Well, maybe there is something new under the sun. Readers of this column know that your author often writes separate articles about the tax magic of an ILIT (irrevocable life insurance trust) and an IDT (intentionally defective trust).
An ILIT is also known as "the super trust" because it allows the death benefits (of the life insurance it purchases) to be received tax free, no income tax, no estate tax. A fly in the ointment? Yes, necessary gifts each year by the trust creator to pay premiums kicks up a gift tax problem. The larger the premium the larger the problem, which this marriage eliminates (and in addition, creates a host of tax-free and wealth-building opportunities).
An IDT, also irrevocable, is defective only for income tax purposes. In all other respects, including estate taxes, it is the same as any other irrevocable trust. An IDT is the perfect strategy to transfer income producing assets, like a family business and/or real estate, from dad and/or mom to kids. The transfer is tax-free to dad and the kids. For example, when transferring a closely held business, the tax savings run about $200,000 per $1 million of the stock value. For example, a $7 million price for a family business saves $1.4 million in taxes. Cool!
Okay, we are ready for the wedding ceremony of ILIT and IDT. But before tying the knot, there is one more concept you should know: "arbitrage," which Webster defines as, "The purchase and sale of the same or equivalent security in different markets in order to profit from the price discrepancies." Keep your eye on the word “profit.”
Here's what makes this marriage work: If you own an asset that currently earns a rate of return that exceeds today’s low-interest rates, you can use the arbitrage profit to pay insurance premiums, creating tax-free wealth, while avoiding the loss of any dollars to the IRS for taxes.
Wait, there's more: crazy American tax law allows you to take various discounts (like discount for lack of marketability and discount for minority interest) that reduce the real market value of the asset in the 30% to 40% range for tax purposes. Increase the arbitrage profit and make the tax-savings a slam dunk.
Now, let's run through an easy to understand seven-step example to initiate and complete an arbitrage ILIT.
Step No. 1: Create the arbitrage ILIT. Remember, your lawyer must create the trust defective for income purposes, combining the ILIT an IDT in one document. Joe is our tax hero in this example. Joe will be responsible to personally pay the income tax due on all trust earnings. Why? Because the trust is ignored for income tax purposes. Before going to the next step, let's look at some basic facts: Joe is married to Mary, both are age 65 and in good health. The insurance consultant quotes the cost of a second-to-die policy at $11,832 per $1 million of death benefit. Joe owns Success Co. (an S corp. worth $6 million) which is run by his son Sam. Joe and Mary want Sam to own Success Co. A major concern is how to treat their two non-business kids equally. Aside from Success Co., they have $5 million of other assets, about one-half is liquid.
Step No. 2: Select the asset to sell to the ILIT. Typically, the creator (Joe) of the ILIT will sell one of three types of assets to the ILIT: the stock of a closely held business; an interest in a FLIP (family limited partnership), which owns real estate and/or securities; or an interest in an LLC (usually holding real estate). No matter what type of asset is selected, the transaction is arranged so Joe keeps absolute control of the asset for as long as he lives, even though the asset is out of his estate.
Joe decides to sell all of the non-voting stock (10,000 shares) he owns in Success Co. to the ILIT, keeping all (100 shares) of the voting stock. Get the picture? Joe gets Success Co. out of his estate while keeping absolute control (with less than 1%, the non-voting stock, of the Success Co. shares). Note: If you don’t have non-voting stock it’s an easy tax-free transaction to create voting and non-voting stock.
Step No. 3: Have the asset sold to the ILIT professionally valued. No messing around. You want to get a professional valuation of the asset, with the expert determining the discount of the asset: almost always (a) about 40% for the non-voting stock of a family business, so $1 million of stock is only worth $600,000 for tax purposes and (b) about 35% for a limited partnership interest in a FLIP, so $1 million of such an interest is only worth $650,000 for tax purposes. These discounts super-charge the arbitrage profit.
Success Co.'s 10,000 shares of non-voting stock are valued at $6 million as its fair market value, but the appraisal expert applies a 40% discount making the stock worth $3.6 million for tax purposes (after a 40% discount of $2.4 million). It should be noted that future earnings of Success Co. are estimated at $1.2 million per year.
Step No. 4: Pay for the assets sold to the ILIT. The ILIT pays Joe in full for the 10,000 non-voting shares with a $3.6 million note with interest at 4%.
Step No. 5: Purchase the life insurance. Remember, the ILIT’s income is estimated at $1.2 million per year. The ILIT purchases $6 million of second-to-die life insurance on Joe and Mary… Cost per year: $70,992 ($11,832 X 6).
Step No. 6: Operation of the trust. The trust will use the dividends from Success Co. (say $1.2 million) each year to pay the insurance premiums ($70,992), the interest due on Joe’s note, about $144,000 the first year and the balance to pay down Joe's $3.6 million note. The arbitrage profit is huge: the difference between Success Co.’s profit and the interest.
Step No. 7: The final curtain. Someday Joe's note will be paid in full (in about five to eight years, depending on Success Co.'s profits. Then, using the income stream from Success Co., the ILIT will continue to pay the policy premiums, and the three children (Sam and the two non-business children) will share the balance of the income. When both Joe and Mary have gone to the big business in the sky, the ILIT will receive the $6 million death benefit tax-free.
The 10,000 shares of Success Co., non-voting stock will be distributed to Sam and the $6 million insurance cash (plus other assets left by Joe and Mary) will be used to treat the three kids equally.
Some final thoughts… This ILIT/IDT strategy can be tailored to almost any situation where you, the reader, own income producing assets. But a warning: even though the arbitrage ILIT is a super powerful-tax-saving weapon, space does not permit giving all the details, tax traps and nuances of this strategy. Yes, it can solve the estate planning problems of most readers of this column. But no, it will not work unless your professional knows how to draft the required documents and make the terms fit your exact facts and circumstances.
If you have questions, call me (Irv) at 847-674-5295.
Time for the wedding reception! Let the tax-savings begin. You are invited to the party.
Irv Blackman, CPA and lawyer, is a retired founding partner of Blackman Kallick Bartelstein 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.