[Editor’s Note: I occasionally get a guest post that I find interesting but whose author is surprised to find that I won’t run it on the blog except as a Pro/Con style post because they already felt they included the “con side” in their original submission. Most of the time, I don’t know anyone that could write a really great “con” post, so I end up writing it myself. That often puts me at a disadvantage because I usually know less about the subject than the original author. That’s okay though, the point of these posts isn’t to “win a debate” but rather to provide a well-rounded, in-depth look at a controversial topic.

restricted property trust

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Today’s topic is the “Restricted Property Trust” and comes from a submission from insurance agent Jason Mericle of RestrictedProperty.com. I’ll let him explain what it is and who might want to look at it. Then I’m going to explain why I think most docs shouldn’t bother. Jason and I have no financial relationship.]

Pro – Jason Mericle

Restricted Property Trusts Can Benefit Some Physician Business Owners

Over the past two decades, there have been a few strategies promoted by life insurance agents touting large tax deductions using life insurance as the primary funding vehicle. Many of these plans (412(i), 419a(f)(6), 419(e), and Section 79) eventually came under IRS scrutiny and ultimately became useless or even worse — listed transactions.

The Problem with Business Owned Life Insurance

Most of the abuses occurring under these plans were a direct result of administrators and insurance companies pushing the limits of the Internal Revenue Code (IRC) and life insurance product design.  The end result being an epic (and costly) failure for participants. Without going into all the details as to why and how each of these plans was abusive, the main underlying theme of all of them was TAX AVOIDANCE.

The fallout from these abusive plans is that any strategy involving a deduction and life insurance is automatically deemed to be abusive. Does that mean you should throw caution to the wind when you see a plan offering a deduction and life insurance? Absolutely not. Abusive plans still exist in many different forms. It is an unfortunate part of the life insurance industry. Whenever any type of deduction exists somebody will try and figure out a way to push the limits and add life insurance.

For purposes of full disclosure and transparency, I have held an insurance license since 2000 with a focus on life insurance. I have seen the good, bad, and ugly of these plans and product manipulation for nearly 20 years.

In the early 2000s I did “sell” a client a 412(i) plan. However, instead of funding it with life insurance, I chose to recommend funding the entire contribution using a fixed annuity. The result was a positive outcome for the participant and their overall retirement strategy.

Introducing the Restricted Property Trust

Jason Mericle restricted property trust

Jason Mericle

In 2010, I was introduced to a strategy called a Restricted Property Trust. Due to the history of the industry and the aforementioned abuses, I was skeptical. After completing my own due diligence and understanding of the mechanics it became clear to me it was different than the “other” plans.

The Restricted Property Trust (RPT) is designed for high-income earning business owner physicians and key employees. An RPT provides long-term, tax-favored cash accumulation and cash flow utilizing a conservative whole life insurance policy. Before we get into the details of how the Restricted Property Trust works it is important to note it has a 100-percent successful track record with the IRS, including four national reviews. The IRS has determined it is not a listed transaction because the plan is a mechanism for tax-deferral, not tax avoidance. This is critical.

Is a Restricted Property Trust Right For You?

A Restricted Property Trust can only be established by an S-Corp, C-Corp, Limited Liability Company (LLC), or Limited Partnership. Sole proprietors cannot adopt a Restricted Property Trust, which includes LLCs taxed as a sole proprietorship. Contributions to a Restricted Property Trust are a 100-percent deductible contribution under Internal Revenue Code (IRC) 162 to the business. The participant will typically recognize 30-percent of the total contribution on their individual return in the form of an 83(b) election.

There are two primary factors to consider prior to establishing a Restricted Property Trust.

  • First, the minimum annual contribution is $50,000.
  • Second, there is a mandatory 5-year funding commitment.

Following completion of the 5-year commitment, the participant has the option to continue funding for an additional 5-years.

A key provision of the Restricted Property Trust is the employer is required to make the annual contribution in accordance with the pre-established funding period. In the event the employer is not able to make the contribution during the funding period, the policy is surrendered to the trust. The proceeds are then distributed to a public charity designated by the participant when the trust is established.

Contributions from the employer to the Restricted Property Trust are used to purchase a whole life insurance policy.  Whole life insurance is a low-risk asset class like a certificate of deposit (CDs), money market, or treasuries.

Legitimate Business Need

Since we are using whole life insurance (in order to qualify for the deduction) there must be a reasonable business need for the life insurance coverage. This is most easily understood by recognizing what the economic loss to the business would be if the participant passed away.

