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Want to learn how to turn your qualified plans from a dangerous tax trap into a great tax advantaged victory

Wednesday, May 6th, 2009

There are many types of qualified plans: pension, profit-sharing, 401(k) and IRAs are the most popular. True enough, each is a great tax strategy if you ultimately need the plan funds for retirement and (1) you are in a low tax bracket when you take the funds out of the plan and (2) your estate is not large enough to kick up an estate tax problem. Perfect for over 90 percent of American taxpayers.
But what happens if you are in the highest income tax bracket when you retire and you have an estate tax problem (say the highest bracket of 45 percent)? Sorry, the IRS has you in a tax trap. No matter when the funds are taken out of the plan (during your life or after your death), the IRS gets 67 percent of the dollars in your qualified plans. Your family only gets 33 percent. The tax trap has been sprung. A tax travesty!
Is there any way out of the trap? Actually, my network of working-together professionals has developed several strategies. The one we use most often is called a “subtrust.”
Here’s a typical example of how a real client used a subtrust: Joe and his wife Mary are both 60 years old. They needed $2 million of second-to-die life insurance to solve their estate tax problem. The premium cost was $22,400 per year; a bit more than Joe wanted to spend. Joe’s 401(k) plan had $400,000 in it. Joe sadly understood that his $400,000 would only net his family $132,000 ($400,000 times 33 percent).
Here’s what we did. We set up a subtrust as part of the 401(k) plan (Plan). The subtrust will pay the annual premium after receiving the funds from the Plan. Since the policy is actually an asset of the Plan, the annual premium payment is a tax-free transaction.
When both Joe and Mary pass on, their family will receive the full $2 million in policy proceeds. No income tax. No gift tax. No estate tax. The subtrust tax strategy, in this case, actually turns $132,000 after-taxes into $2 million after-taxes (actually more because a portion of the original $400,000 401(k) plan funds, plus earnings, will still be in the plan).
If you have $300,000 (or more) in one or more qualified plans (for example, profit-sharing, 401(k) and IRA) and have an estate tax problem, you are in a tax trap. Want to learn more about how a subtrust and other strategies that can get you out of your qualified plan tax trap? Send me (Irv Blackman) a fax at (847-674-5299); include (1) name and birthday; (2) same for your spouse; (3) total amount in all of your qualified plans: and (4) all phone numbers where you can be reached. Mark “Eagle 09-23” at the top of your fax.

Posted in Corporate Tax, Family Tax Issues, Featured, Uncategorized | Comments Off

How a second opinion enriched Joe and his family at the expense of the IRS

Wednesday, May 6th, 2009

This is a war story. Joe, a 60-year old reader of this column, owned 100-percent of Success Co. He called me and wanted to know which of two estate plans he should choose.

Here are the significant facts: Joe’s wife Mary is 53 years old. His only child Sam, 31 years old, has worked in the business since he was 12. Sam owns one share of Success Co. stock; Joe owns all the rest of the stock: 199 shares.

The business is worth $4 million and has enjoyed about a 10 percent growth in profits in each of the past five years. This growth should continue into the future. Joe’s total net worth is $10 million including a residence, various investments (mostly the real estate leased to Success Co. and a portfolio of stocks and tax-free bonds) and $950,000 in a profit-sharing plan.

The two estate plans Joe asked me to review (“Give me a second opinion” in his words) follow. At the core of both plans was a $4 million life insurance policy on Joe’s life.

Plan 1: The life insurance policy would be owned by Sam. Joe would gift Sam the annual premiums. At Joe’s death Sam would buy Success Co.’s 199 shares from Joe’s estate for $4 million.

Plan 2: Success Co. would own the $4 million in life insurance and at Joe’s death would redeem the 199 shares from Joe’s estate.

In the end, the final results would be exactly the same: Sam would own 100 percent of Success Co. and the estate would have $4 million in cash instead of $4 million in stock. First, the good news: (1) Joe’s estate would owe no income tax on the sale of the stock. Why? Because the estate would get a raised basis equal to the fair market value of the 199 shares on the date of Joe’s death. (2) No estate tax because the $4 million of insurance proceeds will wind up in Mary’s trust and receive the benefits of the 100 percent tax-free marital deduction.

Sounds pretty good. Joe loved it.

Yes, it is a good plan. Certainly better than no plan at all. As a matter of fact, either of the plans outlined above — or some variations — is the most popular way of transferring a business to the next generation. Now the bad news: two problems always cause us to turn thumbs down on any such plan: (1) Joe’s team of professional advisors forgot that Mary did not need the income that would be produced by the $4 million of insurance proceeds. The other $6 million of assets owned by Joe is more than enough to take care of her lifestyle needs. (2) When Mary passes on, the IRS is guaranteed a big payday; 55-percent of the $4 million. That’s right, the IRS will get $2.2 million and the family only $1.8 million. Plus, a huge undeserved bonus to the IRS of 55-percent of the after-income tax balance on the income in (1) above, which is explained in the following paragraph. An outrage!

