The invention relates to a program that administers a method of
funding life insurance policies using annuities that are purchased
at least in part using borrowed money, using business and trust
structures to reduce and/or eliminate tax. This investing can be
done either directly by the policy or through the trust and/or other
business entity. As an internal investment of the insurance policy
the income generated by the annuity and the inside build-up are
non-income taxable to the owner of the policy. The resulting death
benefits will also be non-income taxable to the beneficiary.
What is claimed as new and desired to be protected by Letters Patent
of the United States is:
1. A method using a computer system of managing combined life insurance
and annuities for a group of insured persons, comprising the steps
of: having arranged financing from a commercial lender; having acquired
through a first entity at least one annuity for each insured person
using a portion of the financing from the commercial lender, wherein
the first entity is owned by a second entity that is of a tax favored
nature, and wherein each annuity provides an income stream that
is allocated to the second entity so that it receives tax favored
treatment; having acquired at least one life insurance policy for
each insured person using a set of third entities, wherein the owner
of each third entity has an insurable interest in one of the group
of insured persons, and each third entity has acquired at least
one life insurance policy on the life of the insured person in which
its owner has the insurable interest; wherein each third entity
is organized in a manner to shield the insured person on which it
has acquired life insurance from liability from the commercial lender
and from any taxes on the annuity acquired for that insured person;
and wherein a portion of the financing from the commercial lender
has been used to pay the initial premium for each life insurance
policy; administering income streams relating to the annuities,
the financing, and the life insurance policies and maintaining information
pertaining to the income streams using the computer system, and
distributing the income streams from the annuities to pay the annual
premiums for the life insurance policies and to pay the interest
and principal on the financing from the commercial lender based
on the income stream information maintained in the computer system.
2. The method of claim 1, wherein a portion of the financing from
the commercial lender is paid to the first entity as a service fee.
3. The method of claim 1, wherein the third entity comprises a
4. The method of claim 1, wherein at least one of the third entities
is owned by the person on whom the third entity has purchased the
life insurance policy.
5. A method of managing combined life insurance and annuities for
a group of insured persons through a computer system, comprising
the steps of: acquiring or having acquired through a first entity
at least one annuity for each insured person, wherein the, first
entity is owned by a second tax favored entity, and allocating the
income stream from each annuity to the second entity so that the
income streams receive tax favored treatment; acquiring or having
acquired a plurality of life insurance policies using a set of third
entities, wherein each third entity acquires or has acquired at
least one life insurance policy on the life of one of the group
of insured persons, and each third entity is organized in a manner
to shield the insured person on which it has acquired life insurance
from any taxes on the income stream from the annuity acquired for
that insured person; administering through the computer system the
income stream relating to the annuities, the financing and the life
insurance policies and maintaining information pertaining to the
income streams using the computer system, and distributing at least
a portion of the income stream from the annuities to pay the annual
premiums for the life insurance policies based on the information
maintained in the computer system.
6. The method of claim 5, wherein each third entity provides funding
to the first entity to acquire the at least one annuity for the
person on whom the third entity has acquired the at least one life
FIELD OF THE INVENTION
The present invention relates to a method and apparatus for administering
life insurance policies using annuities for funding, while realizing
substantial tax advantages.
BACKGROUND OF THE INVENTION
In the past, private individuals and businesses currently use annuities
as funding sources for insurance policies. However, the income tax
ramifications as well as the lack of a system to administer such
transactions on a large scale significantly limit the market for
Individuals and charities or otherwise tax-exempt organizations
have been approached with a number of systems over the years that
employ the use of insurance products. There are three primary reasons
that most of these systems have been unsuccessful.
First, the U.S. Internal Revenue Service has attacked many systems
involving life insurance products. Tax-exempt organizations in particular
must be careful not to engage in any activities that may endanger
their tax-exempt status. Second, individuals and tax-exempt organizations
will not generally use their existing resources to fund directly
or to be used as a guarantee for the funding of such arrangements.
This is because these arrangements generally do not meet their criteria
for investing. Third, simplified tools necessary to administer these
very complex strategies are generally not available.