For example, let’s assume a physician establishes a Restricted Property Trust for their practice. We review the company’s tax return and determine we are comfortable defending a $5 million death benefit. The reason for this is if something happens to the physician, the practice is in big trouble.

The IRS may ask why didn’t do this for your receptionist? If something happens to the receptionist, the physician is going to get a new receptionist. There would not be an economic or financial loss to the practice that would come even close to the loss of the physician.

Because of this, the Restricted Property Trust is fully-selective. Unlike qualified plans, the business can choose who participates provided the company would suffer an economic loss due to the untimely death of the participant. At the end of the day clients generally only care about the deduction 9 times out of 10. They’re not necessarily death benefit motivated. The tax deduction is what motivates them to do it. The life insurance is only along for the ride.

Restricted Property Trust Case Study

Let’s look at a scenario where we have a medical practice with four equal owners varying in age from 42 to 68. Each of the physicians earns approximately $1 million per year, and the medical practice is conservatively valued at $15 million.

One of the physician-owners is introduced to the Restricted Property Trust and is interested in its potential to help them deduct and defer a portion of their income. The physician takes it to their other three partners, and they decide they are not interested in participating. But they agree to allow this physician to establish a plan.

The physician interested in establishing the Restricted Property Trust is a 50-year old male in a 45-percent tax bracket with a desire to contribute $100,000 per year. Since the value of the practice is $15 million it is easy to determine the financial loss to the remaining shareholders if he were to pass away is $3.75 million ($15 million times 25-percent ownership). The only question left is whether $3.75 million of life insurance coverage is enough to support the desired $100,000 contribution. Given the fact pattern, a $100,000 contribution would require a $3,305,581 initial death benefit. For the Restricted Property Trust to work the company is required to make the contribution. Instead of the physician receiving $1 million of income for the year the company would make the $100,000 contribution, and the physician would recognize $900,000 of income.

Since the physician is going to owe taxes on 30-percent of the total contribution via an 83(b) election he would need to gross $124,545 to net the $100,000 contribution ($30,000 (taxable amount) divided by (1 less .45 tax rate) plus $70,000). The alternative is to not participate in the RPT and recognize the $124,545 as income resulting in net income of $68,500 ($124,545 time (1 less .45 tax rate)).

restricted property trust

Assuming the physician contributes $100,000 for 5-years and extends it for another 5-years he will receive a net deduction of $700,000 over the ten-year period. When the funding period is complete the policy is distributed from the trust to the participant.

When the policy is transferred there will be additional taxes owed. The tax payment is most commonly paid by taking a withdrawal from the policy. The participant is not required to pay this tax from other assets. In some cases, it may make sense to consider doing this, but it is not a requirement. After the policy is transferred and the tax is paid, the death benefit is reduced in order to maximize the tax-deferred growth inside the policy. At this point, the policy owner can access tax-free income from the policy.

Under this example, if the physician elected to access income from the policy at age 66 they would receive $87,229 per year for 20-years based on current assumptions. This results in a tax-free income of $1,744,580 over a 20-year period.

restricted property trust cash flow

If we compared the $87,229 distribution to a taxable investment earning 8-percent — the taxable investment account would be depleted by the end of year sixteen. Resulting in total income of $1,504,790 over this period.

restricted property trust comparison

In addition to the tax-free income created by the Restricted Property Trust, if death were to occur the life insurance policy would pay a death benefit to the named beneficiary. The death benefit is received income tax-free. Once all the income is received from the policy there is still a death benefit of $353,677 in this example. This death benefit will be paid upon the death of the insured in addition to the income already received.

A Restricted Property Trust allows business owner physicians to reduce income taxes, defer growth, and receive tax-free income in the future. It is a way for physicians to accumulate additional assets for retirement in a tax-friendly environment. The life insurance is the mechanism that makes the Restricted Property Trust work. If you were given the option to receive a 100-percent corporate deduction (of which you would owe taxes on 30-percent of that contribution individually), defer the growth of the assets, earn an equivalent 8-percent return on a conservative asset class (e.g. bond portfolio or Certificate of Deposit), and then be able access a tax-free stream of income would you do it?

Now, if I told you this was all possible to do, but in order to do so and achieve the exact same results — it would require you use a whole life insurance policy as a funding vehicle. Would this change your mind? The reality is the life insurance policy is a bonus. It is simply along for the ride with the added benefit of providing your beneficiaries a death benefit.

