Often, I feel like an old-fashioned country doctor makin’ house calls. But there is a difference: my patients are sick of paying taxes.
Recently, I visited a successful family business in North Carolina, owned by a semi-retired 64-year-old named Joe and run by his son, Sam, a 36-year-old.
Joe called me. He wanted a second tax opinion for a business transfer plan and an estate plan put in place by Sam (with the advice of his professional advisors, the “best” estate planning team in the county) almost two years ago.
Wow, this patient was really sick (running a high tax fever, bleeding lots of tax dollars).
This is the story of the symptoms, the diagnosis and the “magic tax potions” that cured the patient.
First, the facts:
Joe owns 98 percent of two corporations: a profitable S corporation (Success Co.), which operates a string of stores, and a C corporation (a tax-paying corporation, called R/E Co.), which owns real estate leased to Success Co.
The real estate has an income tax basis of $1 million, but a current fair market value of about $6 million. Sam owns the remaining two percent of the stock of both corporations. Each of the corporations is the owner and beneficiary of a separate $1 million insurance policy on Joe’s life.
Four more little details:
• Joe’s second wife, Mary, is 45 years old and they have a premarital agreement that gives Mary the income from one-half of the value of Joe’s assets at his death for as long as Mary lives. But get this: none of the stock of Success Co. can be used to provide Mary her income.
• An artificially low price in a buy/sell agreement would force Joe’s estate to sell his stock in Success Co. back to Success Co. and the same for R/E Co. (Result: Sam would then own 100 percent of both corporations.)
• Joe has two other grown children who are not in the business.
• Joe is not insurable.
The diagnosis:
• The $1 million in life insurance payable to R/E Co. would kick up an unnecessary alternative minimum tax.
• The full $2 million of insurance would be included in Joe’s estate because he controls both corporations, but the $2 million (less the alternative minimum tax of about $150,000) would belong to the corporations, not Joe’s estate.
• There are not enough liquid assets to satisfy the obligation to Mary. Worse yet, if the obligation to Mary is met, there would be zero dollars (outside of the corporations) to pay an estimated $3.5 million estate tax liability. Simply put, the estate would be broke.
Our objectives to cure Joe’s tax illness are clear:
• Reduce the value of Joe’s estate.
• Get cash to fund the obligation to Mary.
• Pay the estate tax.
Here are the five major tax medicines I recommended to cure Joe’s business transfer and estate plan:
• Merge R/E Co. into Success Co. This maneuver is tax-free. R/E Co. is worth about $6 million as a real estate investment company but, as part of the operating company, its value is reduced by at least $2 million for estate tax purposes. Estate tax saving — over $1 million.
• Transfer the nonvoting stock (created after the merger) to a grantor retained annuity trust (GRAT), which reduces the value of Success Co. by about 40 percent for estate tax purposes. This maneuver saves about $.5 million in estate taxes.
• Joe takes the $2 million in insurance policies out of the corporations and gives it to his children. Result: The value of Joe’s estate drops about $2 million and will save another $1 million plus in estate tax.
• Change Joe’s will to put the entire estate tax obligation on the children. The $2 million in income tax-free/estate tax-free insurance proceeds will handle the entire estate tax load when Joe dies.
• Make sure Joe’s will qualifies for the 100 percent marital deduction for Mary’s one-half share, thus deferring any estate tax on this portion of Joe’s estate until Mary dies. Yes, there are other details and nuances in the plan, including gifts to Joe’s children, but these five tax medicines cured the patient.
What’s the lesson to be learned from this true-life Joe/Sam/Mary story? Always, yes always, get a second opinion after your estate plan is done, preferably before any documents are signed.
