Mistake 1: Not creating the correct succession plan. Joe owns 100 percent of Success Co. (an S corporation), which is run by his son, Sam. The company is worth $9.7 million and grows 5 to 10 percent in revenue every year. Joe’s estate plan leaves Success Co. to his wife Mary, and to Sam after her death. This is a mistake because the potential estate-tax liability grows along with the ever-increasing value of Success Co.
Now is the time to transfer Success Co. to Sam. Here’s what we did for Joe. You should also be thinking of doing it if you own all or part of a closely held business. First, recapitalize Success Co. This means creating voting stock (100 shares) and non-voting stock (10,000 shares). This is a tax-free transaction. Joe keeps the voting shares and absolute control for as long as he lives. The non-voting shares are entitled to a 40-percent discount under the tax law, so these shares are only worth $5.82 million for tax purposes.
Next, Joe transfers (actually sells) the non-voting shares to an intentionally defective trust (IDT) for $5.82 million, taking an interest-bearing note as payment. The entire IDT transaction is tax-free for Joe.
Even better is that Sam does not pay one penny for the stock. Instead, the cash flow of Success Co. (via S-corporation dividends to the IDT) is used to pay the note plus interest. Sam, who is the beneficiary of the trust, receives the non-voting stock tax-free when the note is paid in full.
Mistake 2: Not avoiding the double tax on qualified plans and IRAs. Joe and Mary have $1.9 million in the Success Co. 401(k) plan and various IRAs. If left alone, these funds will be double taxed (income and estate tax). Using 2013 tax rates, the IRS winds up with 70 percent of these plan funds, and the family receives a paltry 30 percent.
We used a strategy called “retirement plan rescue” (RPR) to purchase $5 million of second-to-die life insurance on Joe and Mary. Actually, the policy was purchased and is owned by an irrevocable life insurance trust (ILIT). The beneficiaries of the ILIT are Joe and Mary’s three non-business children (Sue, Sy and Sid). The ILIT will help treat the three children equal to Sam. The three will receive $5 million tax-free.
Mistake 3: Not putting investments into a family limited partnership (FLIP). Joe and Mary have $8.1 million in cash, CDs, stocks, bonds and income-producing real estate. They created two FLIPs: one for the real estate and one for the other investments (except $2 million was held back to be used in Mistake 4). So, the amount put into the FLIPs is $6.1 million. A FLIP is allowed a 35-percent discount, reducing the $6.1 million to $4 million (rounded) for tax purposes, thus saving estate taxes on $2 million.
Mistake 4: Not taking advantage of life insurance as a tax-advantaged investment. There are actually dozens of core life-insurance strategies. Joe used three of the core strategies as follows:
• Strategy 1: In reference to Mistake 1, a portion of the funds received each year by the IDT for its share of Success Co.’s S-corporation profits is being used to purchase a $3 million second-to-die life insurance policy on Joe and Mary. The $3 million death benefit, along with the other second-to-die policies described in the following two strategies, will be used to give Joe’s three non-business children their fair share of the estate.
• Strategy 2: Refer to Mistake 2, in which an RPR strategy is used to acquire $5 million of second-to-die insurance on Joe and Mary.
• Strategy 3: Remember in Mistake 3, $2 million was held back to be used in this strategy. This is called the “single premium immediate annuity strategy” (SPIAS). In a nutshell, here’s how the SPIAS works. First, Joe and Mary purchase a joint and survivor type of single premium annuity for $2 million. As long as one of them is alive, they will receive an annuity payment of $109,304 every year. A portion of the annuity is received tax-free due to IRS regulations, so they will have a net amount of $96,362 every year after income taxes. This amount is used to pay the annual premium on another second-to-die policy for $7,268,294. Actually, that policy was purchased and is owned by an ILIT. Sue, Sy and Sid will receive the death benefit tax-free because of the ILIT.
Mistake 5: Not having a comprehensive estate plan. A comprehensive plan dictates that you have two plans: a lifetime plan (the real tax saver and wealth builder) and a death plan (the typical type of estate plan that most people have). The lifetime plan must dovetail with the death plan.
The first four mistakes described above are all part of your lifetime plan. Your comprehensive plan deals separately with each significant asset that you own. It gets these assets out of your estate for tax purposes, yet allows you to control each asset for as long as you live. When properly done, your plan should completely eliminate the impact of the estate tax.