Archive for the ‘Family Tax Issues’ Category

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Gaining wealth is easy when compared with human aspect of tax game

Saturday, March 28th, 2009

Recently, I read an article titled What Makes for Success? by Kemmons Wilson, the founder of Holiday Inn. He said, “It is great to attain wealth, but money is really just one way — and hardly the best way — to keep score.”

Interesting quote, huh?

Most readers of this column call me with tax problems because they have attained wealth (no doubt they have and do keep score with money) and they don’t want to share that wealth with the IRS — perfectly normal. Yet, it’s amazing. Once the reader realizes that we really do know how to pass their wealth — all of it and intact — to their family, the conversation turns to other ways that they might keep score. Sure, they are delighted to find there are legal ways to totally win the estate tax game. But they readily admit that they don’t know how to deal with the other problems (other ways to keep score).

The other problems fall into the general category of little kids, little problems; big kids, big problems.

Stuff like which of my kids should run the business? How do I treat the kids fairly? What about the non-business kids?

What happens if one (or more) of my kids get divorced? How do I take care of my wife (the second one who is 15 years — or more — younger than the caller)? The callers tell me about family problems, business problems and/or assorted personal problems. To me every word is important, even though I’ve listened to so many tales of woe before. But, although similar, each problem has its own peculiar twists and turns.

Let’s face it — stuff happens. After years of solving wealth transfer problems, business succession (usually the business is at center stage) and estate planning problems, experience has taught me that solving only the money problems can never yield a perfect plan.

The human stuff — your spouse and kids support your plan — must be solved too.

What about your son-in-law or daughter-in-law? I know. It sounds like cornball. But if you really want to win the game of life after you have won the money game (really the easy part), you must attempt to solve the human part, the emotional stuff.

Here’s my suggestion to start the process. Make two lists: the money-problem list and the human-problem list.

Solve the money problems first (usually you are home free if you solve these three money problems:

• maintain your lifestyle — and your spouse’s — for as long as you live;

• transfer your business to the business kids — tax-free; and

• kill the estate tax.

Then, it’s easier to tackle the human-problem list. Interesting, many times solving the money problems also solve some (often all) of the human problems.

Finally, you must work with experienced professionals who know how to solve both problems: the money problems and the emotional human problems that come with accumulating wealth and trying to pass it on.

One more thing: Each piece of your plan must be part of a single comprehensive and integrated plan, all implemented at the same time. Piecemeal planning, based on my 50 years of experience, is a disaster that not only enriches the IRS, but fails to satisfy the normal human desires of a typical family and its business.

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One happy Mom learned that the right planning can be tax magic.

Friday, March 27th, 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 a way out.

Here’s a true story of one way to get the job done. You’ll like it. Joe called me with this problem. Joe and his brother Jeff each owned 30 percent of Success Co., which they managed.

His mom, Mary, 66, owned 20 percent in her own name, and a trust created when Joe’s dad died owned the other 20 percent. Mary’s professional advisors recommended that she obtain $2 million of insurance using an irrevocable life insurance trust 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 any chance of coming up with the annual premium requirements of $32,000 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. The charitable trust 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 trust would go to charity. Each year Mary must pay $25,000 in income tax on the $72,000 of income from the charitable trust and $32,000 in premiums for the $2 million policy, which is owned by the life insurance trust, or a total of $57,000. This leaves Mary an extra $15,000 per year to buy presents for her grandchildren.

The life insurance trust will give Mary’s children $2 million in insurance proceeds when she dies. The entire $2 million will be tax free: no income tax and no estate tax.

But where does the charitable trust get the income to pay Mary? The charitable trust 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 charitable trust 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 contribution to the charitable trust.

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 charitable trust. This $200,000 (immediate deduction) results in about $70,000 in cash income tax savings for Mary — more expensive presents for the grandkids.

(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 whopping tax of $180,000.)

A side note before concluding: There are many other ways to get cash or other types of property out of C corporations in a tax-effective manner. If you have such a problem, as a service to readers of this column, call me with your problem (847) 674-5295.

The use of a charitable remainder trust in tandem with an irrevocable life insurance trust is actually a method for making a tax-advantaged investment for your family. You may actually create wealth and make a real economic profit by giving to charity.

