man to be avoided at all costs. Always remember there are far worse retirement investing methods than a simple taxable mutual fund or brokerage account.
Life Insurance Isn't A Tax Deduction
Life insurance premiums, as a general rule, aren't tax deductible. That combined with additional costs (insurance costs and fees) generally makes it inferior to most retirement accounts. 5% is also an exceedingly optimistic projection for future returns on a whole life policy bought today. Your more likely returns will be in the 3-4% range, and that's after 3-5 decades of holding the policy. You also need to make sure your policy would be paid up in 8 years, since you don't want to be having to make those huge premium payments on your expected lower income later. You should also consider that putting 50% of your retirement savings into whole life insurance, even if you were a big believer in it, would create a ridiculously imbalanced asset allocation.
Costs Matter
Forming a C corp, dealing with the administrative and tax hassles of that corporation, and purchasing and maintaining not one, but two whole life insurance policies (one inside and one outside of the C corp) adds a lot of additional hassle, complexity, and expense. Those expenses come directly out of your investment returns. I doubt that some slight tax savings will make up for the additional costs and lower returns of the whole life policies.
Roccy DeFrancesco Weighs In
Roccy DeFrancesco, JD, is the author of several books aimed at financial issues for physicians. We don't agree on every financial subject, but since his books cover a lot of complex schemes like this one (some of which he likes, some of which he doesn't), I thought I'd ask him his opinion of this one, and I liked his explanation of it enough to quote it nearly verbatim below:
What you have been pitched has been around since the beginning of time (or so it seems). You create essentially a bogus C-Corp that you never had before and funnel income to that entity. Usually it’s a management company. Then the entity retains earnings (pays corp. tax on its income). Because income is taxed at fairly low rates for modest amounts of income (income tax rates that are lower than your own) it seems like an interesting idea.
Then you have the C-Corp buy a cash value life policy where the money is allowed to grow in a tax-protected manner. So it’s not the tax deductible purchase of life insurance, it’s buying insurance with what the client sees as after-tax income taxed at a lower rate. The problem is that the assets accumulated in the C-Corp are treated as retained earnings. This means that if you want to get the money out of the C-Corp you have to pay taxes on that money when you take it out. That’s why promoters of this say that when you get to retirement you would have the C-Corp take a tax free loan from the life policy and then lend that money to the C-Corp owner. This feels like getting the money out of the C-Corp tax free, but that’s not exactly true.
Any loan from the C-Corp has to be at a fair market rate (defined by the IRS) with compounding interest. The long-term AFR is currently 3.28%. That loan will have to be paid back at death somehow. Since the policy is owned by the C-Corp, the death benefit from the policy isn’t going to be helpful to pay back the loan. So, you’d typically have to buy a separate policy (typically an increasing death benefit policy) on an individual basis with truly after-tax money to be used to pay back the C-Corp upon deah. Then you have a C-Corp with retained earnings and earnings on the retained earnings which is a really crummy asset to give to the heirs who then have the tax problem with the retained earnings.
Some promoters suggest that as soon as you retain the earnings and every year thereafter you take a loan from the C-Corp and buy the life policy individually. This is problematic because it can be seen as a step transaction- meaning that except for the tax benefit, you wouldn’t have done steps 1, 2, and 3. While each individual step wouldn’t cause a problem with the IRS, when you put them all together solely to gain a tax benefit, it’s a step transaction and any tax benefit is going to be taken away from you. Bottom line is that I am not a fan of this type of tax play and I don’t recommend it.
Tom Martin, CFP, is a fan of good Variable Universal Life policies in situations like this. Even if you wanted to use a VUL or WL policy, I think you could reasonably do that outside of any corporate shell. I don't see the tax savings there worth the hassle or complexity. I certainly couldn't condone putting all $75K into cash value life insurance but I don't think $10-25K per year would be any great financial sin, as long as you understand all the downsides of mixing investing and insurance. If I were you, I'd look very seriously at a defined benefit/cash balance plan instead. Schwab offers a personal DBP for independent contractors such as yourself. Personally, I'd probably just use the additional savings above and beyond what I could stuff into a 401K/profit-sharing plan, a defined benefit plan, personal and spousal backdoor Roth IRAs, 529s for the kids, and a stealth IRA, to pay down debt (remember Texas has very nice homestead asset protection laws) and invest in a taxable account.
What do you think readers? Where should this physician put his additional retirement savings? Comment below!
All the investments fees and commissions come right off the top of your investment returns. Why pay an additional 2% in fees to get 2% more in your portfolio?
