This is a war story. Joe, a 60-year old reader of this
column, owned 100% of Success Co. He called me and wanted
to know which of two estate plans he should choose.
Here are the significant facts: Joe's wife Mary is 53 years
old. His only child Sam "31 years old" has worked in the
business since he was 12. Sam owns one share of Success Co.
stock; Joe owns all the rest of the stock: 199 shares. The
business is worth $4 million and has enjoyed about a 10
percent growth in profits in each of the past five years.
This growth should continue into the future. Joe's total
net worth is $10 million including a residence, various
investments (mostly the real estate leased to Success Co.
and a portfolio of stocks and tax-free bonds) and $950,000
in a profit-sharing plan.
The two estate plans Joe asked me to review ("Give me a
second opinion"' in his words) follow. At the core of both
plans was a $4 million life insurance policy on Joe's life.
Plan #1. The life insurance policy would be owned by Sam.
Joe would gift Sam the annual premiums. At Joe's death Sam
would buy Success Co.'s 199 shares from Joe's estate for $4
million. Plan #2. Success Co. would own the $4 million in
life insurance keyman insurance and would redeem the 199
shares from Joe's estate. In the end, the final results
would be exactly the same: Sam would own 100 percent of
Success Co. and the estate would have $4 million in cash
instead of $4 million in stock.
First, the good news:
(1) Joe's estate would owe no income tax on the sale of the
stock. Why?... Because the estate would get a raised basis
equal to the fair market value of the 199 shares on the
date of Joe's death.
(2) No estate tax because the $4 million of insurance
proceeds will wind up in Mary's trust and receive the
benefits of the 100 percent tax-free marital deduction.
Sounds pretty good. Joe loved it.
Yes, it is a good plan. Certainly better than no plan at
all. As a matter of fact, either of the plans outlined
above""or some variations""is the most popular way of
transferring a business to the next generation.
Now the bad news: two problems always cause us to turn
thumbs down on any such plan:
(1) Joe's team of professional advisors forgot that Mary
did not need the income that would be produced by the $4
million of insurance proceeds. The other $6 million of
assets owned by Joe is more than enough to take care of her
lifestyle needs.
(2) When Mary passes on, the IRS is guaranteed a big
payday; 55% of the $4 million, that's right, the IRS will
get $2.2 million and the family only $1.8 million.
Plus a huge undeserved bonus to the IRS of 55% of the
after-income tax balance on the income in(1) above, which
is explained in the following paragraph. An outrage!
Continuing with (2) above, watch this tax disaster unfold.
Mary is a healthy 53-year old with a normal life expectancy
to age 83. Her grandparents, on both sides, all lived to
age 92 or older. Good genes.
Mary's mom and dad are in their late 70s, healthy and lead
an active lifestyle. Let's say Mary lives to age 85. That's
32 years of earnings on the $4 million in her trust. Let's
use a conservative after-tax earnings of 4%. Have you any
idea of how much that $4 million will grow to in those 32
years? Would you believe $16 million?... Really that's the
number.
And what do you think the IRS's bite would be?... An
amazing $8.8 million.
Lousy planning! Yet, that's the way most business owners,
on the advice of their professionals, do it. What should
you do when your facts are the same or similar to Joe's
facts?
Here's the four-step plan put in place for Joe:
Step #1. Success Co. elected S corporation status. We
recapitalized the company so Joe wound up with 99.5 percent
of the voting stock"100 shares"(So Joe could keep control
of Success Co. for as long as he lived.) Then, Joe sold the
non-voting stock "19,900 shares" to an intentionally
defective trust (IDT). The non-voting stock, under the tax
law, is allowed to take various discounts. So, the value of
the Success Co. stock Joe sold to the IDT, for tax
purposes, was only $2.4 million (actually almost all
profit, because Joe started Success Co. 31 years ago with
$12,000, most of it borrowed.) The IDT trust is a wonderful
creature under the tax law that allows Joe to collect the
entire $2.4 million (plus interest) tax-free. Also, the
IDT takes Success Co. out of Joe's estate, avoiding another
big tax loss to the IRS.
Step #2. We initiated a strategy called retirement plan
rescue (RPR), using the $950,000 in the profit-sharing
plan, to acquire a $4 million second-to-die life insurance
policy on Joe and Mary. We created an irrevocable life
insurance trust (ILIT) to own this policy. Because of the
RPR and the ILIT, none of the $4 million in insurance
proceeds will be subject to income tax or estate tax. Every
penny will be tax-free.
Step #3. Joe decided to invest a portion of the funds in
the profit-sharing plan in senior settlements (SS) to help
pay the life insurance premiums in Step #2. SS earn an
average of 15.82% per year without market risk (created by
a public company that sells on the NASDAQ).
Step #4. We created a family limited partnership (FLIP) to
hold Joe's investments and started an annual gift-giving
program to give interests in the FLIP to Joe's and Mary's
other two children (neither are in the business). The
four-step plan we substituted for the original proposed
plans will increase the amount of wealth Joe and Mary will
leave to their family by an estimated $5.5 million
(increasing every year Mary lives and growing to over $14
million if Mary lives to age 85, as explained above) more
than the original plans.
Joe was right: He sure needed a second opinion.
----------------------------------------------------
Irving Blackman is a very experienced CPA and lawyer. He is
the founding Partner of Blackman & Kallick, the largest
independent CPA firm in Illinois. He is also the founding
Chairman of the Board of New Century Bank of Chicago.
He is the author of 8 books and is currently being
published in 59 business trade publications in the USA.
His web site is http://www.taxsecretsofthewealthy.com .
If you want to contact Irv, please call 888-278-3623.
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