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@taxsecretsofthewealthy.com/blog 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.taxsecretsofthewealthy.com/blog.

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.

2. Joe can borrow (tax-free) against the property if he needs cash.

3. A sale of the property is subject to only one capital gains tax, which Joe can report on the installment method if he takes back a mortgage for a portion of the
purchase price. Joe might even exchange it tax-free for another piece of property (called a “1031 exchange”).

4. When Joe dies, his heirs get a raised basis, for example: Say Joe bought the property 25 years ago for $100,000, and it is now fully depreciated down to $20,000 (the cost of the land). The value of the property on his date of death is $620,000. Now get this – that built-in $600,000 of profit escapes income tax. Forever! And also this – Mary now owns the real estate (free of income and estate taxes) with a brand new tax basis of $620,000… Just as if she had bought the property for the $620,000 price. Yes, she can depreciate this property (except for the value of the land) using her new $620,000 tax basis, which will shelter her rental income.

5. The property can be put into a Family Limited Partnership (FLIP), which has many tax and non-tax benefits. For example, a $1 million piece of real estate transferred to a FLIP can receive a discount for estate tax purposes of about $350,000. The estate tax savings could be as high as $157,500 (using current estate tax rates)

And, oh yes, when Mary dies, the law allows her to repeat the raised-tax-basis trick (to raise the value of the property at her death) all over again when she leaves the property to the kids.
Now you know why owning real estate in a corporation is not only a tax trap, but it also prevents you from reaping a tax harvest during your life, at your death and beyond.
Want to learn more tax tricks that will save you a bundle?… take a peek at my website: www.taxsecretsofthewealthy.com. If you have a question call Irv (847-674-5295).

Result: Lengthy wrangling. Expensive costs, very expensive fees. Nobody wins.
Following is a solution that works about nine out of ten times. Except for the names everything you are about to read actually happened. Here’s the story: Three brothers – Ed, Ted and Fred – each owned one-third of Success Co. Their Dad left the business to the three boys when he died 31 years ago. Ed and Ted have worked in the business all their adult lives. Fred never worked even a day at Success Co.
Ed (from Wisconsin but winters in Florida) has a son and daughter who work in the business; Ted has one son in the business. Ed and Ted want their kids to continue the business The three young business kids thrive in the business and ultimately want to take over.
Success Co. is an S corporation. (If it had been a C corporation, we would have elected S status). We then recapitalized Success Co. (a tax-free tactic), issuing 300 shares of voting stock and 9,000 shares of nonvoting stock. Each of the three brothers now owned 100 shares of voting stock and 3,000 shares of nonvoting stock.
Ed sold his 3,000 shares of nonvoting stock to an intentionally defective trust (IDT). An IDT is defective in the sense that it is not recognized for income tax purposes (making the sale tax-free), but it is recognized for estate tax purposes. That’s it, a three-step succession plan: (1) be or become an S corporation, (2) recapitalization and (3) sale to IDT. As the beneficiaries of the IDT, Ed’s two kids wind up owning the nonvoting stock, while Ed keeps control via the voting stock.
Of course, Ted – simultaneously with Ed – used the same succession plan to transfer his nonvoting stock to his business son. About seven months later, Fred followed his brothers with an identical plan to get his nonvoting shares to his two kids (not in the business). Fred liked the tax-free sale and getting the value of the nonvoting shares out of his estate.

Note: An IDT saves the family about $700,000 in taxes for each $1 million of fair market value of the business stock being transferred. It’s one of the best tax strategies I have ever used for a client who wants to transfer his business to the kids, yet keep control.
An insurance-funded buy/sell agreement was entered into by the kids, which should avoid any future controversy and is designed to keep the stock in the family (should one of the kids get divorced).
The plan worked. Great! But why doesn’t it work all the time if it’s so wonderful? The noncooperating shareholder can (and sometimes does) hold up the plan in two ways: (1) refuses to sign an S election when the corporation is a C corporation (no signature, no S election), and (2) votes against the recapitalization (and you need the vote).
Even if the “bad-guy” brother tries to wreck the plan as described above, there are other ways – short of legal action – to get your personal succession job done without the signature or vote of all shareholders. We’ll explore these ways in a future article.
Do you have a brother-type succession problem at your business? If so, you are invited to join the reader test…. To solve your problems. We will write up the results of the test and report back to you in this column.
To participate, please send the following information by courier (send copies, do not send original documents) for each owner who is cooperating:
1. Personal. A financial statement for you and your spouse.
2. A family tree. Your name and birthday. Same for your spouse, kids and grandchildren (indicate which kids are in the business).
3. For the business. Your last year-end (a) financial statement and (b) a list of stockholders.
Send to Irv Blackman, Succession Test, 4545 W. Touhy Ave., #602, Lincolnwood, IL 60712. (If you have a question – concerning your own business succession problem – call Irv: 847-674-5295).

