Missed Opportunities

Finished your estate plan? You may be overlooking some potential tax breaks.


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This article tells the story of Joe, a typical owner of a family business who decides it is time to establish his formal estate plan. Joe (age 63) organized a meeting with his long-time friend and CPA, Chuck, and his lawyer, Lenny, who specializes in estate planning.

To start, Chuck computed Joe’s estate tax liability based on his current wealth. He prepared a worksheet that showed all of Joe’s assets and their values, the potential estate tax liability ($4.08 million), the liquid assets available to pay that estate tax ($807,300), and the shortfall (about $3.27 million). Chuck and Lenny recommended that Joe buy a $2.5 million term life insurance policy on his wife, Mary (age 57), that Joe would own and that would be used to pay potential estate taxes. Lenny also presented the rest of his plan for Joe, which included a typical traditional estate plan, pour-over wills and A/B trusts.

Joe purchased the life insurance policy on Mary, but he was not comfortable with the rest of this plan and called us for a second opinion.

First, we zeroed in on the most common errors we see closely held business owners like Joe make in their estate planning that cause them to lose millions of dollars of their wealth to the IRS. And by “errors” I really mean missed opportunities to save on estate taxes.

We started by taking a closer look at Joe’s personal wealth. His net worth is $21.1 million. This includes Success Co., the business of which he is the sole owner and that is worth $6.6 million. It nets about $1.2 million per year after Joe is paid a $290,000 salary, along with many fringe benefits. Joe also holds $10.4 million in various investments (mostly real estate), $1.8 million in a 401(k), $800,000 in miscellaneous assets and, finally, a $1.5 million life insurance policy on himself.

The Tax Loophole

There is a huge loophole in the tax law that allows the value of certain assets to retain their real, fair market value, yet enjoy a lower, discounted value for tax purposes. The following table shows exactly what that discount is, according to the type of asset and the tax strategy that will enable the holder to realize the discount.

Asset      Strategy                Discount
Business                 Non-voting stock       40%
Investments       FLIP         35%
Residence            Split ownership 30%

We used all three of the above strategies to help Joe minimize his estate tax liability. The discounts totaled $6.52 million, bringing the taxable value of his estate down from $21.1 million to about $14.6 million. (Actually, after including the $1.5 million insurance policy that Joe already owned, the value of his estate for tax purposes was now $12. 6 million. I’ll address that insurance policy in a minute.)

The overall goal of these tax strategies was to remove Joe’s major assets from his estate. First, we created a family limited partnership (FLIP) to hold his investments. Here, gifts to Joe’s three children are the weapon of choice. Joe and Mary can each make tax-free gifts of $14,000 to each child, and they can also each take advantage of a portion of a $5.43 million lifetime gift-tax-free credit.

Next, we created an intentionally defective trust (IDT) and used it to transfer newly created non-voting stock in Success Co. to Joe’s children, without incurring taxes for Joe or the children. Although these assets were out of Joe’s estate, he was able to continue to control the company with new voting stock in Success Co.

Finally, we changed the title on Joe and Mary’s house so that an A/B trust in Joe’s name owned half of the residence and one in Mary’s name owned the other half.

Insurance can be the Go-To Strategy

As I said earlier, Joe owned a $1.5 million life insurance policy and had purchased a new $2.5 million policy on Mary’s life that would be used to pay estate taxes. We recommended some changes regarding these two policies.

The $1.5 million policy required annual premiums of $19,501 and had a cash surrender value (CSV) of $64,000. A better option was a second-to-die policy, because it will incur no estate tax until after both Joe and Mary die. Joe dropped the old policy and pocketed the $64,000 CSV. We then set up an irrevocable life insurance trust that purchased a $1.5 million second-to-die policy with a lower annual premium of $16,023. Having the trust own the policy rather than Joe or Mary would keep the death benefit out of their estate.

Because we eliminated the bulk of the estate taxes that the $2.5 million policy on Mary’s life was intended to cover, this policy was no longer needed. However, when we explained to Joe that its premiums could be paid by the IDT, he decided to have the IDT buy another second-to-die policy for $2.5 million for the benefit of their children, and, of course, it was structured to be estate-tax-free.

Life insurance may be the most misused tool in estate planning. Wrong type of policy. Too-high premiums. Proceeds subject to estate taxes. Over-insurance and under-insurance. I could write a book. In general, you should review all insurance policies you own once a year and get a second opinion before you buy new ones. The result may be significantly higher death benefits for the same premium dollar.