Last year was the first year I can remember in which there were no significant changes in the tax laws, neither in those related to income taxes nor estate taxes. So for tax-planning purposes, 2015 should mirror 2014.
We analyzed our client files to determine which strategies we used most last year to legally “beat up” the IRS. The following seven techniques were the clear winners.
1. Family Limited Partnership (FLIP). A FLIP is an entity set up to hold the assets contributed by its members, and it has tax benefits. We’ll use Success Co. owner Joe’s financial information to illustrate how this particular strategy works. Joe owns $10 million worth of various investment assets that include real estate, cash-like assets, stocks and bonds. By transferring these assets to a FLIP, their value for tax purposes drops to $6.5 million, thanks to a 35-percent discount allowed by current tax laws. The result is a savings of $1.4 million in estate taxes.
2. Intentionally Defective Trust (IDT). Say Joe wants to transfer Success Co., which is valued at about $10 million, to his son Sam. If he sells the company outright to Sam, the result is a tax tragedy. To come up with the $10 million to pay his father, Sam must earn about $17 million and then pay about $7 million in income tax. Then, after the sale, Joe will have to pay about $2 million in capital gains tax, leaving him with just $8 million. Essentially, Sam must earn a whopping $17 million in order for Joe’s estate to keep $8 million.
Under the Internal Revenue Code, Joe can transfer the company to Sam through an IDT, freeing them both from income and capital gains taxes. And Joe can still maintain absolute control of his company for as long as he wants.
3. Captive Insurance Company. A captive is a bona fide property and casualty insurance company that insures those risks that a typical property and casualty insurance company does not, such as the loss of large customer or a key employee. Joe’s children form and own a captive, and Success Co. pays the captive a $500,000 annual premium. The company deducts the premium, however, so it only pays $300,000 out of pocket. The captive receives the entire $500,000 tax-free and can invest all of it. Over the years, the captive will accumulate millions of dollars, which ultimately will go to its owners, Joe’s heirs, at only capital gains rates.
4. Retirement Plan Rescue (RPR). This strategy involves using money from an existing qualified plan such as profit sharing, a 401(k) or IRA to purchase a second-to-die life insurance policy on Joe and his wife, Mary. An RPR does two things: 1) it avoids the double taxes (income and estate) that funds in a qualified plan are subject to and 2) it uses the plan funds to create additional tax-free wealth. Typically, each $250,000 to $350,000 in the plan is used to create about $1 million of tax-free wealth.
5. Private Placement Life Insurance (PPLI). The primary purpose of PPLI is to turn taxable investment profits (whether capital gains, dividends or interest income) into tax-free income. It is a form of variable universal life insurance that is offered privately rather than through a public offering. The cash value of variable life insurance is dependent on the performance of one or more investment accounts in the policy. Imagine $1 million or more compounding tax-free over many years. This is especially lucrative for those with large investment portfolios.
6. 50/50 Title Strategy for Personal
Residences. Transferring the title of every residence so that it is 50 percent owned by Joe’s traditional trust and 50 percent owned by his wife’s trust entitles them to a discount of about 30 percent for estate tax purposes. For example, if they own a main residence worth $2 million and a vacation home worth $1 million, they can reduce those values to $1.4 million and $700,000 for estate tax purposes, resulting in tax savings of $360,000, just by transferring the titles.
7. Premiums Financing (PF). This strategy combines knowledge of tax laws, a bank loan and life insurance. Joe buys a large insurance policy, either single-life or second-to-die insurance, with a death benefit ranging anywhere from about $8 million to $100 million, depending on his age and health. He does not pay premiums on the policy, but rather they are paid with bank loans that are repaid after his death. This strategy is recommended for anyone worth more than $10 million. It almost sounds too good to be true: using current wealth as leverage to create additional tax-free wealth without spending any of that current wealth.
These seven strategies, when combined with the more traditional estate plans, almost always eliminate the potential estate tax burden, no matter how much a person is worth. So if you are worth $40 million, the entire $40 million will go to your heirs, completely tax-free. However, your estate plan typically must include at least two of the above strategies to accomplish this.
Each of these are legally accepted tax strategies when they are executed correctly. Make sure you work with an advisor who is experienced in executing the strategies that interest you in order to help you win the tax game.