A Restricted Property Trust (RPT) is a little-known tax strategy. It can be an excellent option for high income business owners.
This structure gives you the ability to make pre-tax contributions that will grow tax deferred. They also have critical estate planning options that make them great for closely held businesses.
In this guide, we discuss how these trusts work and show you why they can be an excellent tax planning tool. Let’s get started.
Table of contents
What is a restricted property trust?
A restricted property trust is a unique structure. Contributions by the business owner get an effective 70% tax deduction.
Assuming a 40% marginal tax rate, this means that every dollar contributed results in a tax savings of 28 cents. A 28% tax savings works great when it is combined with tax deferred growth.
An RPT is not a qualified retirement plan like a 401(k) or cash balance plan. As such, any contributions into the trust have no impact on contributions to a qualified retirement plan. Unlike most retirement plans, the business owner can exclusively fund an RPT.
It is available to most entity structures. This includes S-Corps, C-Corps, and partnerships. However, they are not available to sole proprietors.
There is no maximum contribution amount to an RPT. But they are limited by the reasonable compensation rules. These are the same rules followed by S corporations and C corporations. Your CPA should be familiar with these requirements.
As a result, annual contributions of $100,000 or $200,000 are not unheard of. Because of the upfront tax deductions, these are great supplements to cash balance plans or other defined benefit plans. When combined together, there are situations where you could see year one contributions as high as $1 million. Not such a bad deal.
How does a restricted property trust work?
The trusts seem complex at first. But once you review the details they really aren’t that bad.
At first glance they appear to work similar to a deferred compensation plan with a few twists. It is a combination of owner compensation and life insurance. Ancillary to the trust is a charitable component and a death benefit.
Once the structure is set up, here’s how it works:
- The business agrees to pay an owner a reasonable wage for the work performed. This is a combination of a W2 wage and a contribution to the RPT. For example, the business might pay the owner $200,000 in W2 wage and $100,000 to the RPT. This totals $300,000 of reasonable compensation that will be deducted on the tax return. Note that the W2 wage is subject to employment tax, but the RPT contribution avoids employment tax.
- The W2 wage is received by the owner like a normal salary. But the RPT contribution goes into a trust. Because the owner has specific funding requirements, the IRS deems that there is a “substantial risk of forfeiture.” It is this fact that allows the tax deduction.
- Annual contributions made from the employer to the RPT are fully tax-deductible by the company. However, the business owner must include 30% of the contribution in their taxable income.
- At the end of the term, the policy can be transferred to the owner. Once transferred, the owner can access non-taxable income from the policy. He can continue to fund the policy or even exchange the policy.
- Once the annual contribution is made, the trust acquires a cash value life insurance policy. There are a few insurance options that can be used to make it most economically friendly to the business owner as possible.
That’s the basics of the structure. But there are a few other important points to note.
The cash value grows tax-deferred within the insurance policy. The plans generally have a 5 year term.
What happens if contributions are not made during the term? The life insurance will lapse. The remaining cash value is then forfeited to the selected charity.
What happens if the owner dies during the funding period? Then the spouse will receive the death benefit.
At the end of the term, the RPT distributes the policy to the owner. However, a small percentage of the cash surrender value will be taxable. The policy cash value will typically pay the tax liability.
The business owner must include 30% of the company contribution in their taxable income. Essentially, the business owner ends up with a net 70% tax deduction. The owner must make an 83(b) election. The contributions will fund the life insurance policy. A minimal Economic Benefit cost on the death benefit.
What does the IRS say?
The IRS imposes strict rules on RPTs. The owner is not able to take “constructive receipt” of the funds. If they do, they will not get a tax deduction. Because there is no receipt, the IRS deems there is a “substantial risk of forfeiture.”
The distribution from the policy to the employee takes place once the funding is complete. The participant will pay income tax on a portion of the distribution.
At the end of Year 10 period, the policy is distributed to the owner. The owner recognizes taxable income on the excess policy cash values thanks to the 83(b) election and the Economic Benefit costs. You can pay the tax liability with the policy cash value.
The employee/participant can access the tax-exempt cash flow to retain the death benefit three exchange the insurance policy for additional death benefits.
Once you make the contribution, the funds reside in a whole life insurance policy. Because of this, assets are able to grow tax deferred.
The IRS has litigated them several times with clear results. In fact, most large insurance companies (like Penn Mutual) structure them.
Who are great candidates for restricted property trusts?
Here are a few situations in which an RPT can make sense for business owners who have the following characteristics:
- high tax bracket and live in high taxing states
- desiring life insurance and do not currently have a policy
- looking for asset protection
- have a charitable interest
While they work for many different businesses, great candidates for an RPT include:
- Physicians and medical groups;
- Small private companies with owners earning an income of $500,000 or more;
- Professional practices and solo consultants; and
- Law firms and other types of businesses.
Remember that even though the people mentioned above would be great candidates, an RPT cannot be used by sole proprietorships.
What are the advantages?
Let’s take a look at the advantages:
- The company receives a 100% tax-deductible contribution for the amount contributed.
- Assets receive full creditor protection.
- The plans can be used solely for the owner and can exclude all employees.
- They do not impact other contributions made to qualified retirement plans or deferred compensation plans.
- The contribution is not subject to employment taxes.
- It is available to S-Corps, C-Corps, and partnerships.
- If the owner passes away during the funding period, the spouse receives the death benefit.
These plans are great for people in high tax brackets. The life insurance policy within the trust must be a whole life insurance policy to preserve the legitimacy of the plan tax benefits. A whole life policy offers conservative and predictable growth.
Even when considering conservative funding, the RPT can achieve very nice rates of return when you factor in all the tax benefits.
What are the disadvantages?
There are a few disadvantages to consider:
- You must fund the plan for a minimum number of years. If not funded during the term, the funds remit to the charity.
- The investment returns are conservative.
- They are not allowed for sole proprietors.
- Owners must commit to funding a minimum contribution of $50,000 per year.
- The term commitment is at least 5 years.
- The owner must make an 83(b) election.
Restricted property trust example
So, let’s take a look at an example. Let’s assume that Mike is a self-employed physician. Let’s look at some specifics below:
|Annual taxable income||$500,000|
|Desired RPT annual contribution||$100,000|
|RPT commitment||10 year (5 year out)|
How to set up a restricted property trust?
Here are the 5 steps to setting up a restricted property trust:
- Review RPT structure
There is a lot of analysis that goes into setting up an RTP. The insurance company must work closely with the financial advisor.
- Determine funding level
Remember that there are no funding maximums for RPTs. (subject to reasonable compensation rules). You can select annual contributions as high as you like. But you must commit to the same funding over the required term.
- Analyze tax impact
The higher your tax bracket the more important these plans are. Taxpayers in California will see a better tax case compared to taxpayers in Florida. Review the trust structure and funding level for tax efficiency with your CPA.
- Fund the trust
Once everything is set up, it is time to fund the trust and take the tax deduction on the tax return. The insurance company will send you a 1099-R for the 30% income allocation.
As you can tell, an RPT can be a great tax structure. They can be somewhat complex. But in the right situation, they can be a home run.
Not many other structures allow for an effective 70% annual tax deduction. You know we are big fans of cash balance plans, but RTPs run a close second!