Continuing with (2) above, watch this tax disaster unfold. Mary is a healthy 53-year old with a normal life expectancy to age 83. Her grandparents, on both sides, all lived to age 92 or older. Good genes.

Mary’s mom and dad are in their late 70s, healthy and lead an active lifestyle. Let’s say Mary lives to age 85. That’s 32 years of earnings on the $4 million in her trust. Let’s use a conservative after-tax earnings of four-percent. Have you any idea of how much that $4 million will grow to in those 32 years? Would you believe $16 million? Really that’s the number. And what do you think the IRS’s bite would be? An amazing $8.8 million. Lousy planning! Yet, that’s the way most business owners, on the advice of their professionals, do it.

What should you do when your facts are the same or similar to Joe’s facts? Here’s the four-step plan we put in place for Joe:

Step 1: Success Co. elected S corporation status. We recapitalized the company so Joe wound up with 99.5 percent of the voting stock-100 shares-(So Joe could keep control of Success Co. for as long as he lived.) Then, Joe sold the non-voting stock-19,900 shares-to an intentionally defective trust (IDT).

The non-voting stock, under the tax law, is allowed to take various discounts. So, the value of the Success Co. stock Joe sold to the IDT, for tax purposes, was only $2.4 million (actually almost all profit, because Joe started Success Co. 31 years ago with $12,000, most of it borrowed.) The IDT trust is a wonderful creature under the tax law that allows Joe to collect the entire $2.4 million (plus interest) tax-free. Also, the IDT takes Success Co. out of Joe’s estate, avoiding another big tax loss to the IRS. Now here’s the tax wow! Once the $2.4 has been paid to Joe, Sam will own all of the non-voting stock, as beneficiary of the IDT (free of all taxes-income, gift and estate taxes).

Step 2: We initiated a strategy called retirement plan rescue (RPR), using the $950,000 in the profit-sharing plan, to acquire a $4 million second-to-die life insurance policy on Joe and Mary. We created an irrevocable life insurance trust (ILIT) to own this policy. Because of the RPR and the ILIT, none of the $4 million in insurance proceeds will be subject to income tax or estate tax. Every penny will be tax-free.

Step 3: Joe decided to invest a portion of the funds in the profit-sharing plan in senior settlements (SS) to help pay the life insurance premiums in Step 2. SS earn an average of 15.82-percent per year without market risk (created by a public company that sells on the NASDAQ).

Step 4: We created a family limited partnership (FLIP) to hold Joe’s investments and started an annual gift-giving program to give interests in the FLIP to Joe’s and Mary’s other two children (neither are in the business).

The four-step plan we substituted for the original proposed plans will increase the amount of wealth Joe and Mary will leave to their family by over $5.5 million (increasing every year Mary lives and growing to over $14 million if Mary lives to age 85, as explained above) more than the original plans.

Joe was right: He sure needed a second opinion.

Posted in Corporate Tax, Estate Tax, Family Tax Issues | No Comments »

Exploring the various needs in estate planning

Saturday, May 2nd, 2009

Most of the concepts and strategies you read in this tax column are really answers to questions asked (or concerns, problems or fears told to us) by readers who called our office.

Also tossed into the column is a large helping of our many years of experience consulting with our readers.

About three out of every four readers who call ask a variation of this troublesome question, “What will estate planning do for me, my family and my business?”

The simple answer: The “right plan” will accomplish all your goals. Actually the right estate plan is a group of small plans that all dovetail together.

There are basically two types of plans: a lifetime plan that should start now (in the next two or three months), and a death plan (really your will and trust documents) that can sit in a drawer until you get hit by the final bus.

By far, the lifetime plan is the most important of the two. Let me say it loud and clear: Never, under any circumstances can your will and trust — no matter how fancy or how long — accomplish your lifetime goals. Even worse, standing alone, rarely can your will and trust accomplish your estate planning (death) goals.

Remember, your death documents do absolutely nothing until after you have drawn your last breath.

OK, so lifetime planning is the way to go. The typical business owner (let’s call him Joe) will have three plans: (1) a retirement plan, (2) a business succession plan (who will run the company when Joe slows down, because in practice Joe rarely totally leaves the business until he goes to business heaven) and (3) a business transfer plan (usually leaving the business to Joe’s business child or children) or a sales plan (to key employees or an outside buyer if there are no kids or employees to take over the business).

Can you imagine any of these three lifetime plans being effectively handled in death documents?

