The typical T-fusion candidate is fortunate to have at least one of the following:
1. Excess cash. This person has enough cash or cash-like assets (CDs, stocks or bonds) to maintain his or her lifestyle with excess to invest.
2. Income-producing assets. This person owns all or a portion of a profitable, closely held business; real estate for rental income; or any other asset (including stocks and bonds).
Any of these assets can be used to successfully implement a T-fusion. The asset used may change, but how a T-fusion works never changes.
For example: Joe owns $5 million in real estate that produces 7-percent net ($350,000) rental income. Joe (age 70) and his wife, Mary (age 66), could buy second-to-die life insurance for an annual premium of $14,452 per $1 million of death benefit if both were healthy. However, some medical issues cause the premium to rise to $24,617 per $1 million of coverage. They decide to buy a policy with a $5.5 million death benefit with an annual premium of $135,394 (5.5 × $24,617).
In the real world, all documents needed to create a T-fusion are done at the same time. However, exploring the process in four steps makes it easier to understand. For convenience, some numbers are rounded.
• Step 1: Create a family limited partnership (FLIP). Joe and Mary contribute $5 million in real estate to the FLIP and receive 1-percent interest as general partners and 99-percent interest as limited partners. The transaction is tax-free, but under tax law, the limited partner’s interest receives a 35-percent discount, or $1.75 million (35 percent × $5 million). The discount is supported by a professional appraisal. So for tax purposes, the real estate is worth only $3.25 million.
• Step 2: Make transactions using an intentionally defective trust (IDT). Joe and Mary create an IDT, which is intentionally defective (meaning it will be ignored) for income tax purposes. Then, they sell their limited partnership interest to the IDT and receive a $3.25 million note in payment. When the note is due, the terms specify that interest is at 5 percent ($162,500 per year) for 15 years. Of course, this transaction is tax-free.
The key to the transaction is the 35-percent discount on the FLIP interest allowed by the tax law. The amount of the note is not based on the real intrinsic value of the real estate ($5 million), but its $3.25 million tax value. The discount causes a cash-flow surplus in the IDT computed as follows:
Rent income +$350,000
Note interest -$162,500
Policy premium -$135,394
The IDT cash flow covers the required interest and premium payments. When both Joe and Mary have gone to heaven, the IDT will immediately receive the $5.5 million policy proceeds (see Step 3). There are no income, gift or estate taxes.
Wait! There is one more big tax benefit for Joe and Mary: The annual interest ($162,500) they receive is tax-free under the IDT rules. However, the IDT cannot deduct the interest paid against its taxable rental income ($350,000). Typically, Joe would contribute a portion of the tax-free interest received to help pay the IDT income tax bill.
• Step 3: The IDT buys the $5.5 million second-to-die life insurance policy on Joe and Mary. The trust is the owner and beneficiary of the policy. What if Joe or Mary (or both) are still alive in 15 years when the note becomes due? They have a few options: pay the note partially or in full using other assets, or pay the note with a new note (interest only or with principal payments).
• Step 4: Create a family bank. Joe and Mary can tailor the terms of the IDT to accomplish their precise financial goals and dreams for their kids and future generations. Remember, the $5.5 million policy death benefit will come to the IDT tax-free.
The funds can be distributed immediately or set aside to become a “bank” for the future generations. The funds can help provide a down payment on a first home, start a business, pay emergency medical bills, and more.
Joe and Mary could also create a dynasty trust by setting aside enough funds to buy new life insurance policies on the older beneficiaries of the IDT. When those insured beneficiaries go to the big business in the sky, a new tax-free, cash benefit will enrich the trust to bank future generations (to be repeated forever).
If you are fortunate enough to own the type of assets needed to do a T-fusion (this includes almost any kind of income-producing investment or ownership in a family-owned business), then you owe it to yourself and your family to check out the tax-fusion concept.