The answer: Mistakes. Actually, mistakes that professional advisors make, causing readers of this column to lose unnecessary dollars to the IRS.
You are about to read the story of a real-life column reader, Joe, who is 63 years old, married to Mary, age 62. Joe e-mailed me asking, “Can you give me a second opinion on my estate plan, just completed by my lawyer (Lenny, who specializes in estate planning)?”
The new estate plan consists of typical wills and A/B trusts (all well drawn), but nothing else. Joe’s net worth is $24 million, plus two life insurance policies totaling $4.2 million: (see mistake No. 6). All numbers are rounded. If Joe and Mary got hit by the same bus, the estate tax monster would get about $6.9 million. Ouch!
Let’s review the mistakes Lenny made (actually, tax-saving and tax-free-wealth-creating strategies that most advisors miss). Read closely. Chances are you’ll recognize mistakes (and how to correct them) that will enrich you and your family instead of the IRS.
Mistake No. 1: A/B trust can save taxes. An A/B trust is a good start... it avoids probate. It also spells out who will get which assets you own after you go to heaven and when they get the assets. But sorry, it cannot save you even one cent of estate tax.
Mistake No. 2: Leaving assets in joint tenancy. Joe and Mary acquired various assets during their married life. Most were titled as joint tenants. A no, no! Why? Because when one joint tenant dies, the survivor owns 100% of each joint tenant asset. Result: The tax consequences are terrible.
What about the A/B trust that leaves one or more of those joint assets to your heirs? Useless! What should you do? Transfer title to all assets that you want covered by the A/B trust to the trust. It’s that simple. (Lenny failed to make the title changes. We did.)
Mistake No. 3: Overpaying payroll taxes. Joe rarely went into the office. He was constantly on the phone consulting with his two sons (Sam and Tim) who ran Success Co. Yes, Joe slowed down, yet he continues his $475,000 annual salary. The outrageous payroll tax cost ... about $29,500. We cut his salary to $120,000, just over the amount required to maximize social security benefits ($118,500 for 2015). The result: over $14,500 payroll tax savings every year.
Mistake No. 4: Not getting Success Co. out of Joe’s estate. Success Co. was professionally valued at $6.5 million. Every year for the past eight years, net profits grew in the 8% to 12% range, increasing the value of Success Co. about $1 million (and the potential estate tax liability by about $400,000) per year. This trend is expected to continue. What to do?
We used a two-step strategy: 1.) We recapitalized Success Co. (eliminated the existing common stock and issued 100 shares of voting stock and 10,000 shares of non-voting stock... a tax-free transaction). 2.) Joe and Mary kept the voting stock and control; and sold the non-voting stock to an intentionally defective trust (IDT) for $3.9 million (after discounts allowed by the tax law).
The IDT paid Joe in full with a $3.9 million note, plus interest of 3%. The future cash flow of Success Co. will be used to pay Joe’s note, plus interest.
Because the IDT is intentionally defective for income tax purposes, the payments received by Joe (both principal and interest) are tax-free.
When the note is paid in full, the trustee would normally distribute the non-voting stock to the trust beneficiaries (Sam and Tim). However, since both boys are married the trustee will keep the stock for their benefit. Why? In case of a divorce, the stock would not be an asset considered in the divorce matter. Of course, now the boys would enjoy the income from Success Co.
On average an IDT will save you about $190,000 in taxes per $1 million of the price (here Joe saved $741,000... 3.9 times $190,000).
Mistake No. 5: Not creating a family limited partnership (FLIP). Joe and Mary had $12 million in various investments: stock and bond portfolio and real estate. Putting these assets in a FLIP yields a discount of about $4 million, (saving them $1.6 million in estate taxes), yet retaining control.
Mistake No. 6: Leaving the life insurance as is. Here are the facts before I entered the picture: Mary’s $2 million policy had a cash surrender value (CSV) of $.953 million; Joe’s $2.2 million policy had a CSV of $1.22 million. We transferred the policies to an irrevocable life insurance trust (ILIT), using up about $2.17 million of their $10.86 million lifetime exclusion.
Then, I called in my insurance network guru who cashed in the two existing policies and purchased a second-to-die policy on Joe and Mary in the amount of $5.9 million (using the CSV of the two old policies). No more premiums. And the ILIT will keep the entire $5.9 million out of their estate.
In the end, we not only eliminated the impact of the estate tax, but increased the tax-free wealth (because of the insurance) Joe and Mary will leave to their heirs.
Finally, here’s a plan to help you save a ton of taxes (and allow me to sleep better) while helping the Red Cross. My book, Tax Secrets of the Wealthy sells for $367. It shows you step-by-step how to eliminate the estate tax, whether you are worth $10 million or $100 million. Simply write a check to the Red Cross, for $100 or more, and the book is yours.
Send your check to Irv Blackman, 4545 Touhy Ave., #602, Lincolnwood, Ill., 60712. Affix your check to your business letterhead (just your name, address and phone number if you are not in business).
As always, if you have a question, call me (Irv) at 847/674-5295 or email me at [email protected].
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.