Dealing with retained earnings and cash

DO YOU HAVE a large amount of retained earnings and excess cash in your corporation, but the double taxing power of the law has your cash locked in the corporation? Most business owners think they are stuck, but there's an easy way out. Here's a true story of one way to get the job done. Joe called me with this problem. Joe and brother Jeff each owned 30% of Success Co., which they managed. Their

DO YOU HAVE a large amount of retained earnings and excess cash in your corporation, but the double taxing power of the law has your cash locked in the corporation? Most business owners think they are stuck, but there's an easy way out.

Here's a true story of one way to get the job done. Joe called me with this problem. Joe and brother Jeff each owned 30% of Success Co., which they managed. Their mom, Mary, age 66, owed 20% in her own name, and a trust (created when their dad died) owned the other 20%. Mary's professional advisers recommended that she obtain $2 million of insurance using an irrevocable life insurance trust to pay the estate-tax liability that would be due at her death (because of the value of the assets she owned directly in her own name and indirectly as a beneficiary of her deceased husband's trust).

The advisers were right. Mary needed the insurance, but she did not have a ghost of a chance of coming up with the annual premium requirements of $32,000 per year for as long as she lived.

I asked Joe lots of questions, conferred with the advisers and requested a large pile of information — stuff like tax returns and financial statements. After discovering that Success Co. had $2.5 million in excess cash, this is what I recommended.

Mary gifts $1.2 million of her Success Co. stock (the total value of Success Co. was appraised at more than $8 million) to a charitable remainder trust. The CRT agrees to pay Mary $72,000 per year for as long as she lives. At Mary's death, the balance (called the " remainder") in the CRT will go to charity. Each year Mary must pay $ 25,000 in income tax on the $ 72,000 of income from the CRT and $32,000 in premiums for the $ 2 million policy, which is owned by the ILIT, or a total of $ 57,000. This leaves Mary an extra $15,000 per year to buy presents for her grandchildren.

You actually create wealth by gifting to charity.

The ILIT will give Mary's children $ 2 million in insurance proceeds when she dies. The entire $2 million will be tax-free.

But where does the CRT get the income to pay Mary? The CRT sells the gifted stock back to Success Co. for $1.2 million.

Let's summarize Mary's tax picture: Mary avoids all capital gains tax on the sale of the Success Co. stock. The balance in the CRT (estimated at $1.1 million) at Mary's death goes to Mary's favorite charity and is free of income tax and estate tax.

In addition, Mary gets an immediate income tax deduction of about $200,000 for her charitable contribution to the CRT. For what, you ask? For the present value of the remainder (of the $1.2 million) gifted to the CRT.

This $200,000 (immediate deduction) results in about $70,000 in cash income tax savings for Mary.

If Mary had sold the $1.2 million of Success Co. stock directly to the company, it would have been taxed as a dividend, resulting in a whooping tax of $180,000.

The use of a CRT in tandem with an ILIT is actually a method for making a tax-advantaged investment for your family. You actually create wealth (make a real economic profit) by gifting to charity.

When to call the pros
All the following topics could have books written about them, but here's a brief recap of the big issues for which you need to call for professional help

1. Business succession. Hands down, this is reason No. 1. The remedy, almost every time, is to use an intentionally defective trust to make the transfer.

2. Control. My remedy is to use: voting/nonvoting stock (you keep the voting and transfer the nonvoting) for your business; a qualified personal residence trust for your residence; and a family limited partnership (sometimes a limited liability company) for your investments.

3. Life insurance. Properly used, insurance — actually a tax-advantaged investment — is a taxpayer's best friend. That's why the rich buy so much of it.

There are a few musts. For existing insurance, have an independent professional analyze your policies. Experience has proven that 93% of the time you will be able to get a better deal.

When buying new insurance: Work with an independent adviser to determine your insurance needs, and then, get quotes from at least two insurance consultants with each of them showing you proposals from four (or more) insurance carriers.

4. Asset protection. A must, in our crazy, litigious society.

Large amount in qualified plans: 401(k), IRA, profit-sharing and others. Gotta have a subtrust, otherwise the IRS gets 73% of the dollar value in your qualified plans, leaving only 27% for the family.

S corporation vs. C corporation. About half of closely held corporations have it backward: S's are C's, and vice versa. The following general rule should help almost every corporation: A C corporation is only the right choice if it has a before-tax profit of less than about $125,000 per year, or your C corporation has a carry-forward loss to be used up.

Irving Blackman is a partner in Blackman Kallick Bartelstein, 10 S. Riverside Plaza, Suite 900, Chicago, IL 60606; tel. 312/ 207- 1040, or via e-mail at [email protected].

TAGS: Taxes