There are two types of annuities relevant to this specification,
deferred and immediate. Deferred annuities differ from immediate
annuities in the following way. Deferred annuities "defer"
payments to the investor and immediate annuities have payments to
the investor that start "immediately". Annuities were
originally designed as immediate annuities because customers desired
income for as long as they lived. However, as customers' interests
evolved, holders of annuities desired to start their income stream
at some point in the future rather than immediately, perhaps after
the death of a spouse. Consequently, they put money in an annuity
at present, let an insurance company invest it, and at some point
in the future convert the annuity from a deferred compensation plan
to an immediate compensation model. That's how the name "deferred
annuity" arose because the first payment to the investor is
deferred to some point in the future.
Presently, the majority of annuities that are sold are deferred
annuities. The primary reason for their current popularity is that
the earnings accumulate on a tax deferred basis. Thus, many customers
use them strictly as a tax efficient investment vehicle. However,
annuity contracts always have the right to convert it in some cases
must convert at a certain age to an immediate annuity, primarily
for tax reasons. Specifically, customers use annuities to defer
their income tax. An immediate annuity yields an immediate income
stream. Immediate is defined by the IRS as an annuity where the
first payment starts within one year, i.e. within one year of the
first annuity investment.
If the first payment is deferred for more than one year, it's not
treated as an immediate annuity for tax reasons. It becomes similar
to a deferred annuity. Most importantly, the taxation of payments,
and the character of the taxation changes, with a corresponding
change in the tax consequences.
Furthermore, an immediate annuity income stream can be based on
life expectancy. An 81 year old has a shorter life expectancy than
an 80 year old, thus enhancing the pay out, which is based on life
expectancy as determined from actuarial tables. Suppose a customer
gives an insurance company $100 (setting aside interest and profit).
Suppose also the person had a life expectancy of ten years. The
insurance company then states agrees to give that person $10 a year
for the rest of their life.
Such an arrangement is, for tax purposes, characterized as a return
of principal and not as taxable earnings. In an actual immediate
annuity arrangement with a commercial life insurance company, the
insurance company also adds interest and this interest is taxable.
Also, once the principal amount has been fully returned, the entire
annuity payout is taxable. Since the return of principal is completed
at life expectancy, all income from the annuity after life expectancy
is fully taxable. This constitutes a major increase in the tax obligation
for those individuals that live past their life expectancy.
The reason the insurance company can guarantee a life income is
the law of large numbers. Actuaries can tell statistically how many
people are going to die before their life expectancy, and annuity
companies get to keep the balance of the money. For the people that
die after their life expectancy, they use the money that was saved
from the early-deceased people to pay them.
Consider a person who has a five-year life expectancy. When they
give the insurance company $100, the insurance company will agree
to give them $20 a year for life, which looks like a 20% return
guaranteed on an investment. Few other kinds of financial instruments
can get a guaranteed for life 20% return on an investment, especially
from an AAA rated company. Thus, the rate of return drives the concept
of annuities. Another benefit is that if the purchaser lives beyond
the life expectancy they win, because they get more money than what
they paid. Their estate also wins if they take that income stream
and peel off part of it and buy a $100 life insurance policy. This
is because if they die in the first year their estate will get their
$100 back from the life insurance policy.
The life expectancy of a 30 year old is much longer than an 80
year old; therefore their annuity income stream will be much smaller.
Thus, the strategy described earlier would not be practical for
a 30 year old because the payout of the annuity would be so low.
However, an 80-year-old client can borrow money and get a high enough
pay out. A qualified 80-year-old can borrow the $100 and get a high
enough pay out from the annuity to pay interest on the loan, and
pay the premium on a $120 life insurance policy. When he dies the
lender would receive the $100 back. The $20 that's left over goes
to his family.
Consequently, the lender receives money in two ways. The first
is taking interest payments from the income stream paid by the immediate
annuity. Second, a major life insurance company guarantees that
the remaining principal will be repaid at death. The basic premise
of using an annuity income stream to buy life insurance has been
in the public domain for many years.
SUMMARY OF THE INVENTION
In view of the foregoing, there exists a need in the art for a
system which combines annuities and life insurance in a way that
is advantageous for tax purposes. One aspect of the present invention
provides a system for combining life insurance and annuities, including
borrowing money from a lender, purchasing an annuity and a life
insurance policy using the borrowed money, paying premiums for the
life insurance policy using income from the annuities, making periodic
payments on the borrowed money using income from the annuities,
and managing tax consequences of the income within an investment
trust. In another aspect of the invention, the investment trust
includes a partnership connected to a tax favored entity. In yet
another aspect of the invention, the members of the partnership
are paid by dividends.
