Often, I feel like an old-fashioned doctor who makes house calls. The difference is that my patients are sick of paying taxes. I recently visited a successful family business in North Carolina, owned by Joe, a semi-retired 64-year-old and run by his son, Sam, a 36-year-old.
Joe called me because he wanted a second tax opinion for a business transfer plan and an estate plan that he put in place almost 2 years ago. This is the story of the symptoms, the diagnosis and the "magic tax potions" that cured the patient.
Let's examine the facts: Joe owns 98 percent of two corporations: a profitable S corporation (Success Co.), which operates a string of stores, and a C corporation (a tax-paying corporation called R/E Co.), which owns real estate leased to Success Co. The real estate has an income tax basis of $1 million, but a current fair market value of about $6 million. Sam owns the remaining 2 percent of the stock of both corporations. Each of the corporations is the owner and beneficiary of a separate $1 million insurance policy on Joe's life.
Four more details are thrown into the mix: 1) Joe's second wife, Mary, is 45 years old, and they have a premarital agreement under which Mary will receive the income from half of the value of Joe's assets at this death for as long as she lives. However, none of Success Co.'s stock can be used to provide Mary her income. 2) An artificially low price in a buy/sell agreement would force Joe's estate to sell his stock in Success Co. back to Success Co.; and the same goes for R/E Co. The result: Sam would own 100 percent of both corporations. 3) Joe has two other grown children who are not in the business. 4) Joe is not insurable.
The diagnosis: 1) The $1 million in life insurance payable to R/E Co. would kick up an unnecessary alternative minimum tax. 2) The full $2 million of insurance would be included in Joe's estate because he controls both corporations, but the $2 million (less the alternative minimum tax of about $150,000) would belong to the corporations, not Joe's estate. 3) There are not enough liquid assets to satisfy the obligation to Mary, and yet, if the obligation to Mary is met, there would be nothing left (outside of the corporations) to pay an estimated $3.5 million estate tax liability. Simply put, the estate would be broke.
Our objectives to cure Joe's tax illness are clear: reduce the value of Joe's estate, get cash to fund the obligation to Mary and pay the estate tax.
Here are the five tax remedies I recommended to cure Joe's business transfer and estate plan:
- Merge R/E Co. into Success Co. This maneuver is tax-free. R/E Co. is worth about $6 million as a real estate investment company, but, as part of the operating company, its value is reduced by at least $2 million for estate tax purposes. The estate tax savings would be more than $1 million.
- Transfer the nonvoting stock (created after the merger) to a grantor retained annuity trust (GRAT), which reduces the value of Success Co. by about 40 percent for estate tax purposes. This maneuver saves about half a million dollars in estate taxes.
- Joe takes the $2 million in insurance policies out of the corporations and gives it to his children. What results is that the value of Joe's estate drops $2 million and will save another $1 million plus in estate tax.
- Change Joe's will to transfer the entire estate tax obligation to the children. The $2 million in income tax-free/estate tax-free insurance proceeds will handle the entire estate tax load when Joe dies.
- Make sure Joe's will qualifies for the 100 percent marital deduction for Mary's half share, thus deferring any estate tax on this portion of Joe's estate until Mary dies.
There are other details and nuances in the plan, including gifts to Joe's children, but these five tax remedies were sufficient to cure the patient.