Vol 6 No 8		December 2004

Katt & Company is a national fee-only life insurance advising firm. The June 2002 Forbes magazine, and a July 16, 2003 Wall Street Journal article, name Peter Katt as one of only four nationally recognized advisors. The Forbes article states that, "…advisers are well worth the money… These savants are working for no one but you…" For references please contact us.

Personal Equity Plan (PEP) - A Tax Avoidance Scheme

My main purpose here isn't PEP per se, but how schemes like this expose the difference between professional cleverness and decency.

Before getting on with PEP, a quick update on our November 2004 Perspectives' commentary about the marketing of death-futures life insurance. A new client informs us that he has been approached by some investment guys selling life insurance policy investments as described in our November Perspectives. He received information on four policies he could invest in. The information included the insured's names, life insurance company, amounts of premiums and death benefits, and insured's life expectancy in months. This is SHAMEFUL.

I have written often about tax avoidance schemes that promise non-qualified tax-deductible contributions and tax-free benefits. Life insurance is almost always used in such schemes because its complications make certain items hard to see and the hidden compensation is huge. I have run into the Personal Equity Plan (PEP) several times in the past couple of years. Unlike abusive VEBA, 419 and 412(i) plans that have really caught the IRS' attention, I'm not sure PEP has been picked up by the IRS. None of the PEP participants I have worked with have run into trouble with the IRS, yet. PEP involves split-dollar, but I am ignoring how the new split-dollar regulations affect it. I know PEP is an ongoing program for those already in it, but I don't know if PEP is still being marketed. My main purpose here isn't PEP per se but how schemes like this expose the difference between professional cleverness and decency.

My comments about PEP only apply to those I have reviewed and they may not be completely representative of other PEPs.

1. Dr. Smith became a participant in a PEP in 1995 through his employer, Doctors, Inc., The employer was solicited to purchase PEP from it's corporate attorney who is with a very prestigious firm that has a large presence in the state. Doctors, Inc. paid $14,000 for what appear to be pure boilerplate documents by this law firm who also offered to render a tax opinion for an additional fee. I recently learned from another client that this law firm is listed as co-counsel on PEP.
   
   
2. PEP promises: tax-free retirement income / pre-tax funding / no plan contribution limits / not subject to ERISA / extremely safe. The tax-free retirement income is in the form of life insurance policy loans - nothing controversial with that. It is the pre-tax funding that is either a very clever tax loophole or catch-us-if-you-can tax avoidance. It appears that considerable effort has gone into papering over the actual transaction, but if my understanding of PEP is correct the critical transaction is simply goofy.
   
   
3. The critical transaction consists of Doctors, Inc. taking three annual loans from what the PEP folks claim is a third party lender. Doctors, Inc. borrowed $125,181 a year for three years for Dr. Smith's PEP. There are very serious appearing documents transmitted to a third party lender each year requesting these loans, but Doctors, Inc. received no money. Instead the insurance company notifies Dr. Smith that his unscheduled premium in the amount of the requested loan has been received. Doctors, Inc. pays tax deductible 12 percent interest on the loan. Here is the goofy part. The loan interest payment is made to the insurance company. The claimed third party lender receives nada, zero, zilch, NOTHING. And with a wink-wink the after-tax cost of this loan interest payment is subtracted from Dr. Smith's compensation. The tax-deductible interest payment (sic) paid to the insurance company for Dr. Smith is $15,022 the first year, $30,046 the second year and $45,065 each year thereafter. Dr. Smith also makes an annual premium payment with his after-tax money of $34,935.
   
   
4. After seven years in PEP the insurance company has received from Doctors, Inc. and Dr. Smith $521,938. But because the loan interest (sic) was deductible, the net cost is $427,300 for a policy with a surrender value of $411,514. This PEP scheme saved Dr. Smith $175,755 in taxes that he was able to apply to the life insurance policy.
   
   
5. In 2003 Dr. Smith decided to end his PEP participation so the PEP and split dollar agreements were terminated. Impressive security release documents were circulated between the insurance company, Dr. Smith and Doctors Inc., but no checks went to anyone. Doctors, Inc. didn't owe anyone for the, ahem, loans, and Dr. Smith didn't owe Doctors, Inc. anything for its split-dollar contributions.
   
   
6. PEP appears to be very much like a leveraged split-dollar plan that was smashed in the Tax Court ruling Lowery R. Young, Jr., et ux., et al. v. Commissioner (T.C. Memo, 1995-379, Tax Ct. Dkt. No. 2861-94). Dr. Young's loan interest payments were treated as constructive dividends.
   
   
7. The amount of the PEP life insurance was $4,627,833. Based on Dr. Smith's family protection goals and other life insurance he was over-insured by about $3,100,000. The irony is that the additional costs associated with this over-insuring were more than his tax savings. In other words Dr. Smith was induced to take tax-avoidance risks without any demonstrable advantage.
   
   
8. Background information I received claims that 122 law firms and 300 CPA firms have advised clients to implement PEP. No doubt the documents that support PEP are impressive, but these claimed 422 professional firms really have little chance of uncovering the clever PEP trick because it is only obvious if you can see how the supposed loan is really handled, or know how to do life insurance math to realize from the beginning that no bona fide loan interest is being paid to a third party lender, it is going to the insurance company as part of the premium. What I need help in understanding is, whether the firms that put together the documents really know about the subterfuge or are simply ignorant of how the loan really works. What I have no doubt about is their knowledge of how huge their fees are in churning out documents.