In yet another aspect of the invention, the annuities are purchased
from a purchaser's existing assets, and no loan is necessary. In
yet another aspect of the invention, the beneficiaries of the life
insurance policy or policies are charitable institutions.
BRIEF DESCRIPTION OF THE DRAWINGS
The foregoing and other features and advantages of the invention
will become more apparent from the detailed description of the exemplary
embodiments of the invention given below with reference to the accompanying
FIG. 1 shows one possible result of combining annuities and life
FIG. 2 shows an improvement in the results of FIG. 1 using the
techniques of the present invention.
FIG. 3 shows a flowchart of the first embodiment of the present
FIGS. 4A and 4B show a flowchart of the second embodiment of the
FIGS. 5A and 5B show a flowchart of the third embodiment of the
FIGS. 6A and 6B show a flowchart of the fourth embodiment of the
FIG. 7 shows a modification of the first embodiment of the present
FIG. 8 shows the Charitable Endowment Life Insurance Policies (CELIP)
as used within the present invention.
FIG. 9 shows a computerized implementation of the present invention.
FIG. 10 shows the implementation of FIG. 9 integrated within a
DETAILED DESCRIPTION OF THE PREFERRED EMBODIMENTS
Borrowing money to buy life insurance has been around for a number
of years. For example, American General Insurance offers a capital
maximization strategy plan to its users to finance life insurance
premiums and annuities. The present invention builds upon this basic
concept of taking an immediate annuity contract with a life insurance
company that pays a guaranteed income stream for a period of time.
It does so by using what are called "life only" annuities
(or annuities that have a life expectancy component), which means
that for as long as one is alive they get a specified amount of
money. The insurance company guarantees that money. `Life only`
annuities differ from `period certain` annuities. Period certain
annuities extend for a specified number of years. The present invention
uses only "life only" immediate annuities (or variations
that include a life expectancy element). Again, these do not resemble
deferred annuities. Immediate annuities are simply a contract for
a guaranteed income stream.
Unfortunately, income from an annuity contract that is not the
return of basis is fully income taxable. This income tax is a particular
problem when the annuitant on an immediate annuity contract lives
past their life expectancy. Under those circumstances all of the
distributions will be income taxable. The income tax ramifications
on the distributions are a major impediment when considering the
use of income from an annuity to purchase a life insurance policy.
If a charity or otherwise tax-exempt organization is involved in
this type of transaction there is an additional concern. If any
money is borrowed to fund any portion of this transaction the charity
or otherwise tax-exempt organization could be subject to taxation
on the income from the annuity as unrelated business income. This
would force the charity to file tax returns on their activities
that would not otherwise be required.
Private individuals and businesses currently use annuities as funding
sources for insurance policies. However, the income tax ramifications
as well as the lack of a system to administer such transactions
on a large scale significantly limit the market for such purchases.
Charities or otherwise tax-exempt organizations have been approached
with a number of systems over the years that employ the use of insurance
One target of the present invention is a wealthy person who is
considering the purchase of a deferred annuity or has an existing
deferred annuity. Because this investment, unlike many other investments,
is tax deferred (it is taxable upon distribution) many wealthy clients
historically continue to defer any distribution until death. They
often choose to spend investment that will be taxed before they
spend tax favored investments. When they die their estate or heirs
will pay state and federal income tax as well as estate tax. Instead,
they could take this deferred annuity, convert it to an immediate
annuity and buy life insurance with the resulting income stream.
Where this arrangement can be properly structured, the tax-free
death benefit would be paid to the heirs from what would have otherwise
been substantially taxed.
Suppose the above wealthy individual already owns a deferred annuity
generating a significant annual income stream. That individual can
convert the annuity from deferred to immediate and use that income
stream to buy life insurance. Suppose that individual client dies
with a $1 million annuity, they are going to pay state and federal
income taxes so that the net yield could go down to $500,000. After
paying the estate tax in addition to the income tax, they could
wind up with as little as $250,000.
Conversely, a more astute individual would convert that annuity
from deferred to an immediate income stream. They'll buy a $1 million
life insurance policy, the proceeds of which their children will
receive tax-free. Instead of getting $250,000 after tax as described
above, if they convert it and buy a life insurance with the income
stream (and the arrangement is properly structured), the policy
will pay $1 million after tax. Such a maneuver has well known in
the industry. In fact, an insurance professional named Barry Kay
has written a book on the lending of money using annuities to buy
life insurance, entitled "Die Rich and Tax Free" (Forman
Publishing, Inc., Santa Monica Calif., ISBN 0-936614-15-3).
