Joe (age 74) owns 55 percent of an S corporation (Success Co.), and each of his three children owns 15 percent of Success Co. He has two boys, Sam (48) and Tom (42), who have been in business with Joe since they graduated from college. Joe's daughter, Sue, was not and never will be involved in the business. Joe lost his first and only wife last year.
Following is a list of Joe's assets: various liquid investments, $190,000; 55 percent of Success Co., $1,630,000; real estate leased to Success Co., $600,000; balance in rollover IRA, $780,000; and residence and summer home, $435,000. The total is $3,635,000.
Joe's lawyer, who just completed Joe's estate plan, computed the estate tax at $1,419,771. His only recommendation: buy $1.5 million in insurance to pay the tax.
Joe called me for a second opinion. After a long telephone conference, the following is how Joe spelled out his goals:
- Control Success Co. (and the rest of his assets) for as long as he lives.
- When he is gone, have Success Co. owned 50 percent each by Tom and Sam.
- Maintain his lifestyle.
- Give Sue a dollar value equal to the amount received by each of her brothers.
- Find a way to have each of his kids receive one-third of what he is worth now, all taxes paid in full. (Joe laughed a bit at this goal; he didn't think it was possible.)
Stop for a moment. Substitute your own list of assets and goals. What follows is the plan we implemented and the strategies we selected to accomplish Joe's five goals.
- We recapitalized Success Co. (a tax-free transaction) so Joe now owned 55 percent of the controlling voting stock (55 of 100 shares) and 55 percent of the non-voting stock (5,500 of 10,000 shares).
We transferred the liquid investments and the real estate to a family limited partnership (FLIP). As the general partner (owning 1 percent of the FLIP), Joe kept control of these assets. He made annual gifts ($10,000 each) of limited partnership interests to the kids. These limited interests have no voting rights and are entitled to discounts (about 35 percent) for tax purposes. As a result, Joe can give about $15,000 to each kid of limited FLIP interests every year, yet for tax purposes, the interests are only worth $10,000.
- Joe sold the 5,500 shares of non-voting stock to a so-called defective trust (for income tax purposes) for $1.5 million plus interest. The trust paid for the stock with a note payable over 10 years. Success will distribute dividends each year to the trust, which will then pay off the note to Joe.
The beneficiaries of the trust are Tom and Sam, who will each own half of the 5,500 shares when the note is paid and the trust terminates. Joe's 55 voting shares will go to Tom and Sam. The shares owned by Sue will be redeemed by Success Co., according to a new buy/sell agreement, when Joe passes on. Then Tom and Sam will each own 50 percent of Success Co.
- Joe's flow of cash to maintain his lifestyle would come from many sources: (a) a small salary from Success Co., plus all of his usual perks; (b) The note payments from the trust (the entire $1.5 million plus the interest is tax-free to Joe because of the defective trust); and (c) distributions from the rollover IRA. For the 10 years while the note is being paid off, Joe will have more cash than he needs to live. This excess cash will be put into the FLIP. All the assets of the FLIP will be available to Joe if needed.
- As a final back up, Joe will enter into a death benefit agreement with Success Co. that will pay Joe $75,000 per year starting when Joe retires (probably never) and continuing until the day he dies.
We created a Subtrust (using the Rollover IRA and Success Co.) to purchase a $1.5 million life insurance policy. The entire $62,187 annual premium will be paid out of plan funds (not costing Joe a penny), and because of the subtrust none of the $1.5 million ultimate policy proceeds will be included in Joe's estate.
- The residence (worth $355,000) was transferred to a qualified personal residence trust (QPRT). The QPRT was set up in such a way that Joe could inhabit the residence for as long as he lived, yet it would be out of his estate.
If Joe gets hit by a bus the day after the plan is put in place, "goal 5" will be accomplished (along with the four other goals). The longer he lives, the less the IRS gets and the more the kids get.
One warning: The above story does not explain all the technical details of Joe's plan. Only work with a tax advisor who knows, understands and has worked with the strategies used for Joe. A will and trust alone (no matter how long or how fancy) will not get the job done.