Be In The Know To Create And Maintain Wealth

Knowledge is power. The right kind of new knowledge—if you know what to do with it—is, has been and always will be an economic powerhouse for you and your business.

In terms of wealth, it’s important to know both how to make it and how to keep it. Let’s start with the latter category and examine some important changes to tax law that Congress is likely to pass before the end of 2009. These new-tax-law candidates can be divided into two distinct groups: the “good guys” and the “bad guys.”

First, let’s examine the current estate tax law. In 2009, the first $3.5 million of your net worth ($7 million for married folks) is exempt from the estate tax, with the top rate at 45 percent. In 2010, the rate will be zero. That is, no tax, even if you are worth a zillion dollars. Starting in 2011, the exemption will be a puny $1 million ($2 million if married), and the top rate will adjust to 55 percent.

Now for the “good guys.” Congress is considering two happy alternatives to replace the current estate tax law. The budget outline passed by the House keeps the 2009 exemption and top rate. The Senate’s budget outline is even better: The exemption would rise from $3.5 million to a delightful $5 million ($10 million for married couples) and the top rate would be reduced from 45 to 35 percent. Applause!

You won’t like the “bad guy” possibilities. First, if LIFO is terminated by new law, you’ll probably have 5 or 6 years to pay the income tax due (LIFO, which stands for “last in, first out,” is an accounting method for inventory costs). Second, the Washington heads are seriously talking about eliminating the long-standing discount rules (typically held in the 35- to 45-percent range) when valuing a closely held business for tax purposes. This would be a terrible and extremely costly tax change.

My advice: If you intend to transfer your business to your kids, don’t wait. Make your transfer or sale to your kids before the stupid new discount rules become law.

Now, let’s take a look at two “how to make it” ideas. First, consider a captive insurance company. As a business owner, you must carry property and casualty insurance (P&C). Every year, you pay a premium for your usual coverage: workman’s compensation, fire, theft, liability, vehicles and other such risks (note that health care costs are a separate expense).

Let’s assume your premium is $400,000 and your claims for the year are only $100,000. Sorry, but your insurance carrier keeps the $300,000 excess. Worse yet, the premiums you pay probably significantly exceed your claims year after year. However, that’s the way the P&C game is played. Your insurance carrier becomes a welcome friend only in that rare year, when your claims—usually one big one—exceed premiums paid.

So here’s the real question: Is there some way to keep those excess premiums while ensuring coverage if a catastrophe strikes? Enter captives. The Internal Revenue Code allows you to form a captive, which is owned by you or (more likely) a younger family member. Say your captive pays that $400,000 in premiums, which your company deducts. Here’s the beauty of the tax law: The captive not only receives the $400,000 tax-free, but also invests it for earnings. Premiums plus earnings (called “unused reserves”) are available to pay your claims. A concept called “reinsurance” covers your company if you unused reserve is not large enough to pay claims.

Wait, there’s more. A captive can insure risks that your regular P&C carrier will not (for example, product warranties or the loss of a key customer, supplier or employee). You deduct the premiums, and your captive receives them tax-free.

Another “how to make it” idea involves premium financing for life insurance. If you know how to do it, life insurance is the best tax-advantaged investment I know. It’s an investment that never loses (death is guaranteed), and your profit—that is, policy proceeds less premiums paid—is free of income and estate tax.

However, one problem with life insurance is that the blasted stuff costs money, in the form of premiums. Premium financing is one way to get a large amount of life insurance coverage while paying zero or minimal out-of-pocket costs for premiums. Premium financing for life insurance has been on a long vacation because of the current credit crunch. Now, though, lenders—if you know where to find them—are back in the premium financing game.

How does premium financing work? Rather than you or your trust paying premiums, the lender pays them, creating a loan. Loan interest can be paid or capitalized (that is, added to the loan). Of course, when you go to heaven, the loan is paid back out of the insurance proceeds, while your heirs get the balance of the insurance coverage (typically $5 million or more) tax-free. The result is that your family is enriched at your death while your premium cost during life is zero or miniscule.

If you need a large amount of life insurance, or you just want an investment that creates tax-free wealth, premium financing is at the head of the class for “how to make it.”