However, the above maneuvers, some of which are mentioned in Barry
Kay's book, do not account for all of the possible tax consequences,
and the target audience for his book is a narrow spectrum of very
wealthy persons. The tax consequences are of particular concern
when borrowed money is used to facilitate the transaction. When
borrowed money is used to buy the immediate annuity, a tax problem
exists with the basic transaction. Generally when borrowed money
is used to purchase insurance products, the loan interest is not
tax deductible. Life insurance premiums are not tax deductible and
the annuity income above basis is fully income taxable at ordinary
rates. Further, when a charity is involved there is the additional
concern that these transactions may be subject to tax under the
unrelated business income tax rules that apply to charitable organization
that engage in business activities that are not directly related
to their charitable activities.
Using borrowed money to purchase an annuity to fund life insurance,
however, is not conventional. As an example, a company borrows $100,
and then buys a $120 life insurance policy by using part, perhaps
$5, of the borrowed money to pay the first year's premium and the
first year's interest. Using the remainder of the borrowed money,
perhaps $95, they then buy an immediate annuity and the immediate
annuity income will pay the ongoing insurance premiums as they come
due (most often annually), as well as the ongoing interest and perhaps
some principal on the original $100 loan. Suppose the individual
has retired $20 of principal of the original $100 loan. At the death
of the principal, the insurance policy would pay $120, of which
$80 goes to repay the lender for the unretired portion of the loan.
The $40 that's left over goes to the principal's family (supposing
they are designated as beneficiaries), or a charity. In either case,
that $40 would generally be tax free. This transaction would work
for older insureds if there were little or no annual income taxes
to be paid. However, in the majority of cases there is not sufficient
income to pay the annual taxes on the annuity stream and still be
able to pay the insurance premium and the interest on the loan.
As a result most attempts to combine annuities with life insurance,
whether using borrowed money or not, become mathematically impractical.
FIG. 1 shows a detailed example of combining annuities with life
insurance using borrowed money. FIG. 1 depicts the first 21 years
of a life annuity purchased by a 73 year old person with a life
expectancy of 12 additional years. The 73 years can be seen from
the "Age" column 102, while the life expectancy can be
determined from the "Basis Balance" column 104, by noting
that the 12.sup.th year is the year at which the steadily declining
Basis reaches zero. That person borrows $13,581,649 (hereinafter
referred to as either a loan or a note) as shown in Total Loan amount
106, and uses the borrowed money to purchase life insurance policies
having a total face value of $18 million dollars as shown by Total
Coverage amount 108. As shown in column 112, each year the individual
or the estate must pay an Annuity Tax for the illustrated 21 years.
If the principal lives beyond their life expectancy, this tax goes
up from $270,828 to $741,995. At the death of the principal, the
annuity payout ceases and a net death benefit is paid to the beneficiaries.
If the person in FIG. 1 lives beyond their life expectancy, the
amount of their $1,854,987 annual annuity payout which becomes taxable
increases substantially (see Amount Taxable in column 110). Computing
the tax on such a payout involves a factor used by the IRS known
as an Exclusion Ratio, shown in FIG. 1 as being 63.5%. Using this
exclusion ratio and assuming a tax bracket of 40%, the tax on the
above annual payout also increases, from $336,288 to $741,995. Thus,
the beneficiaries of the insured person see a substantial reduction
in the net payout (Annuity Payout-Annuity Tax) every year that the
insured lives beyond their life expectancy.
This is because, as stated, once the principal amount has been
fully returned, the entire annuity payout is taxable. Since the
return of principal is completed at life expectancy, all income
from the annuity after life expectancy is fully taxable. This constitutes
a major increase in the tax obligation for those individuals that
live past their life expectancy.
In this way, all transactions discussed using borrowed money would
usually not make economic sense because of their annuity tax implications.
The present invention, however, focuses on reducing the tax implication
and making it a low tax situation or in some cases a no tax situation.
Part of how these taxes are reduced is through the use of trusts.
