Running a closely-held business can be challenging enough without the added difficulty of tax and investment planning. Consider the hypothetical case of Joe, 76, a typical family business owner whose chief struggles include dollars lost, whether to lousy outside investments or inept tax planning, as well as inaction and missed opportunities, mostly due the lack of time that plagues almost all business owners and the failure of professionals to help. Here are four strategies he used to address these challenges:
Strategy 1—Tackle the myth that not making cash payments to a life insurance company means you are no longer paying premiums. Even if you have built up enough cash surrender value (CSV) on life insurance policies to avoid paying cash premiums, you are still losing money. Premiums are still being drawn from your CSV or through a reduction of your death benefit.
Joe and his wife, Mary, age 67, had four policies with a combined CSV of $1.485 million and death benefit of $2.04 million, and were no longer paying cash premiums to the insurance companies. They used a tax-free exchange to replace those policies with new ones that offer a total of $2.9 million in death benefits with no cash premiums.
Another insurance strategy is to dump existing single-life policies and buy new second-to-die policies. Joe and Mary also could have acquired a $3.65-million second-to-die policy, with all taxes paid in full using only their $1.485-million CSV.
Strategy 2—Transfer your business to your children, tax-free. This calls for creating an intentionally defective trust (IDT). Joe owned 100 percent of Success Co., which is worth $4.6 million. He first recapitalized the company, issuing 100 shares of voting stock to himself and selling 10,000 shares of non-voting stock to the IDT for $2.8 million. All of that money escapes the capital gains tax, and the interest Joe receives is also tax-free. The trust’s beneficiary is Joe’s son, Sam, who runs Success Co. Sam will pay nothing for the stock but will use the company’s cash flow to pay his dad.
Strategy 3—Build a comprehensive estate plan. This actually involves two plans: a traditional A/B trust (“marital trust”) with a pour-over will and a lifetime plan. Chances are, if you are married with a completed estate plan, you already have the traditional trust in place. But this is essentially a death plan and can’t save you from estate taxes. You also must have a lifetime plan that enables you to beat the estate tax and invest a portion of your current wealth to create significant additional wealth that passes to your heirs tax-free.
Joe used these sub-strategies to save income and estate taxes while increasing his wealth:
- Family limited partnership (FLIP). A little more than $6 million of Joe’s investments (CDs, cash, stocks, bonds and real estate) were
- transferred into a FLIP. Joe retains 1 percent (all the voting rights) and gives 99 percent (called “limited units”) to his kids and grandkids. The tax law reduces the $6 million to $4 million for tax purposes.
- Gifting program. Every year, Joe and Mary each will make the maximum gifts of $14,000 for each child and grandchild.
- Management company. Joe formed a separate management company (a C corporation) that is not related to Success Co. This new company can award fringe benefits to Joe and Sam, such as paying 100 percent of medical expenses and long-term care deductibles for their families, for total annual savings of about $20,500.
- Sale of annuities to charity. Joe had $850,000 in various annuities that were not doing well in earnings, so he donated them to a charity. This qualified him for a $239,000 tax deduction. He is also using annual annuity payments from the charity to buy a $4-million second-to-die policy on Mary and himself that is owned by an irrevocable life insurance trust (ILIT) and will go to his heirs tax-free.
- “Retirement Plan Rescue” (RPR). An RPR shifts funds from highly taxed qualified plans into tax-free environments, such as life insurance.
- Joe had $2.3 million in various qualified plans (401(k), profit-sharing, IRAs) that he moved completely into IRAs. He then created another ILIT and bought a $4.2 million second-to-die life insurance policy.
Strategy 4—Use a forfaiting program. A forfaiting program is essentially a European money center bank instrument (really a debenture) that is purchased and resold. These monetary securities are bought at a lower price and then resold at higher prices. What makes the program
different is the trader who enters into the required transations never purchases at the lower price
until he or she has a guaranteed sale (an “exit sale”) at a higher price. Thus, the principal of the
investor is always protected and the profit is locked the instant the purchase/sale is complete. The minimum investment in a forfaiting program is $1.3 million, and the annual rates of return run into double digits.
When all was said and done, these lifetime strategies eliminated all but a small amount of the potential estate tax, and the amount of wealth Joe’s family will receive at his death will be significantly more than his current wealth because of the tax-free life insurance.