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The tax knight and his merry men rescue a distressed taxpayer…

Friday, March 27th, 2009

OK, so it’s a corny title. Yet it sure describes the economic and tax pain of Joe, a 79-year-old widower. Don’t feel sorry for Joe, he’s generally a healthy and happy guy. He hits golf balls, spends lots of time with the grandkids and still goes to work every morning at the successful business he started, which he transferred to his two sons, who now own and run it.

But you should hear Joe howl about the cost of paying the annual insurance premiums on his irrevocable life insurance trust. Joe’s trust owns a $4 million insurance policy on his life with annual payments of $87,000. Yes, he needs the insurance to cover a portion of his potential estate-tax liability. No, he couldn’t buy second-to-die — normally at substantially less premium cost — because his wife was uninsurable when the irrevocable trust bought his policy.

It should be noted that an irrevocable trust protects the death benefits of a life insurance policy from the clutches of the estate tax.

Now, stop for a moment and look at your insurance cost situation. Chances are you’ll find you have one or more of the same complaints as Joe. He’s got three:

• Every year when Joe wrote his check to the trust for $87,000, he got four exclusions of $11,000 each, or $44,000 annually, one for each of his two sons and two grandkids. That left a taxable gift of $43,000 ($87,000 minus $44,000), which eats away at his $1 million lifetime unified credit. No cash gift-tax now. Simply put, the first $1 million of taxable gifts do not require cash to pay the gift tax, but are paid by using your lifetime unified credit. When Joe gets hit by the final bus, those annual taxable gifts will turn into an estate-tax liability (most likely 55 percent of the total of all those annual taxable gifts for Joe). Starting in 2006 the $11,000 is raised to $12,000.

Joe fumes!

• Interest rates are much lower now than when Joe bought the policy. Result, the premiums are much more than the projections made by his insurance agent.

Joe’s expletives are not fit to repeat here.

• Joe’s smart. He figured out that in his tax bracket — state and federal combined — he must earn $145,000 and pay $58,000 in income tax in order to have the $87,000 needed to pay his insurance premium which is actually a gift to the trust. Joe fervently argues that life insurance premiums should be deductible. Good idea. But we need an act of Congress to change the Internal Revenue Code.

Now you know why Joe is a distressed taxpayer.

Readers of this column know I have a network of professionals to help me work my tax magic. So I, the tax knight, and my network of merry men, went to work.

We had Joe’s irrevocable trust restructured with his insurance using a strategy called “premium financing.” Essentially, premium financing is an economic concept where policy premiums are paid by a lending bank. Like before, Joe’s premium financing policy is owned by the trust. When Joe dies the bank loans and accrued interest on the loans will be paid out of the policy proceeds.

Joe’s premium financing is set up for $5 million — net proceeds after paying off the bank — to the trust, and the beneficiaries are his kids and grandkids. Joe’s only potential out-of-pocket costs are $60,000 to initiate the bank loan the year the premium financing is set up. If Joe lives to be 100, the total additional cost will be about $352,000, with varying small amounts to be paid each year to maintain the loan. Of course, if Joe dies sooner, these costs stop.

Now, what are the final results for Joe by using premium financing?

• To start, no more $87,000 annual premium payments — actually, no more premium payments. All three of his complaints disappeared.

• No out-of-pocket costs — not the $60,000 or any portion of the $352,000. Why? Because the cash surrender value of the original $4 million policy owned by his trust was more than enough to cover all of the premium financing costs. The old policy was canceled to free up the cash surrender value and put the premium financing strategy in place without any further out-of-pocket costs to Joe.

Even Joe is happy.

Premium financing is a relatively new concept — easy to understand, complex to implement. It really takes a network of experienced professionals working together. The results create an economic windfall — all tax-free.

But sorry, everyone cannot take advantage of premium financing. You must qualify by bringing two things to the table:

First, you must be insurable or if married, one spouse must be insurable, so your irrevocable trust can buy second-to-die coverage.

Next, you must be worth a minimum of $5 million. The more you are worth and the more investment-type assets such as stocks, bonds or even real estate you have, the more likely you will qualify for this strategy.

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Wealth transfer plan should target needs of each generation.