A trust is a mechanism that allows one to impose some controls over
a corpus or resources that a settlor intends to give to an intended
beneficiary. The settlor of a trust is the person who intentionally
causes the trust to come into existence. The manager of the trust
resources, also known as a trustee, has an equitable obligation
to keep or use the property for the benefit of a beneficiary.
The trustee (i.e., administering institution such as KDI shown
in FIG. 2) is the person or entity who holds title for the benefit
of the beneficiary. The trust property is the property interest
which the trustee holds subject to the rights of a beneficiary,
and in the present invention would encompass all loans, annuities
and life insurance policies. The trust instrument is the document
by which property interests are vested in the trustee and beneficiary
and the rights and duties of the parties (called the trust terms)
are set forth. The trustee has a duty to retain trust documents,
to keep track of expenditures necessary to run the trust, and to
keep an accurate history of the trust administration. The computer
system of the present invention is useful for coordinating these
payment duties and maintaining accurate records, as will be discussed
in more detail below.
A trustee must obey the trust instrument as to the time, amount,
form and destination of payments which he is directed or authorized
to make from income or principal to the beneficiaries. Thus, the
trust instruments of the present invention explicitly state how
the annuity stream is to be used to pay the life insurance premiums,
and in the embodiments using loans, how those loans are to be repaid,
all of which is information which is readily programmed into a computer
system as will be discussed in more detail below. Within the present
invention trusts act to isolate the client, beneficiaries, and (where
applicable) business entities from the actual financial transactions.
Because of this isolation, the trust income is not taxed as personal
income to the clients and beneficiaries.
Evidence of this reduction in taxes is illustrated by comparing
FIG. 2 with FIG. 1. FIG. 2 assumes the same amount age, lifespan,
face value, loan amount, and insurance premiums as in FIG. 1. FIGS.
1 and 2 are also the same in that both contain a Net Insurance column
showing the amount that would be paid to beneficiaries upon death
of the individual. However, FIG. 2 is structured using the principles
of the present invention, including controlling the annuity within
a trust as described above. The first and most noticeable difference
is that in FIG. 2, the "Annuity Tax" column has been replaced
by a "Service Fee" column 200. This is because the present
invention is structured so that, although the annual Annuity Payout
is still a taxable event, the tax has been either shifted, reduced,
or eliminated. Accordingly, instead of paying $270,828/year (before
life expectancy is reached) or $741,995/year (after life expectancy
is reached), a flat fee of $100,000 is the only expense.
All four embodiments of the present invention can use borrowed
money to purchase annuity contracts and pay the initial cost of
life insurance. This debt is usually non-recourse, although a recourse
embodiment exists where the principal guarantees at least part of
the loan obligation. The cash flow from the annuity contract is
employed to pay ongoing life insurance premiums, interest on the
borrowed money, taxes resulting from the taxable portion of the
annuity, and other transaction fees including expenses of maintaining
the trust and paying the trustees. The net pay out to the beneficiary
can be greatly improved by adding an immediate annuity payout to
any funds contributed by the insured. The type of annuity is usually
life-only, although the present invention also contemplates using
a "5 year certain" annuity. The policy risk is reduced
since a major institution such as a life insurance company usually
guarantees the annuity payouts. However, although the above principles
apply to all four embodiments of the present invention, some differences
exist between them, as will now be explained.
First and Second Embodiments
The first and second embodiments have the annuity purchased by
the life insurance policy as an internal investment of the policy
(first embodiment), or as an investment of the life insurance company
(second embodiment). As shown in FIG. 3, the first embodiment uses
money that was paid to the policy 312 using money 316 borrowed by
the policy 312 from a third party lender 318. As shown in FIG. 3,
because of regulatory requirements requiring diversification, each
life insurance policy 312 will generally have multiple annuities
302. Depending on the type of life insurance policy 312 used, the
structure internal to the policy 312 may require a trust 314 or
a business entity to conduct the transaction. Initially, each annuity
and loan will be tracked to a particular policy 312, as indicated
by the arrows 304, 306, and 308 FIG. 3. Arrow 310 depicts money
flowing to the life insurance policy after deduction of the $100,000
Service Fee 200 indicated in FIG. 2, indicated by the box "Mortality
and Expenses" labeled $100K.
If a large enough number of insureds is accumulated, it is possible
that a pool of annuities 302 and loans 316 could eliminate the need
for a specific annuity being tied to a specific policy shown in
FIG. 3. Such a non-tied arrangement is shown in FIG. 4.
