Joe was advised by his lawyer and accountant to sell his business, Success Co., to his daughter for $1.8 million. He called me for a second opinion before signing the papers. These are the goals Joe outlined:
1. Save income and estate taxes.
2. Sell Success Co. to his daughter Susan (who works in the business).
3. Get a lifetime flow of income from the business for himself and his wife, Mary.
4. Retire next month, when he turns 65.
5. Control his assets, including the business, for as long as he lives.
6. Treat his nonbusiness children fairly.
A quick valuation (taking legal discounts allowed under the tax law) indicated that the worth of the business for tax purposes was in the $1.1 to $1.2 million range. The business is likely to enjoy modest growth in value (about 5 percent per year). Joe's other assets—his residence ($350,000), 401(k) ($650,000), investments ($500,000), and life insurance ($600,000)—total $2.1 million and are held in joint tenancy by Joe and Mary. Mary is the beneficiary of Joe's insurance and the 401(k). Success Co., a regular, tax-paying corporation, has annual before-tax profit of about $300,000 to $400,000 after paying Joe's $175,000 salary.
Following is what I advised Joe to do, goal-by-goal.
1. Not selling Success Co. to Susan will save Joe about $350,000 in income tax (technically capital gains tax). Saving ( eliminating in this case) estate tax is a bit more complex. Following are the strategies used.
a. Eliminate joint tenancy for all properties. Joe and Mary should each wind up owning about one-half, in value, of all assets (including the stock of Success Co.). The trick is for each spouse to own at least $1 million at the time of death. In this way, a husband and wife can reduce the estate bite to zero on the first $2 million of their assets if their wills are properly drawn. If the wills are wrong, the estate tax on that $2 million in property is a minimum of $435,000.
b. We recapitalized Success Co., a tax-free transaction. Joe now owns all (100 shares) of the voting stock and half (5,000 shares) of the nonvoting stock. Mary owns the balance (5,000 shares) of nonvoting stock.
c. We had Success Co. professionally appraised. The 100 shares of voting stock were valued at $100,000. The 10,000 shares of nonvoting stock were appraised at $1.8 million, before discounts. Various discounts (for lack of marketability, minority interest and nonvoting stock) reduced the value of the shares to $1 million for tax purposes.
d. Joe sold his 5,000 shares of nonvoting stock to an IDT and received a $500,000 note (with interest of 6 ½ percent), issued by the IDT, as payment in full. The IDT will use its share of the S corporation dividends to pay off the note, plus interest, to Joe. Susan is the beneficiary of the IDT and will receive the 5,000 shares of stock after the note is paid.
e. We transferred the residence to a qualified personal residence trust (QPRT), which will remove it from Joe and Mary's estate, yet they can live in it for as long as either is alive.
f. We created a subtrust as part of the 401(k). The subtrust purchased $2.5 million of second-to-die insurance on Joe and Mary. The annual premium payments of $37,750 will be paid by the subtrust. The $2.5 million death benefit will be free of income tax and estate tax.
g. Joe dropped the $600,000 of insurance on his life, pocketing $73,000 (tax-free) in cash surrender value (CSV) and saving $4,800 per year in premiums.
h. Joe created an irrevocable life insurance trust (ILIT) to purchase $1 million of additional second-to-die insurance. The $15,100 premium will be paid from the CSV ($73,000) and annual savings ($4,800) in g. above. If necessary, funds from the FLIP [following] will be used. The $1 million death benefit will be tax free to the ILIT and Joe's heirs.
i. We formed a family limited partnership (FLIP). Joe's investments, primarily a $450,000 piece of real estate rented to Success Co. for $54,000 per year, were transferred to the FLIP. Any excess cash developed by Joe and Mary would immediately be transferred to the FLIP. These funds would always be available to Joe and Mary if needed. Any property in the FLIP should receive a discount of about 35 percent for tax purposes.
j. Success Co. created a death benefit agreement to pay Mary $75,000 per year when Joe dies. Payments will stop when Mary dies.
k. Joe and Mary reduced their estimated estate tax liability from $1.275 million to zero. If the value of Joe's and Mary's combined estates threatens to exceed $2 million (and cause an estate tax), a gift program is waiting in the wings. Joe and Mary can each give $11,000 per year ($22,000 total) to each kid and grandkid.
Next month, we will cover the remaining goals of Joe and Success Co.