Friday, March 27th, 2009

While browsing though my small mountain of files looking for column ideas, I ran across a still timely and interesting article in an old issue of Newsweek titled Darling, It’ll All Be Yours — Soon. The article explains how “the inheritance boom is quietly reshaping how we think about death.” How true.

When I began my professional practice as a CPA and lawyer in the ’50s, a millionaire was hard to find. Today, millionaires are bountiful. And when it comes to estate planning, they scurry around trying to find a professional who can lower their estate tax before they get hit by the final bus.

Robert J. Samuelson’s well-written article, like so many other articles, entertainingly explores the problem, but it offers no solutions.

Let’s set the scene for how you — whether you are parents trying to give it away tax-free or one of the kids on the receiving end — can solve the problem.

Let’s start with Mom and Dad, who have the wealth.

• Fact No. 1: You ain’t dead yet. Typical estate plans (separate wills and trusts for him and her) don’t speak until you are dead — too late to beat the tax collector.

The solutions lie in lifetime planning: A lifetime plan keeps you in control of your wealth for as long as you live, yet transfers it — including your business — to your kids and grandkids while you are alive.

• Fact No. 2: Years of experience have taught us that wealth is always passed on to the younger generations of the family. And then the younger generations step into the parents’ shoes and typically increase the family wealth. This gives the second generation an even bigger estate tax problem than the parents had.

Here’s how we solve this do-not-enrich-the-IRS estate tax problem.

Logic tells you that the children — particularly the business children — are likely to become wealthy. Usually, these children accumulate more wealth than their mom and dad — to be repeated again when the family wealth goes to the grandchildren two generations later.

Because of this generation-to-generation wealth transfer pattern, we view each generation of the family separately in terms of its special needs and objectives. But the plan should not be just for Mom and Dad; it should be a comprehensive plan for the entire family.

Following is an overview of how it’s done: keeping your wealth — every dollar of it — in your family, instead of losing it to the IRS.

You and your spouse (first generation)

Install a lifetime plan that removes wealth from your taxable estate during your life.

Use strategies like:

• A qualified personal resident trust for your residence.

• An intentionally defective trust for your business.

• A subtrust for your profit-sharing plan, rollover IRAs and similar plans.

• A family limited partnership for your other assets — typically investments like stocks, bonds and real estate.

• An irrevocable life insurance trust for insurance, probably second-to-die.

All of these strategies — and there are many others — begin their work now, while you are alive, and allow you to stay in control of your assets, including your business, for as long as you live.

Of course, we’ll dovetail your will and trust (death documents) with your lifetime plan. But when done right, your death documents just clean up what’s left. The first part of the family plan, including a business succession plan, and your wealth transfer plan are completed — tax-free — while you and your spouse are alive.

Your children (second generation)

After we complete a comprehensive plan for Mom and Dad, it is easy to project what the financial future of the kids might look like. So as soon as we finish the plan for the first generation, we start a plan for each of the kids, based on their individual assets and objectives.

Your grandchildren (third generation)

The plans for this generation are closely tied to the plans of the two older generations. Probably the most important point to keep in mind is that because of the young ages in this generation, getting the children into a tax-free environment as soon as possible is a wealth-building must.

These plans center on short-and long-term tax-advantaged strategies that fulfill lifetime needs: education, buying a house, starting a business and, if they don’t go into the family business, building a retirement fund.

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A tale of two clients

Friday, March 27th, 2009

It is rare that I consult with any two clients who are the same. Or even almost the same.

This column is an exception to the rule.

Two couples called me for a second opinion in the same week. They wanted my advice on their four-year-old estate plans.

Let’s start with the basic facts.

Estate A

Joe, 67, and May, 65, have three children, none of whom is in the business. For their five grandchildren they used an education plan.

They used a family limited partnership for their $400,000 in cash assets and their $9.6 million invested in stocks and bonds.

The couple used a 50/50, a method for holding title to their homes yielding a large discount for estate tax purposes, for their two residences worth $1.8 million.

They used a subtrust for their $2.4 million in IRA and 401(k) investments.

They sold their business and their total assets are $14.2 million.