In the first and second embodiments, the present invention greatly
reduces or eliminates income taxes because the annuity portion 302
is built into the life insurance policy 312 and/or the life insurance
company (second embodiment) and is going to be paid as part of the
death benefit 320, as shown in FIG. 3. Insurance companies are required
to invest the money placed into universal life insurance policies.
The earnings on those investments are not taxable, and are called
"inside build up" 326. As an internal investment of the
insurance policy 312, the income generated by the annuities 302
as inside build-up is non-income taxable to the owner of the policy.
The resulting death benefits 320, 323 will also be non-income taxable
to the beneficiary(s) 324.
The second embodiment differs from the first in tax consequences.
In the second embodiment, no inside build-up occurs, and the tax
consequences arc handled by an insurer 402 shown in FIG. 4 which
is not present in FIG. 3. Hereafter, FIG. 4 is construed to mean
FIGS. 4A and 4B taken collectively. This insurer 402 also manages
the investment trust 314, which unlike the first embodiment in FIG.
3, is not an account of the life insurance policy 312. Because in
embodiments 2-4 the investment is not an internal component of the
policy 312, the Service Fee 200 must be accounted for separately.
Accordingly, the $100,000 Service Fee 200 of FIG. 2 is shown within
the first embodiment in FIG. 3 as the Mortality and Expenses from
Annuity Income box and is labeled `100K`. The second embodiment
(and the third and fourth) differ from the first in that the Service
Fee 200 from FIG. 2 is indicated by the box "Management Fees"
in FIGS. 4-6 rather than the box "Mortality and Expenses",
but is also labeled $100K.
Another difference between embodiments one and two is that a pool
of annuities 302 and loans 316 eliminates the need for a specific
annuity being tied to a specific policy.
Embodiments three and four include the administration of investing
in widely available insurance contracts through a unique trust,
business entity and partnership arrangement. This arrangement is
employed in order to closely track and direct the income tax liability
502, as shown in FIG. 5. Hereafter, FIG. 5 is construed to mean
FIGS. 5A and 5B taken collectively. In the third and fourth embodiments,
investment growth no longer occurs inside an insurance policy, and
is therefore no longer characterized as "inside build-up".
Instead, owners of management company 504 that are normal business
entities but have either substantial income tax credits, tax-favored
status, or otherwise reduced income tax exposure, receive a significant
amount of the income tax liability. This improves the cash flow
available to fund the other components of the arrangement and therefore
significantly widens its marketability.
Examples of tax favored entities can include businesses established
within the U.S. Virgin Islands, as approved by the U.S. Congress.
There are economic development zones also in the continental U.S.
as well, such as around some airports. The U.S. Congress has approved
for creation other types of tax favored businesses for various reasons.
Thus, shifting tax consequences to a tax favored model is encouraged
by the U.S. Congress.
In the structure of FIG. 5 (embodiment three), even though the
partnership 504 doesn't pay taxes, the distribution 502a and 502b
to its owners is fully taxable. However, as described earlier, Congress,
through enterprise zones or tax-favored entities 508 allows the
management company 509 to obtain tax credits to be applied toward
income tax obligations 502a and 502b which arise from the annuity
income stream 506. As shown in FIG. 5, embodiment three differs
from embodiment two (FIG. 4) in that the tax favored entity 508
is explicitly shown as being established by a subsidiary management
company 509, which was not shown in FIG. 4.
Thus, it is advantageous to attach a separate business 509 to the
partnership 504. That sub-business 509 purchases annuities 302,
borrows money 316 from the lender 318, pays the interest 510, and
also buys life insurance policies 512. When the person dies, that
partnership 504 will pay the money to that sub-business 509 and,
where appropriate, pay off the note (loan) 316 as well as any negatively
accrued interest. The balance is then passed down to the main partnership
504, which will then pay a death benefit to the beneficiaries (partners)
324 of that client, part of which was financed by the proceeds from
the sub-company 509. The money left over becomes profit, which is
distributed to the more tax-advantageous entity 508. The annual
income on the annuity income stream 506 is taxable. So even though
there is minimal cash flow going down to the partnership 504, there
still is some partnership income (K-1). Under normal circumstances,
there may be little or no money to pay the tax resulting from that
partnership income. However, because the present invention uses
the tax-advantageous entity 508, the tax obligation is greatly reduced.