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 for 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 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.
There are many more ways that the use of a Captive can save your business significant insurance costs. Following are two (of dozens of possible) examples:
Example #1. You own a new (or very up-to-date) building in an area with “zone coverage.” Your building is in total compliance with stringent building codes. Many older buildings in the zone are not complaint. Your building can obtain lower rates from your Captive if you can show that your building is a better risk than the Zone’s rating.
Example #2. Success Co. pays premiums to the Captive to insure for litigation defense, strikes and product warranty. Remember with a commercial insurance company (CIC), if the insured has no losses, the CIC keeps the entire premium. No refunds.
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
ES 09-18(4)
09-05
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.
Make no mistake, your Captive must be formed and operated for a business purpose. The Captive must demonstrate that it is, in fact, acting as a proper insurance company. Follow the rules and the IRS is not a problem. Try to fool the IRS by forming your Captive to take advantage of only the tax-advantaged fringe benefits, without a real business purpose, is almost certain to cause the loss of the sought-after benefits.
No attempt is made in this article to explore all the rules, traps and opportunities in forming your own Captive. It is essential that you work only with qualified, experienced advisors that specialize in Captives. The right advisors can easily tailor your Captive to fit you, your business and your circumstances perfectly.
Now the key question: Is a Captive for you?… If costs were not an issue, the answer would be a resounding ‘YES’ for almost every business. Unfortunately, costs are a factor. For a Fortune 500 company, it’s a slam dunk: The insurance cost savings and tax-benefits are well worth the required costs to create and administer a Captive.
If you can answer ‘Yes’ to any of the following questions, you should strongly consider forming a Captive:
1. Is your before-tax profit $1 million (or more) per year?

2. Are your traditional insured property and casualty expenses $1 million (or more) per year?
3. Is one (or more) of the “uninsured risks” listed above (or one you added) a significant factor in your business?… and worth a premium of about $200,000 a year (or more)?
Logic tells you that the larger your business, the more likely a Captive should be a top priority for your next year’s business plan (i.e. make $1 million – before-tax – or more, Captive is a must). Costs are easily covered by Captive benefits.
But what about smaller family businesses?… The answer can be ‘Yes’ with a new strategy the experts have perfected, if your before-tax profits are in the $250,000 per year range. Benefits are the same as for a larger company but costs are substantially reduced.
What, you are even smaller?… well, we need your help. Show this article to the decision maker(s) of your trade association. Have your trade association adopt a Captive program… then you and the other members can participate. The cost is minimal.
Finally, if you are lucky enough to be a Florida resident and your business is located in any other state there is a little known – legal – tax strategy that enhances your tax savings.
How can you learn if a Captive will work for your business? Please fax the following (on your company letterhead) to 847-674-5299: Your name, title, type of business, total number of employees and any other information you think would be helpful. Also include all phone numbers where you can be reached (business, home, cell). If a trade association, please fax on your letterhead and include number of members and name of decision maker. Please mark “Captive” at the top of your fax.

What does the typical successful family business do with these opportunities? Want to guess? The sad answer: Add them to its present business.

What’s the obvious tax result? More income taxes, with profits of the new business opportunity being taxed at the highest rate. Worse yet, it balloons the family wealth for estate tax purposes. Not a smart tax strategy. You are enriching the IRS, instead of your family?

Whether your kids are babes in arms or experienced business adults active in the family business, this is what you should do with these types of opportunities: (1) Let your kids get all or the lion’s share of the income. (2) Keep all or most of the value of the new venture out of your estate.

There are two basic way s to get this job done right.

Situation 1: You want the kids to own and control everything.

Situation 2: You want the kids to own the venture (for tax purposes), while you control the management.

This is the classical way of handling the first situation. Loan the kids (or their new corporation, Kids, Inc.) the money needed to fund the new venture. Or you borrow the money from the bank and then loan it to Kids, Inc. Charge the going interest rate. The kids can deduct the interest. If you like, you can gift the principal of the loan to the kids at the rate of $12,000 per year ($24, 000 if you’re married) per child.

The second situation is solved in about the same way as the first, except Kids, Inc. issues voting stock (say 100 shares costs you $100 and you own all of it) and nonvoting stock (say 10,000 shares, which the kids own at $10,000). Make additional loans as required. You own less than one percent of the value (for tax purposes) of Kids, Inc., but you have absolute control. Cool!

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.