Very much agree Dr. Whitecoat on taxable accounts. If physicians knew of all the advantages of taxable accounts , it is doubtful they would invest in insurance schemes. Remember you are adding another layer of risk i.e. agency risk when you invest with insurance companies. Do you believe all insurance co. will be around 30 years from now? My Malpractice carrier (rated A+) went belly up and I got nothing on my excess notes.
Taxable accounts can be asset protected if set up right when structured as an LP or LLC. I love my yearly $3000 above-the-line deduction for tax losses. Tax diversification comes in handy at Retirement. You can draw on taxable accounts at capital gains rates while converting IRA/401ks to Roths. Muni bonds are paying above treasury rates right now.
I’m glad this was brought up. A CPA had recently discussed something very similar. He recommended getting a whole life/term hybrid product but instead of having the policy placed in my name, have the corporation get a policy taken out under my children. This would allow for far more lower rates i.e. a whole life policy in a child that’s 8 is significantly more economical than whole life for a 37 year old. The CPA mentioned a plan that returns between 4-10%, which would never drop below 4%. Once I hit my retirement mark I(the corporation) can take theoretical loan draws from the account which are tax free since this is a insurance vehicle, but never repay them back. My child by this time will be roughly 28 and can elect to continue making payments to the policy to reap the future benefits if he so desires. Have you heard of this being done and does this sound feasible?
Feasible? Sure. A good idea? I doubt it. I certainly haven’t seen a whole life product being sold any time recently that guaranteed returns of 4%. Currently guarantees on whole life insurance are ~2%….if you hold it to your life expectancy (53 years for a 30 year old.)
I think you are looking at the real return while he may be looking at the illusion created by saying guaranteed x return but not telling you this is only on the investment side and doesn’t take into consideration the costs. Sure ill guarantee you a 4% return if I can take out much more in fees, commissions, and cost of insurance but still get you to think its a real 4% return. This is why you have to carefully view the illustrations.
I couldn’t agree more WhiteCoat. Furthermore, even if the doctor sets up a Corporation, most likely the IRS would define that as a professional service corporation (PSC). PSCs don’t have access to the lower initial rates. Every dollar they earn is taxed at the 35% marginal rate. Tbus, the double taxation is even more profound.
If it is that complicated, the IRS, and more importantly the Texas Dept of Revenue, will NOT look upon this very kindly. You might win in the end, but only after a very expensive case in “tax court”. Trust me, I settled with my State Dept. of Revenue. Their lawyer almost said it out loud — here is what I heard between the lines — “You might win the judgement for the $12,800 in dispute, but it will cost you $10,000 to litigate it in tax court, and you might lose. Then you’ll be out $22,800.”
No question in my mind that the tax person involved is going straight to hell. But they got my $12,800.
Bottom line: buy some collectible cars or artworks instead.
The tax benefit is there as C-corp taxes are paid at a different marginal rate than personal taxes.
15% for the first 50K
and
25% for the next 25K
Therefor for a $75K investment you get quite a substantial tax savings. You avoid that double taxation by having the C-corp loan you the money to then “invest” in a life insurance policy. The interest you pay the corporation on the loan is tax deductible and the profit the C-corp gets on that interest can be used for the following years $75K. Profit in the life insurance plan can be taken out at any time, tax free. (BTW, another benefit of a C-corp are fringe benefits which I am still learning more about.)
Here is where it gets really tricky. If you want to take out more, then money will need to be repaid, or you need to take out a second insurance plan to cover the loses of the first so that you can empty the plan out, and when you die the second insurance covers the firsts loses. Also, as stated above if the insurance company you bought your life insurance from goes under, ALL of your money is lost. I am also not sure what happens if you fall on hard times, get injured and can’t work and therefor can’t make the payments on the insurance. I would assume any equity in the insurance plan will be withdrawn and then double taxed when it comes back to your personal account.
This is obviously a scheme which is technically legal and can be a very good option for some. The following is just my opinion:
I do not think an income of $500K or even $700K that this is even remotely a good idea, especially if you can’t guarantee making those payments for at least 10 years if not more. I have thus learned that first you calculate how much you want to save every year. Then you max out your 401K, HSA, back door Roth. Then you decide how much you want in a taxable account. I would think a ~1:1 ratio between tax deferred (qualified or non ) and a taxable account is appropriate (Personally I would also add physical gold as well at 5% total savings.) Then if you are comfortable and confident making the payments into an insurance plan, then and only then can an insurance policy be a good hedge for some of your investments. They do say diversify this is exactly that.
So it boils down to numbers
$51K in a 401k
$5.5K in a back door Roth ($11K if married)
$3.25K in HSA ($6.5K if married)
~$7.5K in gold (~5% of savings)
$75K in a taxable account.
That comes out to ~150K in saving every year. Only then if you have more money to save and believe the money will keep coming should one of these other plans be instituted.
