Posts Tagged ‘creditors’

Turn Common Insurance Mistakes Into Tax-Free Wealth

Tuesday, April 14th, 2009

It’s frustrating. Year after year, our office is asked to give a second opinion on the completed estate plans of owners of family businesses. It is rare — very rare — to analyze the estate plan (particularly the life insurance policies) of a real-life client and find that all is as it should be. Typically, we find the wrong kind of insurance. Wrong ownership. Wrong beneficiaries. Wrong tax consequences. It goes on and on.

This is a big deal. We are talking big money.

Typically, the IRS gets 50 to 55 cents out of every life-insurance dollar. Imagine owning a $1 million policy, and the IRS gets $550,000. Your family gets only $450,000. It happens all the time. A needless tax travesty.

Let’s review the three biggest mistakes business owners make concerning life insurance.

Mistake No. 1 — A corporation should never own insurance on the life of a shareholder, particularly a majority shareholder. Why? The trouble starts as soon as the shareholder dies: The policy proceeds are subject to the claims of corporate creditors.

Worse yet, if a C corporation, the proceeds can be subject to the alternative minimum tax (AMT) that can steal up to 20 percent of the proceeds — and the net proceeds (after the AMT) can only get into the hands of your family by paying a second tax via a taxable dividend (ouch!).

If an S corporation, the proceeds (although not subject to the AMT) are still locked in the corporation and can only be paid out tax-free if all old C corporation surplus is first paid out as a dividend (a terrible and tax-expensive idea).

Mistake No. 2 — The life insurance policy is owned by you or your spouse. Someday the policy proceeds will be included in your estate (or your spouse’s estate). You just guaranteed the IRS a big — unnecessary — payday.

Mistake No. 3 — The policy (with cash surrender value) is old and the cash surrender value is half or more of the death benefit. You no longer have a life insurance policy but a lousy investment.

So what should you do? Here are the typical recommendations we give to our clients so that, you and your family — instead of the IRS — win the insurance tax game.

For Mistake No. 1 — Transfer the policy from the corporation to your name, paying the corporation only the amount of the cash surrender value (a tax-free transaction). Next, transfer the policy to a Wealth Creation Trust (an irrevocable life insurance trust that eliminates all income and estate taxes).

For Mistake No. 2 — Transfer the policy to a Wealth Creation Trust.

For Mistake No. 3 — If you are insurable, dump the old policy and replace it with a new policy to be owned by a Wealth Creation Trust. First, if you are married, make sure that replacing the policy on your life is the right type of policy. About 80 percent of the time a second-to-die policy (insures you and your spouse) will give you significantly more bang for your insurance premium dollar. Second, determine how to reduce the premium cost:

(1) if your company has a 401(k) or other qualified plan look into a “Subtrust.” The plan, not you, pays the premiums. Even your IRAs — traditional or rollover — can join in the premium-saving fun.

(2) Whether you need single life (only you are insured) or second-to-die, check out “premium financing.” You don’t pay any premiums to get a large ($5 million or more) amount of insurance, nor do you pay interest, just the low fees to the bank to initiate and maintain the loan.

This article does not even begin to explore all of the economic possibilities and tax tricks that you should learn to win the insurance tax game. Also, there are exceptions and traps, but simple to avoid when you know the tax ropes.

Here’s an easy way to get started: List the policies on your life and your spouse’s life, whether owned by you, your corporation, a trust or otherwise. Then ask this question about each policy: What is the ultimate tax cost-income and estate-while I’m alive? … When I die? … When my spouse dies?

The answer should be zero. If not, do what is necessary to make the answer zero. This usually means implementing one or more of the recommendations listed above for each of the above mistakes.

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Posted in Corporate Tax, Estate Tax, Insurance, Planning | No Comments »

Beware of Johnny-One-Note estate planning

Saturday, April 4th, 2009

Writing this column is fun.

Even more fun is consulting with column readers to solve their real-life family and tax problems.

When a reader consults with me, I ask him/her to send some basic data, including a copy of their current estate plan. Recently, a small parade of readers have asked me to review — or give a second opinion on — what I call “Johnny-one-note estate planning.”

If your estate plan is done or is in the process of being done, the rest of this item is “must” reading. Estate plans that are built around one main theme (Johnny-one-note) do not play well in the complex world of dozens of concepts available to eliminate the estate tax.

Of the last 31 plans I have reviewed, 26 were based on a single theme. The runaway winner (really a loser in tax-saving effectiveness) is the creation of a revocable trust (RT) — one for him and one for her, where a married couple is involved.

An RT for married folks is a good start to an estate plan, but its only good tax trick is to defer the big estate tax bite until the death of the second spouse.

Two other strategies that I see regularly as Johnny-one-notes are the sale of a business to the kids by the business-owner dad (SALE) and family limited partnerships (FLIPs).

A SALE is often used as a strategy to sell your business to your kids (usually on an installment basis). Never, but never, have I seen a sale of a family-owned business as a tax-effective way to transfer a business to the next generation. Instead, take a look at an intentionally defective trust (IDT), which is the best way to transfer a business tax-free from Dad/Mom to the business kids.