The Restricted Property Trust is not for everyone, but for the right high-income earning physician it can be extremely beneficial.

I agree that whole life insurance is generally not a great investment vehicle. However, when you combine the tax benefits available under the Restricted Property Trust with the policy it can be a tremendously valuable asset. The plan itself has outlasted and flourished during a time when many strategies promising big tax deductions involving life insurance failed. For the right physician, it is worth considering.

restricted property trusts (rpt)Con – The White Coat Investor

A Restricted Property Trust Is a Method to Sell More Whole Life Insurance

A useful rule of thumb that has served decades of investors well is to never take any financial advice from someone who sells insurance and especially somebody who gets a significant percentage of their income from the sale of whole life insurance policies. I have spent countless hours online explaining the way these policies work, the issues with the policies, and especially the issues with the way the policies are sold. I’m not going to repeat all of that here, but someone unfamiliar with whole life insurance will likely find the following links useful:

What You Need to Know About Whole Life Insurance

Inappropriate Whole Life Insurance Policy of the Week

As a brief recap, buying a whole life insurance policy is a lot like getting married. It is either “until death do you part” or it is going to cost you a lot of money to get out. So treat buying a policy with the same amount of due diligence you would put into getting married. Be aware of some of the basic stats about whole life insurance: 80% of those who buy policies later surrender them, 75% of doctors who have purchased policies later regret their decision, commissions on a policy are 50-110% of the first year’s premium, and your return on the investment will be negative for 5-15 years and low even if you hold it for decades.

I have written about a business owned life insurance scheme before: Section 79 Plans

So, knowing all that about whole life insurance, does it make sense to buy it if you do so in this particular scheme called a Restricted Property Trust? Probably not. Let me explain why. But first, let me point out a few minor issues with the post above:

Minor Issues With a Restricted Property Trust

Conflict of Interest

Jason is an insurance agent with a business focused on selling restricted property trusts. I’m sure he’s a nice guy and he might just be one of the most informed people on the planet about this infrequently-used, fancy scheme. He also has a massive conflict of interest in getting you to believe it is a good idea. If you Google “restricted property trust”,  almost all search results are links from agents trying to use it to sell whole life insurance. There are no accountants, attorneys, financial advisors, authors, DIY investors, clients etc. out there anywhere advocating this technique in any easy to find place. Although there are a few attorneys offering to help you with the audits of your RPT. That should you tell you something.

Qualifying for Life Insurance

Second, unlike a retirement or taxable investing account or any other investment, you actually have to qualify for life insurance. If you are not healthy, have “dangerous hobbies” like SCUBA diving, mountaineering, flying, or skydiving, or are older, you may not be able to get this sort of plan at all, and even if you can the additional cost of the insurance is likely so high that it would make the plan a stupid choice for you. The life insurance might be “along for the ride” but you still have to qualify for it and pay for it.

Legality

Third, when the post starts out saying “I know all those other plans didn’t end up passing IRS muster, but this one will,” you’ve got to ask yourself if you’re really interested in getting involved in something that, at best, walks right up to the edge of legality, peers down, and then takes a half step back. As the old story goes, the best driver is not the one who can drive the closest to the cliff without going over.

Whole Life Insurance

Fourth, I hate the name. There’s a reason Jason doesn’t call it “Tax-deferred, business-owned whole life insurance.” Whole life insurance has a terrible reputation for a reason and calling it something else doesn’t change that fact. One of his later paragraphs:

Now, if I told you this was all possible to do, but in order to do so and achieve the exact same results — it would require you use a whole life insurance policy as a funding vehicle. Would this change your mind?

is a classic sales technique. Yes, Jason, that would change my mind!

Returns

Whole life insurance is not a particularly attractive asset class. Yes, in the long run, you can expect bond-like returns, but in the short run, you should expect negative returns. That’s not exactly a great swap.

Math

The math gets flakey later in Jason’s post. The idea that you can somehow end up spending more money by using low returning whole life insurance instead of a more appropriately invested taxable account doesn’t stand up to an appropriate analysis using appropriate return and tax assumptions. While he doesn’t show his work, if it is like most comparisons made by insurance agents, it assumes that every dollar of return in the taxable account is fully taxed at maximum ordinary income tax rates, rather than enjoying tax-protected growth, qualified dividend rates, long term capital gains rates, tax-loss harvesting, and the donation of appreciated shares to charity. Even if the assumptions were fine, the comparison presents a false dichotomy in that it doesn’t include using a Single Premium Immediate Annuity (SPIA) as a method of maximizing spending in retirement.

