MAKE YOUR ESTATE TAX PROBLEM MY ESTATE TAX PROBLEM
The Nine Critical Problems (and Their Solutions) You Must Solve to Complete Your Estate Plan
When a concerned taxpayer calls my office with an estate tax problem, their problem becomes our problem… And we solve it.
Some callers are frozen with fear as to how the estate tax will devastate their wealth, which took them a lifetime to accumulate. Some just have a question or two. Most interesting, almost all callers think their problems are unique. But the fact is… we have faced and solved those seemingly unique problems – or a variation – hundreds of times over the years.
Following are the top nine problems (includes questions and concerns) we have solved – over and over – for our clients going back to the early 1960s. Are we creative?… ‘No’. Our secret is knowing the tax law… how to apply it… and structuring a comprehensive plan that accomplishes our clients’ goals, while – legally – beating up the IRS.
The nine following problems were selected because each of them met one or more of these three criteria: (1) A problem that comes up often, but is not generally solved by other professionals, or is incorrectly solved; (2) Other professionals don’t recognize the problem or don’t know what to do; or (3) Solving the problem saves a significant amount of tax dollars or creates a large amount of tax-free wealth. So, relax. None of what follows is technical. As you read, you’ll be joining in the tax-saving fun. When one (or two) of the problem “solvers” that follow helps you, it’s fun; when three or more do, it’s party-time. Chances are you’ll party.
Problem #1. “How can I sell my business to my kids without getting killed with taxes?” About once a month I get a call from a reader (Joe) of my tax column who wants to sell his business to his kids. After a short conversation, Joe understands why a sale is a terrible idea. In this case, Joe’s son, Steve, wants to buy Success Co. for $1 million, fair market value. Follow these strangling tax numbers: Steve must earn about $1.66 to have $1 left to pay to Joe (typically 40% – State and Federal – is the income tax rate; so the tax on $1.66 is 66 cents). Steve pays the full $1 to Joe. Steve cannot deduct any portion of this $1 because the purchase of stock is simply a nondeductible capital expenditure. What about Joe? Steve pays his dad that $1 (plus interest). Joe must pay a capital gains tax (typically 15%) on the dollar and pay his top tax bracket on the interest income. Okay, Joe has 85 cents left after paying the capital gains tax on the $1. If Joe doesn’t spend that 85 cents, the IRS gets up to 55% (using 2011 rates) for estate taxes. That’s another 47 cents for the tax monster, leaving Joe’s heirs with only 38 cents Let’s review. Steve must make $1.66 for Joe to leave his family 38 cents. Turn that into $1,660,000 for Steve – with a $1 million price for Success Co. – to make, while Joe’s family only gets $380,000. Lousy tax planning.
Note: The tax rates may change from time to time, but the principles described above (and the computations) will not change. Simply use the new rates to determine the tax pain of selling your business to your kids.)
Okay, then a sale to your kids is a no, no. What should you do?… Transfer it is the clear answer. Let’s walk through the simple three-step process for transferring your business:
- 1) Recapitalize the company. Your old common stock disappears and is replaced by voting stock (say 100 shares) and nonvoting stock (say 10,000 shares). This is a tax-free transaction. Now, you can keep the voting stock and control, while transferring the nonvoting stock to your kids.
- 2) If you are a C corporation, elect S status.
- 3) Sell your nonvoting stock to an intentionally defective trust (IDT). Here are some benefits:
- (a) Huge discount for tax purposes. The nonvoting stock – because of various discounts allowed by the tax law – has a value of about 60% of the stock’s real value: For example, if the fair market value of your company is $10 million, the value for tax purposes (after discounts) is only $6 million. Wow!
- (b) Tax-free. The IDT will pay for your nonvoting stock. The note will be paid, including interest to you by the IDT, using S corporation dividends from your company. Typically, it takes 5-8 years to pay off the note. All the payments you receive, plus interest, are tax free. When the note is paid off, the trustee of the IDT distributes the nonvoting stock to the beneficiary (typically, your business kid or kids) with no tax consequences.
- (c) The ultimate transfer of the stock to your kids is not considered a gift for tax purposes, leaving your annual gift exclusion ($13,000) and lifetime exemption ($1 million) available for other estate planning strategies.
- (d) The biggest benefit. The family (typically Mom/Dad (here Joe) and the kid(s) (here Steve) save about $750,000 in taxes per $1 million of the price of the family business. For example a price of $3 million (the fair market value of Success Co.) would save Joe and Steve $2.25 million in taxes.