Because of this reduction, the minimal cash flow described above
is sufficient to pay the tax obligation.
During the year of death of the principal, the net proceeds (which
are non-taxable) are passed down to the partnership 504, which pays
the amount out as a death benefit 320 to the partners/beneficiaries.
Most of the red tape (from a taxation point of view) that would
be associated with this death event is removed because the insurance
payment is paid as a non-taxable death benefit to a beneficiary
The fourth embodiment differs from the third in that the annuity
is purchased by a subsidiary 604 of the tax favored business entity
so that the tax obligation is passed to the tax-favored company
508, and the benefit is paid as taxable income in the form of a
dividend 602, as shown in FIG. 6. Hereafter, FIG. 6 is construed
to mean FIGS. 6A and 6B taken collectively. Because of this, the
fourth embodiment is more conducive to charities than the third
embodiment. This is because where a charity is involved, a dividend
602 would be an acceptable distribution method since in most cases
this would not be taxed to the charity. Conversely, the partnership
504 income (K-1) of the third embodiment would be a more difficult
distribution method for a charity.
Any of either the first, second, third, fourth, or non-lender embodiments
described above can be combined with an entity known as a Charitable
Endowment Life Insurance Policies (CELIP), although the third embodiment
is subject to certain limitations when doing so. As stated earlier,
there are three primary concerns for charities in using the financial
structure of the present invention. First, tax-exempt organizations
must be careful not to engage in any activities that may endanger
their tax-exempt status. Second, tax-exempt organizations will not
generally use their existing resources to fund directly or to be
uses as a guarantee for the finding of insurance products. Many
insurance products do not meet their criteria for investing. Third,
computerized tools necessary to administer the very complex (both
legally and financially) strategies are generally not available.
All of the above problems are solved by the present invention's
accommodation of charities using CELIP instruments. CELIPs can enhance
payout of life insurance policy, reduce risk of a life insurance
policy, benefit charity or other exempt organizations, and avoid
adverse income tax consequences associated with other designs. The
primary owner and or beneficiaries could be a charitable or otherwise
tax exempt organization such as a University. Another market could
be a family office.
The CELIP will include within its investment choices the option
to borrow money and the right to purchase an immediate annuity.
These choices will be viewed directly as policy investments or payments
from the annuity to the policy, and will be used (either directly
or through a money market account) to pay expenses and mortality
costs of the life insurance policy.
FIG. 8 shows the sequence by which the CELIP accomplishes these
tasks. The insured can make a donation to the investment trust 702,
and/or money can be lent to the trust 702 by lender 704. This money
is used by the trust 702 to purchase an immediate annuity from annuity
company 706 and commence receiving income therefrom. The trust income
pays interest on the debt, and also is invested in a money market
account 708. Upon death of the insured, that money market account
708 is used to pay funeral expenses, and the lender 704 (if any)
is paid by the death benefit. The net death benefit remaining after
the lender 704 has been repaid is then paid to the designated charity
As shown in FIG. 8 step 6, the CELIP policy will be structured
internally in such a way that the insurance proceeds will first
be used to repay the lender 704 (if any). Only after the lender
704 has been repaid is the main insurance benefit paid to the beneficiary
710, as shown in step 7.
Because of its complexity, computers are necessary to properly
implement the present invention. As stated earlier, the financial
industry has stringent requirements for investment diversity, so
each individual client may have as many as six annuities. A company
that manages several clients must buy annuities throughout various
companies within the annuity industry. Although the examples in
FIGS. 1 and 2 show only two, each client may also have as many as
four life insurance policies. The management company 402/509 will
also get annuity payments every month to the individual policy they
belong to and track all those values. In addition to that, they
must check the loan (supposing a lender embodiment), whether it
is a variable rate loan which will negatively or positively amortize,
must determine on a regular basis what amounts should go into the
policy, and must review the policies and make adjustments on a regular
basis. Additionally, many of these fiduciary relationships are governed
by explicit terms within the trust instrument described earlier.
Thus, management company 402/509, as trustee, is legally required
to manage the information with the utmost scrutiny possible.
FIGS. 3-6 show an additional complication, which is that the annuity
income stream 506 does not flow directly to the trust 314, because
the lender 318 wants control (first dibs) over this cash. Thus,
all of the income stream 506 is assigned to the lender 318. The
lender 318 acts as the pay master. If a payment went to the lender
318, but the lender didn't send it off to one of the three life
insurance companies 220, a "lapse notice" could result.