Major Issues With a Restricted Property Trust

Lack of Flexibility

My first major issue with using a Restricted Property Trust is the lack of flexibility. You must put at least $50K a year into it and you must do so for at least five years. One of the biggest problems that people run into with whole life insurance policies is that life changes, and now they’re stuck with big fat premiums. We routinely underestimate how different our future will be from how we imagine it.

I mean, look at what happens if you can’t make the premium payment one year. All of a sudden all of your past payments are given to charity? What’s up with that? There is no such requirement on any other type of investing account. Why risk that much loss for such terrible returns?

Better Ways to Reach Financial Goals

My second major issue with an RPT is that it feels like a solution looking for a problem. What problem are you trying to solve here? Step back for a minute and ask yourself what the point is. The point is to reach your financial goals. If you’re like most docs, one of your main goals is to save up a big nest egg to retire on. You want to minimize the effect of fees and taxes on the investments and you want to make sure you take enough risk to reach your goals but not too much risk.

If you make $300K a year, perhaps you save $60K a year for retirement. That easily fits into a $56K 401(k) and a single Backdoor Roth IRA. There’s absolutely no reason for a doc with that income and those accounts available to go looking elsewhere for a place to save for retirement. Even for a higher earning doc, let’s say one making $600,000 or even a million dollars a  year, there are usually better options.

Let’s take that doc making a million who wants to save $200,000 a year. How can she do that? Well, there’s that $56K 401(k), maybe a couple of $6K Backdoor Roth IRAs, and a $7K HSA. Most likely, the spouse is contributing something to that income and brings access to a few more retirement accounts. Perhaps that’s enough to shelter $120K of that $200K. Many docs also invest in a taxable account. That allows them to invest in real estate and some tax-efficient mutual funds they can use to tax loss harvest and even donate appreciated shares to charity. It’s usually not terribly difficult to find ways to invest even $200K a year. Even for a doc who wanted a larger tax-deferred/asset-protected account, there is the option of a defined benefit/cash balance plan. I invested 7 figures last year and didn’t seem to run out of good options to invest in that required me to go find an insurance agent.

So who is left that restricted property trusts could possibly be right for? Well, a pretty tiny sliver of doctors. I mean think about all of the requirements for a doctor to even consider this plan:

  1. The doc has to own her own practice (a small and dropping percentage)
  2. The doc has to make a lot of money (the average physician makes $275K, a small fraction of what someone should be making to consider this plan)
  3. The doc has to be a big saver ($50K should be a small percentage of their annual savings)
  4. The doc has to be in a practice where it doesn’t make sense to have a big 401(k)/Profit-sharing Plan plus a Cash Balance Plan because her partners don’t want to save much
  5. The practice has to file taxes as a partnership or corporation
  6. The practice has to have a business need for a big life insurance policy on this partner
  7. The practice has to have employees that would not value larger retirement contributions over additional salary (more on this later)
  8. The doc has to actually qualify to buy life insurance at a reasonable rate
  9. The doc has to remain in a stable earning situation for at least the next half-decade

We must be talking about less than 1% of doctors at this point. As I’ve always said about whole life insurance, it might be right for 1% of doctors. Well, I guess it wouldn’t surprise me to find that an RPT is right for 1% of doctors. What are the odds that you’re in that 1%? Not very good.

Few Practices Have a Legitimate Need for a $5 Million/Doctor Insurance Policy

In the example in his post, Mr. Mericle mentions justifying a $5 Million policy to the IRS as a legitimate business need, i.e. a key-man insurance policy. Perhaps he can convince the IRS of that, but more likely, the IRS just isn’t looking very closely here. I mean, imagine you’re in a very successful ENT practice where each partner is making a million a year. Let’s say one of the partners keels over. Yes, the practice is now bringing in less money. Perhaps $2 Million less a year with similar overhead. But how long does it really take to hire a new ENT? Certainly no longer than a year and more likely six months and you don’t have to pay that partner his $1 Million after he dies. What the heck is the other $4 Million for? Well, the only possible use is to buy out the deceased partner’s estate.