Estate B

Pat, 62, and Sue, 61, have three children, all of whom are in the business. For their seven grandchildren they used an education plan.

They used a family limited partnership for their $300,000 in cash assets and their $1.9 million invested in stocks and bonds.

The couple used a 50/50 for their two residences worth $2.1 million.

They used a subtrust for their $2.2 million in IRA and 401(k) investments.

They used an intentionally defective trust for their business worth $7 million. They used another family limited partnership for their business real estate worth $2.6 million.

Their total assets are $16.1 million.

A few more facts: Joe had a successful business that he wanted to transfer to his son, Sam (the only business child), who ran the business daily.

Sam was killed in an auto accident. Heartbroken, Joe sold the business, including the business real estate. The after-tax proceeds are included in Joe and May’s investments.

An interesting point is that if Joe had not sold his business, the total assets for Joe and May and for Pat and Sue would be almost identical.

Also, the asset mix now — except for the business and business real estate — is identical.

If both couples got hit by the same bus (with their current estate plans in place), the estate tax liability using 2011 rates would be about $6.8 million for Joe and May and $7.7 million for Pat and Sue. That leaves a net of $5.4 million to Joe and May’s family, and $6.4 million to Pat and Sue’s family.

Now look at Estate A’s strategies — the family limited partnership and subtrust — and Estate B’s strategies — the family limited partnership, subtrust and intentionally defective trust. You get a quick bird’s-eye view of two typical estate plans: one without a family business and one with a family business.

This column over the years has hammered away at the concept that you design a proper estate plan by selecting the right strategies to satisfy your goals based on the assets you own. Basically, these two families have identical goals: to maintain their lifestyles for as long as they live, to pass their wealth on to their heirs intact (eliminating the impact of the estate tax) and to educate the grandchildren.

And, of course, Pat and Sue have one more goal: to transfer the business tax-free to their three sons, all of whom are active full time in the business.

One final goal: Both Joe and Pat want to control all their assets — including the business, for Pat — for as long as they live.

Pause for a moment. How many of the above goals are the same for your family?

The strategies used in both of the estates accomplish all the goals listed for both families. The single biggest tax-saver and creator of tax-free wealth is the subtrust, which was used to buy second-to-die life insurance ($5 million for Joe and May and $6 million for Pat and Sue).

When the new estate plans are fully implemented, it is estimated that the families will receive the following dollar values of assets — all taxes, if any, paid in full: Joe and May in excess of $16 million; Pat and Sue in excess of $18 million. These amounts are more than double what would have been received under the old estate plans.

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What’s the worst that can happen?

Thursday, March 26th, 2009

Let’s face it — stuff happens.

Some good. Some bad.

Following are events in the lives of different real-life clients (all readers of this column) that required us to make appropriate changes in their estate plans:

• Joe, a 64-year-old widower with three children and five grandchildren, married a woman 15 years younger, with two children of her own.

• John’s son, Sam, who was the absolute choice to run John’s successful family business, suddenly quit and moved 300 miles away.

• Jim’s business — always pretty good — skyrocketed to become a big moneymaker.

Over a five-year period, starting when Jim was 58 years old, his wealth went from the $8 million range to the $40 million range and is still growing fast.

• Here are three similar changes to different businesses.

All were devastating:

1. The largest customer — 40 percent of total sales — moved to Mexico.

2. The largest customer — 53 percent of sales — began to buy everything from China.

3. The landlord refused to renew the lease after 23 years, and the location was essential to the business.

• Jack’s major competitor went bust. Business life was no longer a daily battle.

• Jason and his wife, Jane, hated their daughter’s second husband and wanted to make sure he never received any of the family wealth.

The above list could go on and on with new examples that happen in our practice almost every month. But there is one common denominator to all of the examples:

When notified of the changes, the professional advisers either did nothing or did not know what to do.

Here’s the lesson of this column: When doing your estate plan — which should include your lifetime plan, business-succession plan and asset-protection and related plans — the key word is flexible.

Do what you have to do to beat the IRS legally, but make sure you have an escape route if circumstances change. Play the what-if game — very good stuff or very bad stuff — for:

• Your business.

• Every significant asset or group of assets you own.

• Every member of your family.