Tom: The C-corp is a management corporation not a professional one and therefor not a PSC.
James: I can’t imagine getting your child involved in such a scheme could ever be a good idea.
John: Forced to pay at gunpoint! I would have paid also.
There is no diversity with whole life. The insurance company takes that money and invests it in their general accounts which are primarily bonds and treasuries. Your return depends on how those do minus all the huge fees/expenses/commissions/cost of insurance etc. That’s like me saying ill be some total stock index fund from schwab and another from vanguard. It isn’t diversity. I already own that stuff in other forms just like everyone else. Just bc they don’t tell you what they are investing in doesn’t make it true diversity.
When they say diversify they aren’t talking whole life period. Its also why dividends for whole life have been falling for a long time now. Its directly correlated with those returns.
The reasons all these ideas exist is primarily to confuse people who might otherwise realize they shouldn’t be purchasing whole life. You will notice that all these insurance folks claim they don’t give tax or legal advice but they recommend this stuff as though they are experts on the tax and legal implications.
Rex, that does make sense. When I meant diversify is that you still get a small guarantee on your investment. Realistically, the more I understand, the more I feel a defined benefits plan may be a better option.
Again, obviously getting whole life or variable life is not an option for the $750K and under crowd, maybe even the $1Mil and under as well. It may be part of estate planning once other avenues are maxed for the wealthier.
Thanks,
-Alex
You are over estimating the value of the guarantee. The guarantee only means if the company can pay. If the underlying investments go belly up then that guarantee will have little value. Fortunately this isnt very common but it has happened and i would guess will continue to happen. There was a link over at bogleheads about the state guaranty assoc (which steps in when an insurance company goes under) and when they step in they have historically on average been able to make clients whole 94% of the time for annuities and 96% for life insurance. That guarantee also has limits of typically 100k of cash value and 300k death benefit. Additionally unless the insurance is purchased within an irrevocable trust, its still part of the estate. You only avoid income tax on death benefits. Most people dont need to create a situation where they have such an illiquid estate where term and investing isnt a better option.
Rex, between WCI and yourself there is so much useful information on this blog. I have learned a great deal in just a couple of weeks. You both got me thinking about my finances in a much better way, that includes who to trust. It even makes me want to do my own taxes in the future while using a qualified CPA as PRN for advice. I used to do my own taxes, but with the PLLC, and all the extra paperwork I have passed that job onto someone else, but no more.
Keep up the great work here. BTW, I have sent so many of my friends your way.
i have made very little contribution here and of course im just another doctor and not a financial professional (although their titles seem to mean very little). Unfortunately there was a time when i wasnt so knowledgeable about insurance companies and who to trust. Ill be working extra years to offset that mistake and i hope to help others avoid similar fates. I dont have strong feelings on the taxes but it depends on how complicated. I dont do my own taxes but i used to. I think WCI does his own taxes.
OMG……run as fast as you can. You really don’t want the IRS sniffing around each year after you attempt some stunt like this, which will draw their attention.
If the OP is an independent contractor really, not just for the purposes of the hypothetical C-corp, he might benefit from a solo defined benefit plan to put more money away tax-deferred.
Here’s a link about an ophthalmologist who was doing something pretty similar to this scheme who ended up in jail.
http://brookline.patch.com/groups/politics-and-elections/p/brookline-opthalmologist-sentenced-for-tax-evasion
Interesting. Seems a little complicated. Was it called a Section 79 plans? If he is looking to set aside money for retirement income he could opt for a Top Hat Exemption Plan, or Non-Qualified Deferred Compensation Plan. Money is put into a grantor trust so it is protected. These plans do not follow ERISA guidelines like Qualified Plans, so business owner is not required to make contributions for rank and file employees. Top Hat Exemption Plans should meet Internal Revenue Code Section 409A. There are no tax deductions upfront, however no minimum commitment either like pension plans. He/she can make a contribution this year, and not participate in subsequent years. Money can be taken out before age 59.5 and is not subject to RMDs. Distributions can be taken as lump sum or annuity stream.
I stopped reading 2/3 of the way through, because I think the questioner was confused about a crucial detail and I suppose you two had not seen it either. What a c-corp can do is deduct bonuses to its owner as compensation if it’s within reasonable compensation limits. The bonus is for the premium on a WL or VUL. The owner of the company is then also the owner/insured on the policy and is then technically responsible for the taxes on the premium, which is the “economic benefit” in this scenario. But then the business entity “double bonuses” the amount which would be due as taxes on the premium amount, which is also deductible to the business. That part is going to be the only real tax implication for the owner. Then the policy is free to grow tax deferred and when taken out incrementally is never going to be taxed again.