Let’s set the stage with a typical problem: Joe, who is married to Mary, owns Success Co., which is worth $10 million. Steve, Joe’s son, runs Success Co. The plan proposed by Joe’s professionals is for Steve to buy Joe’s stock for $10 million (to be paid over 10 years).
Steve must earn about $16 million to pay $6 million in income tax and have the $10 million to pay Joe. Joe must pay about $1.5 million in capital gains tax, leaving only $8.5 million. So, Steve must earn $16 million for Joe’s family to keep $8.5 million. That’s nuts.
The following three lessons are what most tax professionals get wrong:
• Lesson #1: A sale of all or even a portion of your stock to your kids is a lousy idea for tax purposes.
Sometimes professionals use various strategies, such as a stock redemption or a stock purchase agreement, that require insurance on Joe’s life as a means to get the company stock to Steve. This method is better than selling your stock to your children, but the IRS will collect estate taxes on every dime of that life insurance. Using 2009 tax rates, this amounts to roughly $4.5 million to the IRS on $10 million of insurance. In most cases, the insurance is either too much (stock was gifted to Steve while Joe was alive) or too little (Success Co. just kept growing in value).
• Lesson #2: Life insurance can play an important part in your estate planning, but don’t use it in a business succession plan to get Success Co. stock to your business kids. You’ll guarantee the IRS a big payday when you go to the big business in the sky.
• Lesson #3: Never use Section 6166 of the Internal Revenue Code as part of your overall estate tax plan. This section allows certain business owners to pay their estate tax liability over a 15-year period, plus a low rate of interest (not deductible) on the amount of estate tax due. Instead, you should create a comprehensive plan to eliminate the estate tax.
The system to create a comprehensive plan actually requires two plans. The first is a traditional will and trust (one for Joe and one for Mary). This is really a death plan. It cannot save you a dime in taxes. It just defers the estate tax blow until both Joe and Mary have gone to heaven. The second plan, a lifetime plan, beats up the IRS legally.
Let’s look at the lifetime-plan strategies most often used in practice. The system uses strategies that are implemented during your life and are based on the assets you own.
• Your business. We use an intentionally defective trust (IDT) for income tax purposes. This is a tax-free way to transfer non-voting Success Co. stock while Joe keeps the voting stock and control.
• Residence(s). The most common strategy is called “50/50.” We transfer the title of each residence by having 50 percent owned by Joe’s traditional trust and the other 50 percent owned by Mary’s trust. By doing this, we get about a 30-percent discount for estate tax purposes (for example, a $600,000 house is only valued at $420,000 in the estate).
• Funds in qualified plans. These funds are double taxed. Sorry, but the IRS winds up with about 70 percent and the family with only 30 percent. For example, $1 million in a rollover IRA will yield only $300,000 to the family. We use strategies like a subtrust or retirement plan rescue to boost that $300,000 to the $2 to $7 million range (all tax-free), depending on the age and health of the business owner and spouse.
• Investments. A family limited partnership (FLIP) is almost always the strategy of choice. After Joe transfers his investments to a FLIP, the value of the assets are immediately discounted by about 35 percent for tax purposes. That means $1 million of intrinsic value is worth only $650,000 for tax purposes. This yields estate tax savings of $158,000.
These four strategies often kill the estate tax liability. But what if they don’t? We then fall back on one of about 20 life insurance strategies to create tax-free wealth to pay the estate tax.
What if the business owner and his wife are uninsurable? We then use a strategy called a charitable lead trust, which works very similarly to life insurance, to create tax-free wealth for the heirs.
The system as described above always works to kill the estate tax, whether you are young or old, married or single, insurable or uninsurable.
If your professional does not eliminate all of your estate tax burden, get a second opinion.