The various plans that we, as consultants, create are in response to the goals that you, the client, list. To help you get started on the first task of creating the “right plans,” the balance of this article focuses on the 10 most common goals we hear from clients in the real world. Every one of these goals can be accomplished with ease by employing the appropriate strategy or strategies. You’ll easily recognize which are part of a lifetime plan and which a death plan. As you read, circle the goals that match your goals.

• Maintain our lifestyle (Joe’s and his wife Mary) for as long a we live — intentionally defective trust, S corporation, family limited partnership, retirement plan, TIPs, which stands for transferable insurance policies.

• Control my (Joe’s) wealth — including my business —for as long as I live (voting/nonvoting stock for business, family limited partnership).

• Maintain Mary’s lifestyle for as long as she lives (marital deduction, irrevocable life insurance trust, plus all strategies as shown in 1 above).

• Pass all of my wealth — every dime of it — to my family, instead of losing it to the IRS (strategies as shown in the other eleven items in this list).

• Transfer my business to our business children tax-free (intentionally defective trust; never a sale).

• Treat children (really non-business children) fairly (family limited partnership, irrevocable life insurance trust, subtrust, retirement plan rescue).

• Avoid the huge — up to 80 percent — double tax on my qualified retirement plan, like a profit-sharing plan, 401(k) or IRA-money (subtrust, retirement plan rescue).

• Educate my children/grandchildren (Private retirement plan).

Eliminate the capital gains tax (charitable remainder trust).

• Attract key employees and keep my key employees (nonqualified deferred compensation plan).

An investment without risk that earns 8 percent (could be more or less depending on person who calls). TIPs, an investment that has averaged 15.82% annual return for the past 15 years. Offered by a public company that trades on the NASDAQ. Must be a qualified investor, minimum investment $50,000.

• Establish a family foundation and make gifts to charity without reducing the value of our wealth to be inherited by our family (charitable lead trust and charitable remainder trust).

The goals listed above (followed by the tax strategies that easily accomplish your goals) are actually a good roadmap to help you get started on your own tax plans.

Want to learn more? Discover all the tax strategies and an organized system that shows you how to quickly accomplish all of your goals as you create your own lifetime plan and estate plan. Browse my Web site: www.taxsecretsofthewealthy.com/blog.

Posted in Estate Tax, Family Tax Issues, General Tax Strategies | No Comments »

Did your lawyer (inadvertently) rip you off

Wednesday, April 29th, 2009

Joe (a 63-year old reader of this column who hails from Iowa, but winters in Florida) almost cried when talking to me on the phone. He said, “I still want to kick myself for thinking my estate plan was done. For years I was convinced that my plan was perfect.

“I never stopped reading and studying. You know, articles. Even books. All my professionals assured me my plan was the best it could be. I religiously attended seminars. I consulted regularly with my CPA and several lawyers. All confirmed that the estate plan drawn by my lawyer Mike was right for me and Mary (Joe’s wife).

“It never occurred to me that so many estate planning experts could be so dead wrong or that there’s a better way to transfer my business to the kids and deal with my other assets. Not until a friend brought me a small pile of your articles.

“I immediately read and reread the articles. The next day, I went to Mike’s office. Basically he gave three reasons why the dozens of concepts and ideas in your articles wouldn’t work for me: don’t apply to me, never heard of it or he’ll check it out and call me.”

The above summarizes about 20 minutes of Joe telling me about his years of planning with Mike (a friend and well-respected lawyer who specializes in estate planning).

Then, I asked Joe a series of blunt questions. His answers revealed Joe’s professionals had crafted a traditional estate plan.

My bet is that 90 percent of you married guys reading this article also have a traditional estate plan. What is it? Here’s the traditional plan Joe had (See if it sounds like your estate plan, as you read further).

Joe’s plan centers on two basic strategies: First, the plan takes advantage of the unified credit (actually $2 million is tax-free in 2006, 2007 and 2008; rising to $3.5 million in 2009. There is no tax in 2010. In 2011 the credit falls to $1 million). By using a two-trust arrangement (most often called Trust A and Trust B; marital trust and family trust or similar names), Joe and Mary each will escape tax on the amount of their unified credit, depending on their year of death. Second, the couple’s plan takes advantage of the marital deduction, which means zero estate tax when the first of Joe or Mary passes.

That’s it: the traditional estate plan that we see in all 50 states. That was Joe and Mary’s plan. Is your plan the same? Similar?

What’s the guaranteed result? The plan prevents the IRS from collecting a dime at the first death (of either Joe or Mary). Good! However, when the second spouse dies, the IRS gets its pound of flesh. In this couple’s case it’s a ton. If their wealth stayed the same, from today until the day both deceased, their estate tax would have been $4,655,000.

