The easiest way for a successful business owner to create tax-free wealth is by the proper use of life insurance. Unfortunately, because of the complexity of the law, life insurance is also the easiest way to enrich the IRS if you make a mistake. There are dozens of ways that can cause you to fall into an insurance tax trap. For example, wrong ownership of the policy... Wrong beneficiary... That’s the wrong kind of policy. The list goes on and on.
The following are three real-life stories, taken from my private-client files. All concern readers of this column who called me. A common thread — the wrong and right way to use life insurance to create wealth — runs through all these stories.
Story No. 1: Cliff called to tell me his dad (Jim) died two years ago leaving $1.6 million in life insurance (plus various other assets, including the family business) to Mary, his wife. Mary died five weeks later leaving everything to their three children.
Sorry, but it was too late to do effective tax planning. Of the $1.6 million in life insurance, about $640,000 was lost to the IRS. A simple irrevocable life insurance trust (ILIT) would have saved every penny of the life insurance for the kids by avoiding the estate tax monster.
Story No. 2: The facts are almost the same except this time the life insurance policy ($2 million) on Jim’s life was owned by Success Co. (a C corporation owned 100 percent by Jim), which received the $2 million when he died. Soon after Jim died, so did his wife. Cliff (Jim’s son) ran Success Co. The $2 million in insurance proceeds, paid to Success Co., will be socked with at least three taxes: the alternative minimum tax; increase in estate taxes because Success Co. is worth more (with the insurance proceeds); and the tax cost of getting the insurance proceeds (via dividends) out of Success Co. Estimated loss in various taxes (state and federal): $1,180,000 (based on tax rates the year Jim's wife died). Only $820,000 to Cliff. A real tax tragedy!
Burn this rule into your memory: your family corporation (whether a C corporation or an S corporation) should never own or be the beneficiary of life insurance on the life of a major stockholder (one exception: A financial institution requires the insurance as part of the lending process). An ILIT (like in story No. 1) would have saved over $1 million in taxes.
Make sure the proceeds of your policies (old or new) escape the IRS tax net.
Story No. 3: This time Jerry called to tell me he had $8 million in life insurance on his life: some owned by him, some owned by Success Co. We analyzed his insurance policies and the rest of his entire financial situation. Our analysis lead to this decision: cancel all the old policies (Jerry and Success Co. pocketed $802,000 in cash surrender value). Jerry replaced the $8 million in insurance with $11 million in second-to-die coverage (with May, his wife). All premiums will be paid by a “subtrust” (part of Success Co.’s profit-sharing plan). Result: $802,000 tax-free in pocket to start… And ultimately, $11 million in insurance proceeds, with zero out-of-pocket premium cost to Jerry, May or Success Co. Only funds in the profit-sharing plan (via the subtrust) will be used to pay premiums. The entire $11 million insurance proceeds will escape estate taxes. The plan not only saves taxes, it actually will create wealth with no out-of-pocket cost to Jerry and May.
A sure winner
If you have a so-called "paid-up policy" (you no longer pay premiums, but the premiums are paid out of dividends and your accumulated cash surrender value), you are guaranteed to get a significantly larger death benefit by upgrading to a new policy (it's tax-free) without paying one penny more in out-of-pocket premiums. Of course, you must pass a physical. This sure-winner strategy also works if you and your wife have a second-to-die policy. Do you have a paid-up-policy? Call me. I'll walk you through how you can become a sure winner.
What to do with current insurance policies?
It’s a three-step process. 1.) Have an expert analyze your existing policies; 2.) Set up a plan — new policies may be required — that gets you the most insurance coverage needed for the lowest premium cost; 3.) Make sure the proceeds of your policies (old or new) escape the IRS tax net. Yes, there are many more way than an ILIT to avoid the estate tax monster. Always, but always only work with knowledgeable and experienced professionals for each of the three steps.
Here are two ways to help you get started. First, I have arranged for my insurance guru to analyze your existing insurance portfolio. He’s an amazing guy: 90 percent of the time he will get you more insurance coverage for the same premium cost you are paying now or keep the same death benefits you now have, yet lower your premium costs. Just send your policy information (simply a copy of your last bill — or statement — for each policy) to Irv Blackman, 4545 W. Touhy Ave., #602, Lincolnwood, Illinois, 60712. Or second, call me (Irv) at 847/674-5295 to discuss your particular situation.
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.