Sleepless in Estate Planning

Overlooking valuable tax strategies will cost you more than just some shut-eye.


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What keeps this estate tax/succession planner up at night? Mistakes. Mistakes professional advisors make that cause readers of this column to unnecessarily lose dollars to the IRS.

Sixty-three-year-old Joe’s estate plan, completed by a lawyer who specializes in estate planning, consists of well-drawn wills and A/B trusts—but nothing else. Joe’s net worth is $24 million, and he and his 62-year-old wife, Mary, also own two life insurance policies totaling $4.2 million. If he and Mary died today, the estate tax monster would get about $6.9 million. Ouch!

The mistake made by Joe’s advisor (and often made by most others) was overlooking important tax-saving and tax-free-wealth-creating strategies. Correct mistakes like these, and you can enrich yourself and your family instead of the IRS.

Mistake 1: Believing that an A/B trust can save on estate taxes. Creating an A/B trust is a good start. It avoids probate (the legal process for handling a deceased person’s estate) and spells out who will get which of your assets after you die and when. An A/B trust cannot, however, save you even one cent in estate tax. It just defers estate taxes until the second spouse dies.

Mistake 2: Leaving assets in joint tenancy. Joe and Mary acquired various assets during their married life. Most were titled as joint tenancy (joint ownership). The problem with such an arrangement is that when one of the tenants dies, the survivor owns 100 percent of each joint-tenant asset. The resulting tax consequences are 
terrible, and an A/B trust that leaves one or more those joint assets to one’s heirs is useless.

Individuals are allowed a federal estate tax exemption. In 2015, this amount was $5.43 million per person. A couple can’t maintain both individual exemptions if they hold their assets in joint tenancy, however. So when one spouse dies and the survivor adds the deceased’s share of the estate to his or her own assets, that survivor still only gets an estate tax exemption covering $5.43 million of the now combined assets.

The solution is to simply transfer titles of all assets that you want covered by the A/B trust to the trust itself. This prevents losing any part of the federal estate tax exemption when the first spouse dies.

Mistake 3: Overpaying payroll taxes. Joe rarely goes into the office but is constantly consulting with his two sons, Sam and Tim, who run the operations of Success Co., the company Joe founded. Joe continues to take a $475,000 annual salary, incurring outrageous payroll taxes for the company of about $29,500. Cutting his salary to $120,000, just above the amount required for him to maximize Social Security benefits ($118,500 for 2015) results in more than $14,500 in payroll tax savings every year.

Mistake 4: Not getting a business out of the owner’s estate. Success Co. was professionally valued at $6.5 million. For the past several years, net profits have grown in the range of 8 to 12 percent, increasing the company’s value by about $1 million annually and the potential estate tax liability by about $400,000 per year. This trend is expected to continue.

To get the business out of Joe’s estate, we used a two-step strategy. First we recapitalized Success Co., eliminating the existing common stock, and issuing 100 shares of voting stock and 10,000 shares of non-voting stock—a tax-free transaction. Joe and Mary kept the voting stock and control of the company, and then sold the non-voting stock to an intentionally defective trust (IDT) for $3.9 million (the company’s value after discounts allowed by the tax law).

The IDT paid Joe in full with a $3.9 million note, plus interest of 3 percent. Success Co.’s future cash flow will be used to pay the note and interest. Because the IDT is intentionally defective for income tax purposes, the payments received by Joe (both principal and interest) are tax-free.

Normally, the trustee would distribute the non-voting stock to the trust’s beneficiaries (in this case, Sam and Tim) once the note is paid in full. However, since both men are married, the trust will retain the stock for their benefit so that it will not be considered an individual asset in the event of a divorce. The sons will still enjoy income from Success Co., however. 

On average, an IDT will save about $190,000 in taxes per $1 million of the price. (In this case, Joe saved $741,000—3.9 times $190,000.)

Mistake 5: Not creating a family limited partnership (FLIP). Joe and Mary had $12 million in various investments, including a stock and bond portfolio, and real estate. Putting these assets in a FLIP, a tax-free transaction, yields a discount of about $4 million on those investments, saving the couple $1.6 million in estate taxes.

Mistake 6: Leaving life insurance as is. Mary’s $2 million life insurance policy had a cash surrender value (CSV) of $953,000 and Joe’s $2.2 million policy had a CSV of $1.22 million. We transferred ownership of both policies to an irrevocable life insurance trust (ILIT), using up about $2.17 million of a $10.86 million lifetime exclusion. We then cashed in the two existing policies and purchased a second-to-die policy on Joe and Mary in the amount of $5.9 million. There are no more annual premiums, and the ILIT will keep the entire $5.9 million out of their estate. We not only eliminated the impact of estate taxes, but increased the amount of tax-free wealth Joe and Mary will leave to their heirs.