NAPLES, FL -- Readers of this column often ask me to give a second opinion (really a review of an existing estate plan). Typically, the plan has one to three mistakes. Sadly, each mistake causes estate tax dollars to be lost to the IRS, automatically reducing your children's inheritance.
Recently, I reviewed the estate plan of a well-to-do reader (Joe, age 65) with a net worth of $20.8 million. Even I was shocked. Joe's plan had all of the five biggest mistakes. Who's at fault? Joe's lawyer (Lenny).
Most interesting is that Lenny is an experienced estates planning lawyer with a good reputation. The real problem is the way the law schools teach estate planning (how to and to whom to distribute your wealth when you die). That's the way Lenny -- and almost every lawyer I know -- was taught. Mistake #5 (following) tells you how to solve this national estates planning problem.
Joe's mistake-ridden plan motivated me to write this article, which pinpoints the five most common estate planning errors and shows you how to correct each one.
Mistake #1 » Not creating the right succession plan.
Joe owns 100% of Success Co. (an S corporation), which is run by his son, Sam. The company is worth $9.7 million (Joe had a professional valuation done) and grows 5% to 10% in revenue almost every year… profits increase accordingly. Joe's original plan left Success Co. to his wife (Mary, age 64) and after her death to Sam... a mistake. Why? Because the potential estates tax liability grows along with the ever-increasing value of Success Co.
The time to transfer Success Co. to Sam is NOW. Here's what we did for Joe and what you should be thinking of doing if you own all or part of a closely held business. First, recapitalize Success Co. (means create voting stock -- say 100 shares, and nonvoting stock -- say 10,000 shares)... a tax-free transaction. Joe keeps the voting shares and absolute control for as long as he lives. Under the tax law, the nonvoting shares are entitled to a deep discount of 40%, so for tax purposes these shares are only worth $5.82 million.
Next, Joe, transfers (actually sells) the nonvoting shares to an intentionally defective trust (IDT) for $5.82 million, taking an interest bearing note as payment. According to our crazy tax law, the entire IDT transaction is tax-free to Joe (no capital gains tax and no income tax on the interest to be received while the note is being paid). How can this be? The answer is the trust is intentionally defective for income tax purposes under the Internal Revenue Code.
Even better, Sam does not pay even one penny for the stock. Instead, the cash flow of Success Co. (via S corporation dividends to the IDT) is used to pay the note, plus interest. When the note is paid in full, Sam -- as the beneficiary of the trust -- receives the nonvoting stock, tax-free.
Mistake #2 » Not avoiding the double tax on qualified plans and IRAs.
Between Joe and Mary, they have $1.9 million in the Success Co. 401(k) plan and various IRAs. Left alone, these funds will be clobbered with a double tax (income tax and estate tax). Using 2013 tax rates, the IRS winds up with 70% of these plan funds and the family a paltry 30%. A tax tragedy!
We used a strategy called "retirement plan rescue" (RPR) to purchase $5 million of second-to-die life insurance on Joe and Mary. Actually, the policy was purchased by and is owned by an irrevocable life insurance trust (ILIT). The beneficiaries of the ILIT are the three nonbusiness children (Sue, Sy and Sid) of Joe and Mary and will help treat these three children equal to Sam. Because of the ILIT, Sue, Sy and Sid will receive every penny of the $5 million tax-free.
Just how cool? Well without the new plan, the kids would get only $570,000 (30% of $1.9 million). This way they get all of the $5 million (tax-free) -- about 9 times more.
Mistake #3 » Not putting investments into a family limited partnership (FLIP)
Joe and Mary have $8.1 million in cash, CDs, stocks, bonds and income producing real estate. They created two FLIPs: one for the real estate and one for the other investments (except $2 million was held back to be used in Mistake #4). So, the amount put into the FLIPs is $6.1 million. A FLIP, when properly structured in accordance with the tax law, is allowed a 35% discount, reducing the $6.1 million to $4 million (rounded) for tax purposes, thus saving estate taxes on $2 million.