Divide your what-ifs between (a) economic (typically your business or a substantial change in the value of any of your other assets); and (b) human (typically a change in the circumstances involving your family or key employees in your business).

If your estate plan is done, it’s smart to revisit the what-ifs now. Here’s a hint: If your current plan does not get all of your wealth to your family intact — meaning every cent of your wealth, all taxes paid in full — then your current plan needs work and probably a second opinion. Next, deal with flexibility.

If your plan is not done or needs to be updated, work only with an experienced and knowledgeable professional.

Yes, the basic original plan is important. Very important. It must be right for you, your business and your family, with the assumption that no changes will ever be required.

But don’t forget what may, in the long run, turn out to be your best friend: flexibility.

Make sure that when stuff happens, your contingency changes can be easily implemented without destroying your original plan.

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Answers to tax troubles may be only a few keystrokes away!

Thursday, March 26th, 2009

Readers of this column must love my Web site, www.taxsecretsofthewealthy.com, because so many of you visit it. It’s really a learn-more extension of this column.

I love the Web site for a different reason. Whenever I’m stuck and don’t know what to write for the column, a quick review of e-mails from readers who visited the site gives me plenty to write about.

Following is a wonderful example from a Web site visitor.

We’ll call him Joe.

Joe, 61, the owner of a profitable family business, Success Co., filled out a form on the Web site that included this question: “What are your most burning problems or questions?”

Joe typed in the following four goals:

• Selling the business to a son and nephew.

• Keeping control of the company until it’s paid for.

• Eliminating balance-sheet debt.

• The least possible tax liability to myself and them.

Next, I called Joe. He gave me a bit more information.

Then he shipped even more information. We talked again.

Here’s the full story.

Joe was about to execute a plan that would have put him into the chamber of tax horrors, but he decided to contact me first, via the form on my Web site.

Following is the plan Joe’s lawyer and CPA had suggested:

Joe’s son, Sam, and nephew, Nick, would each buy one share of Success Co. stock from Joe for $1,000. Actually, the $2,000 for the two shares was a fair price. Then Success Co. would buy the balance of Joe’s stock for $2.25 million (also a fair price), plus interest of 6 percent on the unpaid balance.

What’s wrong with this picture?

Aside from selling the business, none of Joe’s other three goals was accomplished:

• Joe would have had no control

• The balance sheet would be destroyed with a $2.25 million debt.

• Worst of all, the tax liabilities would hurt Joe and strangle Success Co.

Let’s take a closer look at the tax liabilities. First, Joe’s capital gain would be $2.2 million. At 15 percent, he would get hit with a $330,000 tax bill. Ouch!

Next, let’s look at the real tax disaster for Success Co. — really Sam and Nick because they would own Success Co. State and federal income taxes would total about 41 percent. Call it 40 percent because the state tax is deductible.

Are you ready for a shock?

Success Co. would have to earn $3.66 million and pay income taxes of $1.66 million to have the $2.2 million to pay Joe for his stock — plus that blasted 6 percent interest. Crazy, isn’t it?

We happily killed the above plan. Instead, we created the following three-step plan:

• We recapitalized the company (created 100 shares of voting stock and 10,000 shares of nonvoting stock), a tax-free transaction.

• Success Co. elected S corporation status, also tax-free.

• Joe sold the 10,000 nonvoting shares to an intentionally defective trust (IDT).

Let’s see how using the IDT accomplished all of Joe’s goals:

• He stays in control by keeping 100 percent of the voting stock.

• Success Co.’s balance sheet is free of any liability after the transfer of the stock.

• Best of all, Joe escapes paying tax on the sale of the nonvoting stock to the IDT. The entire transaction is tax-free to Joe.

And what are the tax consequences to Success Co., Sam and Nick? All tax-free. The future earnings of Success Co.

will be used to pay the $2.2 million price (actually a note payable due from the IDT) for the nonvoting stock, plus interest.

When the note (estimate will take six to eight years) is fully paid, the IDT trustee will distribute all the nonvoting stock to Sam and Nick — tax-free!

It is estimated that more than 1 million family-business owners face the same problem — creating the right succession plan — as Joe and Success Co.

Sadly, the wrong succession plan causes tax mega-disasters for both the owner and the next generation.

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