A FLIP is usually not an effective way to deal with a business, a residence, or money in an IRA, profit-sharing plan or similar plan. But it’s a wonderful tax-saving starting point for almost every other asset you might own (stocks, bonds, real estate, you name it.) Properly used, you can 97-26(2) control the assets for life, protect them from the claims of creditors, and reduce their value for estate tax purposes immediately by 30 percent to 40 percent.

For example, say your transfer $1.5 million of investment assets (stocks, bonds, real estate) to a FLIP. For estate tax purposes, the assets are only worth about $1 million, resulting in estate tax savings of about $250,000.

This column over the years has covered RTs, IDTs and FLIPs in detail.

One way you can tell if your estate plan is really properly done is by looking at the estate tax liability if you and your spouse get hit by that proverbial truck.

Whether the liability is $500,000, $5 million or more, your estate plan needs a second opinion.

Why?

Your target should always be to move all your wealth — intact — to your family (for example, if you’re worth $5 million, then the entire $5 million to your family; $50 million, the entire $50 million, etc.).

Following is a list of the six most common strategies we use to transfer your wealth — intact —and eliminate estate taxes. In parenthesis following each strategy is the type of assets you should own to consider the concept.

(1) Qualified personal residence or QPRT (residence).

(2) IDT (your family business).

(3) Subtrust (junk money and other strategies if you have a total of more than $350,000 in your IRA, profit-sharing or similar plan).

(4) Charitable remainder trust or CRT (appreciated assets, including a family business) Briefly, a CRT eliminates the capital gains tax and estate tax.

(5) FLIP (for all assets not list above, generally income producing investments).

(6) Irrevocable life insurance trust or ILIT (insurance is estate tax free to you and your spouse). Use other assets to pay premiums at little or no tax cost.

(7) Premium financing (allows you to buy insurance without paying premiums in cash).

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Posted in Estate Tax, Planning, Uncategorized | No Comments »

Don’t go overboard with one kind of tax strategy

Saturday, April 4th, 2009

Professionally, my second love is writing this column. My first love is consulting with the people who read it.

Every family I work with is different. So are their businesses, their situations, their problems. In spite of these differences, I’m rarely surprised by anything totally new. But one reader sent me something I had never seen before.

Here’s the story.

After about an hour on the phone discussing an estate plan, son Sam calling at the request of dad Joe agreed to send me some typical information: tax returns, financial statements and a copy of the existing plan. About one week later, a heavy box arrived with a five-inch stack of documents. About four inches worth were nine separate family limited partnerships. They were the same except each partnership owned a different asset: the family business, a residence, investments, etc.

As I thumbed through the papers, I couldn’t help thinking about the drunk who was told, “A shot of whiskey each day is good for you.” The guy who did Joe’s estate plan was clearly drunk on partnerships.

One thing should be made clear: I am an enthusiastic cheerleader for the use of limited partnerships in estate planning. Use ‘em all the time. But this overkill of a single strategy just didn’t do the best possible job.

Using the computations of the adviser, the IRS would get more than $2 million in estate taxes. Another $1.1 million of IRS enrichment was likely because of a gross misuse of the partnership strategy.

What does a family limited partnership accomplish? It allows you as a general partner to totally control the use of any asset transferred to the partnership yet reduce the value of the assets transferred. For example, $1 million of assets transferred to a partnership are usually worth only about $650,000 for tax purposes. That $350,000 discount in a 55 percentestate-tax bracket would reduce your estate-tax burden by $192,500. Not bad!

A familylimited partnership is also a great asset-protection strategy. Creditors can’t get at the assets in the partnership. Neither can divorcing spouses of your kids, who are usually the limited partners.

Used properly, a partnership is almost a perfect tax tool. In general, don’t use them to own the stock of your family business. Nor should one be used for non-income-producing personal assets, like a home or car. It’s a valuable strategy for almost every other asset you might own: publicly traded stocks and bonds, real estate, you name it.

Without covering every detail, we terminated the partnerships that held the family business and two family homes. The business elected S corporation status and was transferred to an intentionally defective trust, and the residences were transferred to qualified personal residence trusts. Those are similar concepts that allow you to heavily discount the value of the assets transferred to them.

We used the liquid assets in two other partnerships to pay the premiums on second-to-die life insurance on Joe and his wife, which was owned by an irrevocable life insurance trust that we created. That trust removes life insurance from the taxable estate of the husband and wife.

When all the smoke clears, Joe and his four children, including Sam, will be enriched $4 million to $7 million more than the original overkill plan, depending on how long Joe and his wife live.

One warning: This is an example of overindulgence in one tax strategy. Although the above descriptions cover the main points of how Joe’s problems were solved., this is not a do-it-yourself kit. There are a number of traps and exceptions. Only proceed with the help of an expert.

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Posted in General Tax Strategies, General Tax Talk, Uncategorized | No Comments »