Okay, maybe that flies with the IRS, maybe it doesn’t, but the point is that the more you wish to put into this plan, the more you’re going to have to justify the face value of the insurance to the IRS as a legitimate business expense. It’s not like you can just say “I want to put $200K a year into this plan.” If you’re 40 years old, that’s going to be a massive death benefit on that policy that you’ll need to justify. Mr. Mericle points out that you’re really just doing this for the tax break and not the life insurance. You don’t think that’s also obvious to the IRS? Do you really want to be two or three years into this “retirement plan” and having to defend anything about it to the IRS?

Restricted Property Trusts are Only 70% Deductible

Your premium payment is not completely tax-deductible to the business. It is only 70% deductible. This is very different from a 401(k) or cash balance plan contribution that is 100% deductible. So now you’re not only getting a crummy investment, but you’re not even getting a full deduction for it! Are you really sure you want to do this instead of just paying the taxes and investing in a taxable account?

But Wait, There’s More! (Taxes)

restricted property trust

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Did you catch that bit in the case study about what happens after you get done contributing to this “retirement” plan for a decade and only getting a 70% deduction for your contributions? You get to pay more taxes. How much do you owe? Well, the value of the life insurance policy is basically compensation. It’s FULLY TAXABLE. You’re basically taking the entire cash value and paying taxes on it all at once at the end of year 5 (or 10 if you extend the plan). Perhaps after 10 years of $100K contributions it’s now worth about $1 Million. You now owe taxes on $1 Million! You can either pay them from the policy or you can pay them from other assets, but pay them you will.

This isn’t like a retirement account where you gradually take money out of the account over decades (or even leave it to heirs as a stretch IRA) and only pay taxes on what you take out. You pay all the taxes right now. And then what are you left with? You’re left with a crummy whole life insurance policy you probably would have never bought in the first place if it hadn’t been pitched as a tax-saving retirement plan.

Like most agents, Mr. Mericle loves to mention the “tax-free” aspect of spending that money. Well, it SHOULD be tax free. You’ve already paid taxes on it! If you surrender the policy and go and spend that million dollars, you’re basically spending principal, which is always tax-free. Now it’s cool that you can partially surrender a whole life insurance policy with gains and access the principal first. That’s a legit tax benefit of cash value life insurance. But avoiding taxes on the basis/principal? Nah, that’s the same with everything else.  Same with being able to borrow against it tax-free but not interest-free. That’s the same as your house, car, income properties, and portfolio. Borrowed money is always tax-free.

Hosing Your Employees

A few words should be said here about one other issue that isn’t actually unique to an RPT. Many practice owners don’t want to implement a traditional 401(k)/profit-sharing plan plus a defined benefit/cash balance plan because it will cost them a lot more in fees and required contributions for the employees than it will save the physician personally in taxes. I totally get it. There are reasons that The White Coat Investor, LLC doesn’t have any employees outside of Katie and I.

Bear in mind that any time you choose a different retirement plan for your practice because of this concern that your employees may be getting hosed. Yes, maybe they aren’t financially sophisticated enough to realize the value of a great retirement plan with a solid match and so aren’t willing to take a lower salary in exchange for it, but proper education can go a long way in that department. There is a certain moral/ethical dilemma at play here in this regard that you should be aware of.

Restricted Property Trusts are Just Tax-Deferral

But I really don’t think your employees should be feeling all that bad about missing out on this “retirement plan.” The only real benefit here is being able to wait ten years to pay the taxes on the money you used to buy a whole life insurance policy. In fact, as I understand it (and I could be wrong) I think you’re paying taxes on 100% of the value of the policy when it is transferred despite only getting a 70% deduction on the original contributions! There’s no way the tax-deferral is worth that arbitrage for most people, so I hope I’m wrong about that. But if the main point of this whole scheme is the tax savings, why aren’t the details on the actual tax treatment more clearly spelled out? Probably because they’re not all that good.

Personally, I’d rather just keep things simple, use the retirement accounts that make sense for the practice, pay the taxes, invest the money tax-efficiently in tax-efficient stock index funds, municipal bond funds, and real estate in a taxable account, and skip all this nonsense with a whole life insurance policy, a trust, and the charity for a relatively minor tax deferral benefit.

Does that mean there is NO ONE out there that would rather use this plan over investing in taxable? Of course not, but I don’t know anyone personally that would want to do this once they understood how it really worked. Nor do I know anyone personally who is actually using an RPT. Do you really want to be the guinea pig? If so, let us know how it goes in the comments section.

What do you think? Do you have a restricted property trust? Why or why not? Would you consider using one now that you know what it is? Comment below!