Seven Wonders of the Estate-Tax-Saving World

Use these strategies in your lifetime plan to make sure all your assets go to your heirs tax-free.

To avoid tax traps and pass your estate on to your heirs as intact as possible, your overall estate plan must start now, with a lifetime plan. Waiting for your plan to become effective after you die (such as using the typical A/B trust for you and your spouse) won’t allow you any tax savings, and it will enrich the IRS instead of your beneficiaries. 

Importantly, that lifetime plan must be asset-based, meaning that for each significant asset you own, you plan for 1) what you will do with that asset while you are still living and 2) who will inherit it after you die. Each of the following seven “wonders,” or estate-tax-saving strategies, can help you preserve specific types of assets, saving you hundreds of thousands in estate-tax dollars.

1. Intentionally defective trust (IDT). Say Joe wants to transfer his S corporation, Success Co., to his son Sam. If Joe sells the $10 million company to Sam outright, the result is a tax tragedy. Sam will have to earn about $17 million to cover $7 million in federal and state income taxes, and still have the $10 million to pay Joe. Then Joe will have to pay about $2 million in capital gains tax, so his net gain will only be $8 million. Unbelievable: Sam must earn a stratospheric $17 million for Joe (and eventually his heirs) to keep $8 million. That’s crazy.

Under the Internal Revenue Code, using an IDT to make the transfer of the company from Joe to Sam is tax-free to both of them. This strategy incurs neither income taxes nor capital gains taxes. And Joe can accomplish his goal of getting Success Co. out of his estate while still maintaining absolute control of the company for as long as he wants.

2. Spousal asset trust (SAT). Joe and his wife Mary are both in their early 60s and relatively healthy. He is concerned about being able to maintain their lifestyle without income from Success Co. if they live well into their 90s or beyond. An SAT allows them to gift the company to Sam using $10 million of their combined lifetime gift-tax exemption. (For 2016, the exemption is $5.45 million each, or $10.9 million combined.) The “wonder” here is that the SAT allows them to get Success Co. out of their estate, but they will still draw income from the company for the rest of their lives, and, just like with the IDT, Joe will be able to keep control of the company.

3. Family limited partnership (FLIP). Joe owns $11 million of various investment assets that include real estate, cash-like assets, stocks and bonds. Transferring these assets to a FLIP  instead of owning them outright triggers a 35 percent discount in their value for tax purposes. This reduced tax value of $7.15 million means estate-tax savings of $1.54 million.

4. Retirement plan rescue (RPR). This strategy of ours shifts assets from the highly taxed environment of a qualified plan into tax-free life insurance. In doing so, an RPR 1) avoids the income and estate taxes to which funds in a qualified plan such as profit-sharing, a 401(k) or an IRA are subject, and 2) uses plan funds to create additional tax-free wealth. Typically, each $250,000 to $350,000 in a qualified plan can be used to create about $1 million of tax-free wealth.

5. Private placement life insurance (PPLI). This strategy takes otherwise taxable investment profits and income, whether they are capital gains, dividends or interest income, and puts them into a tax-free insurance policy. A PPLI is a form of variable universal life insurance whose cash value can appreciate based on the performance of the investments held in that policy. Since life insurance is taxed differently than other investments, this is another way to get assets to your heirs tax-free after you die.

6. 50/50 titles for personal residences. Joe owns a main residence worth $2 million and a country home worth $1 million. Changing the titles of these residences so that each of them is 50 percent owned by Joe’s personal trust and 50 percent owned by his wife’s trust entitles them to a 30 percent discount on their values for estate-tax purposes. This makes their main residence worth only $1.4 million and the country home’s value $700,000, for tax purposes, resulting in total tax savings of $360,000.

7. Premium financing (PF). This strategy, which is recommended for anyone worth more than $10 million, combines knowledge of tax laws, a bank loan and life insurance. Joe buys a large insurance policy, either single-life or second-to-die insurance, with a death benefit of about $9 million. (Depending on your wealth, you can make this death benefit as high as you want.) Joe does not pay premiums on the policy. Instead, the premiums are paid with bank loans that are repaid after his death. It almost sounds too good to be true: be able to use current wealth as leverage to create additional tax-free wealth while spending only a minuscule amount to pay interest on the loan. But it is true.

These seven strategies, when executed correctly, will help you win the tax game.