As a group, baby boomers are huge. There are 77 million of them! Born between the years 1946 and 1964, they are maturing into retirement age. But the oldest of them are redefining retirement. They are slowing down, but continue to work. One thing is certain: all of them are at an estate planning age. Roughly 70% of our current estate planning practice helps clients who fall into the baby boomer age bracket.
The three common goals for almost every estate plan we do are eliminate or minimize taxes (income tax and estate tax); maintain control of your assets especially your business, for as long as you live; and maintain your lifestyle. It should be noted that some clients, usually worth north of $25 million, are no longer concerned that maintaining their lifestyle could become a problem.
In 2008, three years before the oldest baby boomers reached the traditional retirement age of 65, my network of professionals decided to test how well estate plans were being done to accomplish those three common goals. So we marketed to get more reviews of completed estate plans, which were done by other professionals. We targeted business owners with a minimum net worth of $10 million.
Here’s a brief summary of the results to date: Few plans came close to accomplishing the common goals, especially the first goal of not losing significant tax dollars to the IRS. But what was the biggest shock? Not one of these well-to-do clients had a comprehensive life time plan for saving taxes during the client’s life; strategies to implement during life that would reduce the estate tax; and strategies to create tax-free wealth.
Six of the plans created irrevocable life insurance trusts (ILITs) to own life insurance to pay the estate tax. A good lifetime planning move! All but three of the clients owned successful businesses. Half of these plans did nothing about a succession plan, while the other half (with a succession plan) did not use the most tax effective way of transferring the businesses. The below example shows you the right way.
Joe (60 years old) is a poster boy for the subject matter. Joe read my articles then he called me for help. Joe sent me a package of information including year-end financial statements for his business, Success Co. (which he owned 100%); a family tree (married to Mary, age 64, and has five kids, four of them – including Sam – work in the business, and nine grandchildren); a personal financial statement showing that Joe and Mary are worth $49 million; and copies of their current estate planning documents. After reviewing all this information, the documents the lawyer drafted were fine and, except for some minor amendments, were left alone. It’s what the lawyer did not do that makes Joe’s story, which follows, fascinating.
Here’s a summary of Joe’s significant assets (in millions of dollars):
Success Co. (IDT) $20
Two residences (QPRTs) 3
Real estate, rental income (FLIP #1) 7
Cash, stocks, bonds (FLIP #2) 16
401(k) (RPR) 3
Success Co. (an S corporation) earns enough profit each year, when added to Joe’s salary and other income, that Joe’s wealth increases about $1.6 million per year (after taxes and money spent to maintain his and Mary’s lifestyle).
Joe has two other significant goals: leave the entire $41 million of his current net worth (or whatever amount it might grow to before he gets hit by the final bus) all taxes paid in full, to his family and leave $10 million to his favorite charity as long as this gift does not reduce the inheritance to his kids and grandchildren.
Most estate planners fail to do lifetime planning and unwittingly cost their clients millions of dollars in unnecessary taxes. Here are some strategies that can be utilized:
Reducing value of assets:This is done for tax purposes and gets assets out of Joe’s estate, yet he keeps absolute control. First, we recapitalized Success Co. (created voting stock of 100 shares and nonvoting stock of 10,000 shares). The nonvoting shares are entitled to various discounts, totaling about 40%, under the tax law. So, Success Co. is only worth about $12 million (after discounts) for tax purposes. Joe sells the nonvoting stock to an intentionally defective trust (IDT) for $12 million. The IDT pays Joe with a note. The cash flow of Success Co. is used to pay the note and interest. The $12 million, plus interest, is tax-free to Joe because of the IDT rules. Tax savings, capital gains tax and income tax are about $2.3 million for Joe. Almost, the full value of Success Co. is out of Joe’s estate, yet he still has absolute control as the owner of all the voting stock. Sam, as the beneficiary of the IDT, will receive the nonvoting stock (tax-free) when Joe’s note is paid in full. Sam will not pay one penny for the stock.
Residences: A qualified personal residence trust (QPRT) allows you to transfer, up to two residences to your heirs, yet you can live in the homes for as long as you like. Joe and Mary transferred their two homes to two separate QPRTs, removing them from their estate.
Real estate, rental income: This real estate was transferred to a family limited partnership (FLIP #1). Joe and Mary own one percent (1/2% each), as general partners, and have control of the assets. They own 99% as limited partners (have no voting rights), and because of this are entitled to a discount (for tax purposes) of about 35%. So, for tax purpose, this $7 million asset is only worth $4.55 million. Wow! Joe and Mary gift the limited partnership interests to the kids and grandkids… a bit each year ($26,000 per child and grandchild).
Cash, stocks, bonds: Joe transferred $14 million in stocks and bonds to FLIP #2. Again, like FLIP #1, this partnership has voting and nonvoting interests. After discounts, the nonvoting interests were valued at under $10 million. Using the $5 million per person special gift tax rules (only law for 2011 and 2012, then set to drop back to $1 million in 2013 and thereafter), we made gifts of all the nonvoting units to the kids and grandkids. Remember, it’s $5 million per person, so Joe and Mary made $10 million in tax-free gifts (plus the $26,000 annual exclusion per child and grandchild used in FLIP #1 above).
Other lifetime strategies
Captive insurance company: We created a captive insurance company (Captive) as allowed under Section 831(b) of the Internal Revenue Code. This allows us to have Success Co. pay $1.1 million to the Captive, which Success Co. deducts. But the Captive receives the entire $1.1 million tax-free. The Captive (a C corporation) is owned by the business children and is out of Joe’s estate.
Buy-sell agreement: An insurance-funded buy-sell agreement was drawn to make sure the stock of Success Co. stays in the family. All four of the business kids were included.
Joe had a term policy for $10 million with nine years left before the term was up. Lenny felt that this policy and the $17 million in cash-like investments was enough to cover the potential estate tax liability. We had Joe drop the term policy. A sad statistic: 98% of all term policies never pay a death benefit. Why? The term expires before the insured goes to heaven. Result: Premiums were wasted. Instead, we used various strategies to acquire $30 million of life insurance: $10 million on Joe and $30 million of second-to-die on Joe and Mary. The way we set it up, Joe never wrote a check to pay a premium using his own funds.
Briefly, here’s how we did it. Joe created a family foundation. Every year he would contribute the required premium to the foundation, take a charitable deduction and have the foundation pay the premium on the $10 million policy. When Joe dies, the foundation will give the $10 million insurance proceeds to his alma mater.
The premiums for the $20 million policies were paid from various sources: the 401(k) (using a retirement plan rescue, RPR), FLIP #1, FLIP #2 and the IDT. The ownership of the policies were structured so the $20 million will not be taxable in the estates of either Joe or Mary.
One warning: This article does not attempt to over every detail, tax rule, exception and possible tax-trap. Make sure you have your second opinion done by a competent and knowledgeable advisor with experience in not only estate planning, but also lifetime planning.
Irv Blackman, CPA and lawyer, is a retired partner of Blackman Kallick LLP and chairman emeritus of the New Century Bank, both in Chicago. He can be reached at 847-674-5295, e-mail [email protected], or on the Web at: WWW.TAXSECRETSOFTHEWEALTHY.COM.