Joe and Mary immediately gave separate gifts of $1,026,000 each to Sue, Sy and Sid: $13,000 from Joe and $13,000 from Mary, which is the annual gift exclusion allowed without any gift tax consequences. The additional $1 million each, used a portion of the $5.12 million one-time gift maximum allowed per person (or a total of $10.24 million for a married couple) for 2012 (goes down to $1 million per person starting January 1, 2013).
A warning: If you are in the financial position to make large gifts to your kids and grand kids, you have until December 31, 2012 to use your $5.12 million ($10.24 million if married). This window of opportunity is closing. Call me if you have a question.
Mistake #4 » Not taking advantage of life insurance as a tax-advantaged investment.
Actually, I could write a book about the many opportunities life insurance gives you to beat Wall Street investments and the tax collector at the same time. There are actually dozens of core life insurance strategies and hundreds of variations. Joe used three of the core strategies as follows:
Strategy #1. Refer to Mistake #1: A portion of the funds received each year by the IDT for its share of Success Co.'s S corporation profits is being used to purchase a $3 million second-to-die life insurance policy on Joe and Mary. The $3 million death benefit, along with the other second-to-die policies described in the following two strategies, will be used toward giving Joe's three nonbusiness children their fair share of the estate.
Strategy #2. Refer to Mistake #2, where a strategy is described that acquires $5 million of second-to-die insurance on Joe and Mary.
Strategy #3. Refer to Mistake #3, where $2 million was held back to be used in this strategy: called "Single premium immediate annuity strategy" (SPIAS).
In a nutshell, here's how the SPIAS works. First, Joe and Mary purchase a joint and survivor single premium annuity for $2 million. As long as one of them is alive, every year (starting immediately), they will receive an annuity payment of $109,304. The IRS regulations make a portion of the annuity received tax-free... so after income taxes they will have a net amount of $96,362 every year. This amount is used to pay the annual premium on another second-to-die policy for $7,268,294. Actually, the policy was purchased by and is owned by an irrevocable life insurance trust (so Sue, Sy and Sid will receive the death benefit tax-free).
To summarize: You can see that life insurance -- when you know how to structure its ownership and the right strategies -- is a true tax-advantaged investment, turning taxable dollars into tax-free dollars and multiplying those dollars in the process.
Mistake #5 » Not having a comprehensive estate plan.
Let's start by pointing out the obvious: If you are doing your estate plan, you ain't dead yet. A comprehensive plan dictates that you have two plans: a lifetime plan (the real tax-saver and wealth builder) and a death plan (the typical type of plan that Lenny did for Joe). Of course, the lifetime plan must dovetail with the death plan.
As you can see, the first four mistakes described above are all part of your lifetime plan. Your comprehensive plan deals separately with each significant asset that you own, getting those assets out of your estate for estate tax purposes, yet allowing you to control each asset for as long as you live. Properly done, your plan (like Joe's new plan) should completely eliminate the impact of the estate tax.
If your estate plan does not, at a minimum, accomplish all that is discussed in this article, you owe it to yourself, your business and your family to get a second opinion.
And finally, a warning: This article does not attempt to cover every possibility, exception and potential tax trap. Only work with advisors who can explain in plain English exactly how your plan accomplishes each of your goals and eliminates your estate tax liability.
Want more information? Browse my website: taxsecretsofthewealthy.com. In a hurry, call me (Irv) at (847) 674-5295.
IRVING L. BLACKMAN is a practicing certified public accountant specializing in wealth transfer, and business succession and valuation. He is a founding partner at Blackman Kllick Bartelstein LLP, CPAs, one of the largest accounting firms in the country, and is a member of the Illinois Society of CPAs and the American Institute of CPAs. Blackman is the author of 31 books on taxation, as well as hundreds of articles for professional publications. Tax Secrets of the Wealthy is headquartered in Naples, FL.