Now, stop for a minute. Just apply the IDT tax-saving formula to your business succession plan situation. You’ll smile.
Problem #2. “How can I avoid the double tax (income and estate) that hits all qualified plans (like an IRA, 401(k) profit-sharing)?” Use a Subtrust. It’s true: The tax collector can get up to 73% of your plan funds (that’s $730,000 per $1 million). Your family gets only $270,000. A subtrust allows you to use plan funds to buy life insurance (usually second-to-die). One of my clients turned $240,000 into $4.5 million of tax-free life insurance. A subtrust generally works best when you and your spouse are about 60 years old or younger.
“Problem #3. What is the best strategy to use if a subtrust is not effective to avoid the qualified plan double tax?” Use a Retirement Plan Rescue (RPR). Here’s how qualified retirement plans are double-taxed: First, you get nailed for income tax (say 40% for State and Federal); then you get socked for estate tax, say 55% using 2011 rates). Result: The tax collectors get 73%, your family only 27%. So, if you have $1 million in (say an IRA)… You’ll lose $730,000 to taxes. Ouch!
Now, stop reading for a moment. Do the math for the funds in your qualified plans. Shocking, huh? RPR to the rescue. An RPR is a simple life insurance strategy – either single life or second-to-die – that turns a tax tragedy into a tax victory. Two examples from my client files tell the story: (1) A client from Ohio turned $274,000 in an IRA into $2.6 million (a single life policy); (2) Another client from Florida turned $342,000 in a 401(k) into $4.5 million (a second-to-die policy).
Problem #4. “What is an effective way to deal with my home(s) for estate tax purposes?” Use what we call the 50/50 strategy. When you get hit by the final bus, your home (or homes if you own two or more) are included in your estate. No question about it, homes are an estate tax trap. The estate tax damage?… 55% (using 2011 rates) of the fair market value of each home. Again, stop for a moment… assess your potential loss in estate taxes. How do you get out of this tax trap?… 50/50 is the answer. This strategy uses the A/B revocable trust most of your married folks (with an estate plan) already have. Here’s what you do?…. exactly 50% of each home is owned by the husband’s trust; the other 50% by the wife’s trust. Now, neither has control and according to the often silly American tax law, you are entitled to a minority discount. The discount is in the 30% range. So a $500,000 house is only worth $350,000 for tax purposes.
Neat!
Problem #5. “How does a Family Limited Partnership (FLIP) save estate taxes?” Think of your investment-type – stocks, bonds, real estate and the like – assets. A FLIP is a great estate tax strategy: including asset protection and a minority discount (just like for 50/50). Happily the FLIP discount is in the 35% range ($1 million in assets are worth only $650,000 for tax purposes). Or put it this way: You don’t lose estate taxes to the IRS on $350,000 out of each $1 million of your investment-type assets transferred to the FLIP. As my grandkids say, “Cool!” A FLIP is also a rock-solid asset protection device. For example, when you gift a portion of your FLIP interests to your kids and/or grandkids and then one or more of them get divorced, your then ex-son-in-law or daughter-in-law is locked out of ever getting one cent of that FLIP interest value. Really, very cool.
Problem #6. “Is there any way to finance the cost of life insurance to significantly reduce the out-of-pocket premium cost?” Yes, it’s called premium financing. Examples are the easiest way to explain the strategy. Example (a): A 60-year old reader got $5 million of insurance with a small total cost (to be paid over his life) of $368,000. Example (b): A 56-year old husband with a 55-year old wife bought $5 million of second-to-die life insurance with a total projected outlay of only $79,000 (to be paid over about 15 years). You must be worth a minimum of $5 million (more is better) to qualify for premium financing.
