I’ll bet the farm that at least half of you planning your estates can relate to the following example:
Joe (age 62) owns Success Co., which employs 82 people, and his son Sam runs the day-to-day operations. When Joe got the “let’s-do-my-estate-plan” itch, he went to see his lawyer Lenny.
Joe told Lenny the following: His wife, Mary, is 63. They have three children and seven grandchildren. Sam, 38, is the only kid working at Success Co., which is an S corporation. Joe wants to keep working until he dies, but to a lesser degree.
Joe has five goals: transfer Success Co. to Sam without getting killed by taxes; treat the two non-business kids equally; keep control of his assets; minimize estate taxes; and make a substantial contribution to charity.
Success Co. is worth about $9 million. In addition, Joe’s four most valuable assets are real estate leased to Success Co., worth $1.3 million; a 401(k) plan, worth $1.8 million; various liquid investments, including stocks, bonds, CDs and other cash-like assets, with a total value of $4.6 million; and two homes, valued at $1.9 million. Other assets bring Joe’s total net worth to more than $20 million. Also, Joe owns a $3 million life insurance policy with a cash surrender value of $462,000.
Lenny delivered the completed plan nine months later. Guess what? The plan was simply two documents: a pour-over will and an A/B revocable trust. Frustrated, Joe called me.
With a few minor changes, Lenny’s traditional documents were used as part of Joe’s final estate plan. Lenny’s cover letter made a few major points. Success Co. would go to Sam after Joe’s death. After both Joe and Mary passed away, the rest of the assets would be divided equally between the two non-business children. The $3 million life insurance policy plus the liquid assets would pay the anticipated estate tax. The letter also suggested that the $3 million insurance policy be transferred to an irrevocable life insurance trust.
On the surface, a pour-over will accompanied by an A/B trust (called a “traditional estate plan”) looks good, but it is nothing more than a death plan. It does not go into action until Joe and Mary are dead. It’s a two-trick pony: It defers the estate tax until Mary dies, and it avoids probate.
Alone, a traditional estate plan does not have a chance of conquering the estate tax and accomplishing Joe’s goals. The answer to estate planning is to use two plans: a traditional and a lifetime plan.
Here are three steps to create a lifetime plan:
• Step 1. List each of your significant assets.
• Step 2. List your goals for each asset.
• Step 3. Select the appropriate strategy to accomplish your goals.
HINT: Life insurance is considered an asset.
The following is an outline we used for Joe and Mary’s lifetime plan. The goal was to transfer Success Co. ($9 million) to Sam and the rest of the assets ($9.5 million) to the two non-business kids. To get equal value to each of the kids, we would need $18 million ($9 million × 2) for the two non-business kids. The shortage would be made up with the purchase of second-to-die life insurance on Joe and Mary (including the $3 million in current coverage on Joe, which would be replaced with second-to-die coverage). The $1.8 million 401(k) would be used to fund an additional purchase of $3.6 million in second-to-die life insurance. That way, $1.8 million would go to charity and $1.8 million would go to the non-business kids.
Here’s how the lifetime plan actually worked:
• For Sam. Success Co. ($9 million) was transferred to Sam using an arbitrage ILIT, which is a combination of an irrevocable life insurance trust and an intentionally defective trust. This type of ILIT enabled the transfer of the non-voting stock of Success Co. to a trust with Sam as the beneficiary. This was done tax-free. Joe kept control of Success Co. by retaining 100 shares of voting stock while selling 10,000 shares of non-voting stock to the ILIT. The tax-free, S-corporation dividends from Success Co. were used to pay Joe for the non-voting stock and purchase second-to-die life insurance.
• For the non-business kids. The $4.6 million liquid investments and the $1.3 million leased real estate were transferred to a family limited partnership (FLIP). These assets were then entitled to a discount (about 30 percent), making their value about $4.1 million for tax purposes. For 2011 and 2012, a temporary gift tax window allows $5 million per person ($10 million if married) as a one-time, tax-free gift. Joe and Mary took advantage of this law by gifting the limited partnership units (99 percent) to these two kids. Joe and Mary maintained control over the assets by keeping the general partnership units (only 1 percent).
The two homes will be left to the two non-business kids using a strategy called a “qualified personal residence trust” and a small portion of the $5 million window.
In the end, the lifetime plan created for Joe and Mary should easily accomplish all of their goals: transferring Success Co. to Sam, treating the two non-business kids equally, making a significant gift to charity without reducing the children’s inheritance and eliminating the impact of the estate tax.