The above scenario described all of the necessary conditions for
one client. Thus, for one hundred clients it is absolutely unmanageable
without a computer system in place. Accordingly, the management
company 402/509 that runs the trust 212 has to be on top of the
lender 216 and share data with them to ensure payments are going
from lender 216 to insurance companies 220, as well as micromanage
other key aspects of the payment system. Specifically, such a data
sharing or reporting system must coordinate data between clients,
a management company 402/509, and lender 318. It is estimated that
the computer system of the present invention will track thousands
of transactions that will be occurring on a monthly basis. These
transactions will include:
Receiving of monthly income from each annuity.
On a monthly basis determining the amount to be credited from each
annuity to each life insurance policy's money market, general account
and/or mortality and expenses.
On a monthly basis determining the amount to be credited to the
lender for each loan. These notes will mostly be floating rate notes.
On a monthly basis determining the amount positive or negative
loan amortization to be added or subtracted from each loan.
On a monthly basis performing a test to determine if the loan is
At the death of the insured, determining the amounts to be paid
to the lender.
The above transactions are shown as the four boxes on the bottom
of FIGS. 3-6, which are labeled "Policy Projections",
"Note Reporting", "Tax Reporting", and "Cash-flow
Reporting". Thus, the management company 402/509 that runs
the trust 212 must monitor payments originating from the lender
216, as well as micromanage the reporting system described above.
If the payment/reporting system is not micromanaged properly, things
could fall apart quickly, with possible legal consequences including
but not limited to breach of the duty of trusteeship. Consequently,
a computer system capable of sharing data including payment records
is crucial to the successful operation of the present invention.
As shown in FIG. 9, main computer system 802 has responsibility
for several of the above duties. The computer system 802 is drawn
as a stand-alone machine, although it could be a combination of
several computers networked together, including servers, desktop
machines, remote terminals, and any combination thereof. Proprietary
software 804 includes means for separately and independently telecommunicating
with each life insurance company 806.sub.1-n, annuity company(s)
808.sub.1-n, commercial lender 810, investors/bondholders 812.sub.1-m,
clients 814 curious about the state of their account, and a KDI-type
service entity 816. Because of the sensitive financial nature of
the information contained therein, all data connections 818 must
be secure. Several possible implementations exist by which to achieve
this, including but not limited to leased line, WAN, ISDN, Internet
sockets upon which reside secure encryption layers, or any of numerous
implementations of secure TCP/IP. Note that the client's 814 connection
818 flows only in one direction, because it is a read-only connection.
Such a connection can be implemented using secure URL which can
be viewed but not modified using any of a variety of Internet browsers.
If the client wishes to make alterations in her account, she cannot
do so using connection 818 but must instead contact an employee
of the service entity 816.
Main computer system 802 preferably has a database application
layer 820 which could include but is not limited to Microsoft Access
communicating closely with proprietary software application 804.
These products run on top of a Operating System (OS) 822. It is
anticipated that any form of operating system can be used, including
a preferably multi-threaded OS. Additionally, because of the time-sensitive
nature of the information and alerts contained therein, computer
system 802 also preferably has a Universal Power Supply (UPS) 824
backup in case of power failure. This is useful for two reasons.
The first is that computer system 802 must remain on-line at all
times in order that no payments or alerts are missed, thereby reducing
the chance of any "lapse notice" being issued. Also, the
integrity of the date/time function within computer system 802 must
be assured. If the computer system 802 had an incorrect date/time,
many false payments and false alerts could result.
FIG. 10 is an overview of how main computer system 802 is integrated
within a larger computer system 902 run by a service entity 816
responsible for implementing the present invention. Main computer
system 802 is located in headquarters 904, while remote terminals
906.sub.1-n are located in Field Offices 908.sub.1-m. Secure logons
910.sub.1-x accessible only by employees of service entity 816 are
located anywhere an Internet connection can be established, including
airports and hotel rooms. Data integrity is maintained by channeling
all employee secure remote Internet logons 910 through a Secure
Exchange Server 912.
While the invention has been described and illustrated with reference
to specific exemplary embodiments, it should be understood that
many modifications and substitutions can be made without departing
from the spirit and scope of the invention. Accordingly, the invention
is not to be considered as limited by the foregoing description
but is only limited by the scope of the appended claims.