BY IRVING L. BLACKMAN
THE FACTS, PROBLEMS and solutions of this month's column are so typical of the readers who call me for help that I felt compelled to write about them. Read slowly; chances are you will see yourself or someone you know.
Joe (age 74) owns 52% of an S corporation (Success Co.), and each of his three children owns 16% of Success Co. He has two boys, Tom (47) and Dick (43), who have been in business with Joe since they graduated from college. Joe's daughter, Harriet, was not and never will be involved in the family business. Joe lost his first and only wife last year.
The following is a list of Joe's assets:
- Various liquid investments — $190,000;
- 52% of Success Co. — $1.63 million;
- Real estate leased to Success Co. — $600,000;
- Balance in rollover IRA — $780,000;
- Residence and summer home — $435,000;
- Total — $3.635 million
Joe's lawyer, an estate-planning expert with a fine reputation, just completed Joe's estate plan and correctly computed the estate tax (using 2011 rates) at $1,419,771. His only recommendation: Buy $1.5 million in insurance to pay the tax.
Joe called me for a second opinion. After a long telephone conference, the following is how Joe spelled out his goals:
- Control Success Co. and the rest of his assets for as long as he lives;
- When he is gone, to have Success Co. owned 50% each by Tom and Dick;
- Make sure he can maintain his lifestyle for as long as he lives;
- Ensure that the dollar value that Harriet receives from Joe's estate is equal to the amount received by each of her brothers; and
- Find a way to have each of his kids receive one-third of what he is worth now, all taxes paid in full. (Joe laughed a bit at this goal; he didn't think it was possible.)
Here's the plan we implemented for Joe and the strategies we selected to accomplish Joe's five specific goals (in the same order as the goals):
- We recapitalized Success Co. (a tax-free transaction) so Joe now owned 52% of the controlling voting stock (52 of 100 shares) and 52% of the nonvoting stock (5,200 of 10,000 shares).
- We transferred the liquid investments and the real estate to a family limited partnership. As the general partner (owned 1% of the FLIP), Joe kept control of these assets. He will make annual gifts ($12,000 each) of limited partnership interests to the kids. These limited interests (99% of the FLIP) have no voting rights and are entitled to significant discounts (about 35%) for tax purposes. As a result, Joe can give about $19,000 to each kid of limited FLIP interests every year, yet for tax purposes the interests are only worth $12,000.
- Joe sold the 5,200 shares of nonvoting stock to a so-called defective trust (defective for income tax purposes) for $1.5 million plus interest. The trust paid for the stock with a note. Success Co. will distribute S corporation dividends to the trust each year, which will then pay off the note to Joe.
- The beneficiaries of the trust are Tom and Dick, who will each own half of the 5,200 shares when the note is fully paid and the trust terminates. Joe's 52 voting shares will go to Tom and Dick when Joe dies. Success Co. will re-deem the shares owned by Harriet, according to a new buy/sell agreement, when Joe passes on. Then Tom and Dick will each own 50% of Success Co.
- Joe's flow of cash to maintain his lifestyle would come from many sources: a small salary from Success Co., plus all of his usual perks; the note payments from the trust (the entire $1.5 million plus the interest is tax-free to Joe because of the defective trust; and distributions from the rollover IRA.
During the years (about eight to 10) while the note is being paid off, Joe will have more cash than he needs to live. This excess cash will be put into the FLIP (and, of course, will be available for distribution in future years). Actually, all the assets of the FLIP will be available to Joe if needed.
As a final backup, Joe will enter into a death benefit agreement with Success Co. that will pay Joe $75,000 per year starting when Joe retires (probably never) and continuing until the day he dies.
We created a subtrust (using the rollover IRA and Success Co.) to purchase a $1.5 million life insurance policy. The entire $62,187 annual premium will be paid out of plan funds (it won't cost Joe a penny), and because of the subtrust none of the $1.5 million in ultimate policy proceeds will be included in Joe's estate.
Appropriate language in Joe's death documents (will and revocable trust) makes sure Joe's "goal" will be accomplished; the $1.5 million in tax-free insurance makes this goal easy.
The residence (worth $355,000) was transferred to a qualified personal residence trust. The QPRT was set up in such a way that Joe could live in the residence for as long as he lives yet it would be out of his estate.
If Joe gets hit by a bus the day after the plan is put in place, this "Goal No. 5" (the entire $3.635 million to the kids) will be accomplished (along with the four other goals). The longer Joe lives, the less the IRS collects and the more the kids get in excess of the $3.635 million.
One warning: Only work with a tax adviser who knows, understands and has worked with the strategies used for Joe. A will and trust alone, no matter how long or how fancy, will not get the job done.
Irving Blackman is a partner in Blackman Kallick Bartelstein, 10 S. Riverside Plaza, Suite 900, Chicago, IL60606; tel. 312/ 207- 1040, or via e-mail at email@example.com.