Problem #7. “Is there some way to get a tax advantage during my life that can be part of my estate plan?” There are many ways but a clear leader is the concept of Captive insurance company (Captive). Just what is a Captive?… First and foremost it is a bona fide insurance company, an insurer established to provide coverage for the company or people who founded it. Again, an example is the easiest way to explain Captives. First, a simple example: Joe owns Success Co., which has some “uninsured risks” (explained in greater detail later) that his current property and casualty insurance (PCI) company will not insure. Joe creates New Co. (a Captive), a corporation, which is an insurance company (covering Success Co.’s uninsured risks). The stock of New Co. is owned by Joe’s children. Now the fun part. Suppose the insurance premium for the uninsured risks are determined (professionally by a consulting actuary) to be $500,000 per year. Success Co. pays the $500,000 premium to New Co. The entire premium is immediately deductible by Success Co. like any other PCI. You’ll like this: Under the Captive rules, all of the $500,000 is income tax-free to New Co. Say Success Co. is in a 40% tax bracket (State and Federal combined). Success Co. is only out of pocket $300,000 ($500,000 less $200,000 in tax savings). New Co. has the entire $500,000 to invest. A good start. But remember, New Co. is a Captive and must hold (really invest) the $500,000, plus earnings, as a fund to pay potential claims for the risks it insurers. Next let’s explain “uninsured risks.” Every business has risks: some insured, some uninsured,. The most common risks – like workmen’s compensation, vehicle, property and general liability – are transferred to a third-party (your traditional property and casualty insurance carriers) and are insured risks. Now let’s list some typical “uninsured risks,” the kind that you can’t buy coverage for in the traditional insurance market (as you scan down the list below, check off those that apply to your business):
- • Litigation defense/asset protection
- • Loss of a key customer
- • Loss of a key supplier
- • Change in a law/regulation/ruling
- • Product warranty
- • Product liability
- • Professional liability
- • Strikes/labor problems
- • Traditional policy exclusions/deductibles
- • Employment practices
The list could go on and on. You probably have one or more uninsured risks peculiar to your business. Go ahead, add ‘em on. Let’s face it, your business is self-insured for all of the above risks, either by choice or because the risk just can’t be insured commercially. A Captive reduces the amount needed to fund such possible future losses. How?… The premiums paid to your Captive are immediately deductible. Even though a Captive cannot reduce (actuarially determined) premiums, a financial windfall results (unused reserve) if the insured’s actual losses are less than actuarially predicted. For example, suppose Joe’s Captive (New Co.) has an unused reserve. A portion of the unused reserve can be (a) refunded to Success Co.; (b) reduce future premiums; or (c) paid to the Captive’s shareholders (Joe’s children) as a dividend… Three nice fringe benefits. There are a number of other what I call “fringe benefits” to a Captive structure. Following are a few: (a) Someday liquidate your Captive and take out the unused reserve at capital gains rates: (b) have the Captive invest a portion of its reserve funds to pay premiums for life insurance on the Captive’s founder or his family members (in effect, deducting the life insurance premiums); (c) use the Captive as an estate planning strategy, passing the Captive (and any life insurance proceeds) to your heirs (like Joe above with Success Co: his kids own the Captive’s stock).
Problem #8 “I have significant excess cash or cash-like assets (municipal bonds, certificates of deposits, and the like). I’m conservative. Hate risk. Are there any tax-advantaged investments for me?” Yes conservative investment life insurance (CILI) which is really a conservative investment. Here’s how CILI works: Joe buys a $1 million (could be more or less) policy. The insurance company agrees to guarantee Joe that upon his death, his heirs will receive the sum of the following: (1) All premiums Joe paid (say he paid $20,000 per year for 20 years. His heirs will get back the entire $400,000), plus (2) a guaranteed rate of return on all premiums paid (usually around 3%), plus 3) the death benefit as a bonus (the $1 million). Get a personal quote. You’ll be delighted. And oh yes, 100% of the dollars paid to your policy beneficiaries: (the premiums you paid, all earnings and the death benefit) are tax-free. Problem #9 “How do I know if my estate plan is done and done right?” Easy. You must be able to answer “Yes” to both of these questions: (1) Do you have and will you continue to have absolute control of your business and other assets? And (2) will all of your wealth pass intact – every penny of it – to your family when you die? “All” means if you, for example are worth $11 million, the entire $11 million (fill in your own net worth number) to your family. If you can’t answer “Yes” to these two questions, your plan is not done and, of course, it is not done right. Get a second opinion from an independent professional. Of course, if you are typical, you want more info. Maybe you have a question. Will a specific strategy work for you, your family and your business?
Okay, here’s what to do…
Contact us with the following:
- (1) identify the problem you want to learn about (i.e. Problem #2, subtrust);
- (2) your name, address and all phone numbers where you can be reached;
- (3) your birthday and same for other family members if insurance is involved;
- (4) if you would like, a short statement of your specific facts:
- (5) fax to (847-674-5299) or e-mail me, blackman@estatetaxsecrets.com with “Tax problem” in the subject line.
Or you may want to browse one or both of my websites: (1) www.taxsecretsofthewealthy.com or (2) www.estatetaxsecrets.com.
There’s a ton of tax-saving/wealth-building ideas. If you are in a hurry, you are welcome to call me (Irv) at 847-674-5295.
