August 23, 2016

Bringing Deferred Compensation On Shore by December 31, 2017: What Can You Do To Minimize the Tax Burden?

By Lisa Marino, Vice President, Wealth Preservation, Marcum Financial Services LLC

Bringing Deferred Compensation On Shore by December 31, 2017: What Can You Do To Minimize the Tax Burden?

Since 2009, hedge fund principals have known that deferred management and incentive fees retained offshore would become subject to tax in the 2017 tax year, whether or not funds are repatriated. Internal Revenue Code Section 457A, along with IRS Notice 2009-8 and Revenue Ruling 2014-18, sets forth the particulars for taxation of this deferred compensation. If you are a hedge fund manager who has accumulated a significant deferred compensation balance offshore, 2017 will be a tax year of reckoning. Any funds deferred and held offshore will become subject to tax at your highest marginal tax rates. While the imposition of the tax cannot be avoided, proper planning can help mitigate the impact. Proactive planning provides an opportunity to reduce your ultimate tax liability, while simultaneously enhancing your family’s net worth.

Utilizing a CLAT (Charitable Lead Annuity Trust) partly or wholly funded by a life insurance policy in the current low interest rate environment creates a significant income tax deduction, while leveraging the funds to purchase a policy. This effectively transfers wealth, with no gift or estate tax to succeeding generations, while simultaneously generating significant charitable donations. A hedge fund manager can accomplish substantial family and charitable planning goals through the creation of a CLAT.

A Simple Example

A. The Facts
Joe Smith, age 57, is a managing partner at Hexon Funds. Hexon is a $1 billion hedge fund with assets split between onshore and offshore funds. Before the end of 2017, Joe is required to repatriate $10 million of management and incentive fees he presently holds offshore. Assuming he is subject to a combined 50% income tax rate, the repatriated funds would be reduced to $5 million after taxes. Furthermore, should these funds remain in Joe’s estate when he and his wife Donna (age 56) pass away, it will then again be subject to a 50% estate tax. As a result, the remaining balance to the family (not considering the earnings on the $5 million to invest during the insureds’ lifetimes) is reduced to $2.5 million.

B. The Solution
Joe and Donna meet with their planning team at Marcum LLP to address the income tax situation they face. The Marcum team explains how a CLAT works to generate significant family wealth, coupled with important charitable donations. By using this strategy, they create a current income tax deduction for the full amount of their contribution to the CLAT. They effectively create $5 million in tax savings, which is leveraged in a life insurance policy, coupled with charitable donations. The CLAT is structured as a “zeroed out CLAT” which provides a pre-determined stream of annuity payments to a selected charity over a specified number of years. The value of the charitable deduction is calculated using the IRS published 7520 rate, which, in a low interest rate environment, is very favorable to Joe and Donna. Because of the way the CLAT is drafted, the Smiths have flexibility in determining which charity will receive the annual contribution from the CLAT. Because it is a Grantor Trust, any taxable investment earnings within the CLAT create an income tax liability for the Grantor/Donor. This plan minimizes exposure to income tax by leveraging the gift through the purchase of a $58 million joint life insurance policy. The policy death benefit is chosen to provide the maximum amount of life insurance (in this particular example) that can be obtained without creating a modified endowment contract (MEC) and unfavorable life insurance tax consequences.

The trust pays a life insurance premium of $2 million per year for five years, thus using the entire $10 million contribution. The policy cash value grows on a tax deferred basis. Since the growth in cash value is in an insurance policy, there is no income tax incurred. The CLAT annually borrows a small portion of the cash value in the policy to make the scheduled annual payments to the selected charity. At the end of the CLAT term, the remaining assets of the trust will be transferred to the trust remainder beneficiaries. Based upon a conservative policy interest rate, current life insurance projections, and an assumed investment return on trust assets, upon Joe and Donna’s passing, their heirs receive a significant life insurance benefit and a potential distribution of remaining cash in the CLAT.


In our simple example, and assuming a conservative return on trust assets, after 25 years, the selected charity has received approximately $14.3 million. The life insurance policy distributed to Joe and Donna’s remainder beneficiaries has a net death benefit of approximately $45 million and a projected cash value of approximately $14 million. On distribution, it is projected that the life insurance policy requires no additional premiums. Most importantly, under this strategy the life insurance policy passes to the named beneficiaries without any gift or estate tax. The $10 million of funds offshore turns into $14.3 million of charity and $45 million of net insurance benefit over the term of this plan.

This strategy for hedge fund managers is extremely powerful. By combining the nontaxable treatment of life insurance cash build-up with a charitable deduction for the full contribution to the CLAT, an ideal family wealth-building strategy is created. Marcum’s dedicated team of planners and life insurance experts have the knowledge and experience to implement the CLAT strategy for high net worth hedge fund managers and entrepreneurs. Wealth-building is achieved with leverage due to the upfront income tax deduction; gift and estate taxes become non-factors. Compared with other wealth-building strategies, the CLAT can multiply the benefits for your heirs, while at the same time accomplishing good deeds for the charities of your choice.

We are here to help. Please contact your Marcum advisor to further address how this strategy may be implemented for you and your family.

Note: Projections of anticipated benefits are dependent upon numerous factors including interest rates, investment returns, and life insurance underwriting. Actual results will vary with each engagement.

Securities offered through Raymond James Financial Services, Inc., member FINRA/SIPC, an independent broker/dealer, and are not insured by FDIC, NCUA or any other government agency, are not deposits or obligations of the financial institution, are not guaranteed by the financial institution, and are subject to risks, including the possible loss of principal.

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