You’ll love the rest of the story.

Joe said, “Irv will you give me a second opinion?” I agreed. Joe sent me a standard package of information (tax returns and financial statements — both business and personal; family tree; and his estate plan documents). After two more telephone conversations, we pinned down Joe’s goals: for him and Mary, his successful business (wanted to leave it to his middle son) and his family (four kids and six grandchildren).

Three weeks later I called Joe and outlined the wealth transfer plan I had created (with the help of my network lawyer, Don). Joe’s family will receive every dime of his and Mary’s wealth, probably more (we actually created additional tax-free wealth because we took advantage of the tax-free environments, particularly strategies involving life insurance and charity — available in the tax law). Gone was the $4,655,000 estate tax obligation to the IRS.

A delighted Joe couldn’t help feeling ripped off by his lawyer’s traditional estate plan. Don and I explained that Mike’s plan was the norm.

After our comprehensive plan was reduced to writing (five new documents and some modifications to the trusts that Mike wrote), we submitted the new plan and documents to Mike. He was easy to work with. Don and I answered his stream of questions. Mike — after about three weeks of “review and research” (his words) — fully endorsed our plan.

For me this is a rewarding story, because it shows that the message we try to deliver — you can always win the estate tax game — is getting through to the readers of this column

If you are married and have a traditional estate plan (the same or similar to Joe’s), most likely your plan is not complete.

Think second opinion.

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Posted in Estate Tax, Family Tax Issues, Tax Strategies | No Comments »

A time-tested method for making a tax-advantaged investment

Tuesday, April 28th, 2009

Do you have a large amount of retained earnings and excess cash in your corporation, but the double taxing power of the law has your cash locked in the corporation? Most business owners think they are stuck, but there’s an easy way out.

Here’s a true story of one way to get the job done and I think you’ll like it. Joe called me with this problem. He and his brother Jeff each owned 30 percent of Success Co., which they managed. Their mom (age 66) owed 20 percent in her own name, and a trust (created when their dad died) owned the other 20 percent. Mary’s professional advisors recommended that Mary obtain $2 million of life insurance using an irrevocable life insurance trust (ILIT) to pay the estate tax liability that would be due at her death (because of the value of the assets she owned directly in her own name and indirectly as a beneficiary of her deceased husband’s trust).

The advisors were right. Mary needed the insurance, but she did not have a ghost of a chance of coming up with the annual premium requirements of $32,000 per year for as long as she lived.

I asked Joe lots of questions, conferred with the advisors and requested a large pile of information — stuff like tax returns, financial statements, etc. After discovering that Success Co. had $2.5 million in excess cash, this is what I recommended.

Mary gifts $1.2 million of her Success Co. stock (the total value of Success Co. was appraised at over $8 million) to a charitable remainder trust (CRT). The CRT agrees to pay Mary $72,000 per year for as long as she lives. At Mary’s death, the balance (called the “remainder”) in the CRT will go to charity. Each year Mary must pay $25,000 in income tax (on the $72,000 of income from the CRT) and $32,000 in premiums (for the $2 million policy, which is owned by an irrevocable life insurance trust, ILIT for short), or a total of $57,000. This leaves Mary an extra $15,000 per year to buy presents for her grandchildren.

The ILIT will give Mary’s children $2 million (in insurance proceeds) when she dies. The entire $2 million will be tax free — no income tax, no estate tax.

But where does the CRT get the income to pay Mary? The CRT sells the gifted stock back to Success Co. for $1.2 million. Let’s summarize Mary’s tax picture: Mary avoids all capital gains tax on the sale of the Success Co. stock. The balance in the CRT (estimated at $1.1 million) at Mary’s death goes to Mary’s favorite charity and is free of income tax and estate tax. In addition, Mary gets an immediate income tax deduction of about $200,000 for her charitable contribution to the CRT. Simply put, even though Mary avoids both the capital gains tax and the estate tax, the IRS writes her a check. For what, you ask? For the present value of the remainder (of the $1.2 million) gifted to the CRT.

This $200,000 (immediate deduction) results in about $70,000 in cash income tax savings for Mary. Lots more expensive presents for the grandchildren. (Note: If Mary had sold the $1.2 million of Success Co. stock directly to the company, it would have been taxed as a dividend, resulting in a whooping tax of $180,000.)

A side note before concluding: There are many other ways to get cash (or other types of property out of your C corporation) in a tax-effective manner. If you have such a problem, as a service to readers of this column, contact me.

The use of a CRT in tandem with an ILIT is a time-tested method for making a tax-advantaged investment for your family. You actually create wealth (make a real economic profit) by gifting to charity.

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Posted in Corporate Tax, Family Tax Issues, Featured, Insurance | No Comments »

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by Irv Blackman

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