A restaurant near my Florida home advertises and serves creative dishes called Fusion, which combines various foods, spices and sauces. The result: delectable, mouth-watering and delicious treats. Great food!
Well, we are about to borrow the fusion concept to create great tax results, while generating a huge amount of cash for your kids and for your grandchildren. We call it the Tax-Fusion concept (T-Fusion for short).
The easiest way to quickly grasp the genius of T-Fusion is by an example. But first, let’s identify the typical T-Fusion candidate: Joe, who is married to Mary, and who is fortunate to have one or more of the following asset situations:
1. Excess cash. Enough cash or cash-like assets (like CDs, stocks or bonds) to maintain Joe’s and Mary’s lifestyle, with an excess to invest.
2. Own income producing assets. For example, own all or a portion of a profitable closely held business, rental-income real estate or any other income producing assets (including stocks and/or bonds).
3. Both of the above.
In practice, any one (or a combination) of the above assets can be used to successfully implement a T-Fusion. The asset or assets used may change, but how a T-Fusion works, as explained below, never changes.
Here are some facts for the example: Joe owns real estate worth $5 million that produces 7% net (or $350,000) of rental income. Joe (age 70) and Mary (66) could buy second-to-die life insurance for an annual premium of $14,452 per $1 million of death benefit, if both were healthy. Unfortunately, some medical issues cause the premium to rise to $24,617 per $1 million of coverage. They decide to buy a policy with a $5.5 million death benefit with an annual premium of $135,394 (5.5 X $24,617).
In the real world, all documents needed to create a T-Fusion are done at the same time, but for ease of understanding the rather simple process, the overall plan is explained below in four steps. For convenience, some numbers are rounded.
Step No. 1: Create a family limited partnership (FLIP). Joe and Mary contribute the $5 million real estate to the FLIP, receiving back a 1% interest as general partners and a 99% interest as limited partners … The transaction is tax-free, but under crazy American tax law the limited partner’s interest receives a 35% discount or $1.75 million (35% times $5 million). The discount is supported by a professional appraisal. So, for tax purposes, the real estate is worth only $3.25 million.
Step No. 2: Transactions with the intentionally defective trust (IDT). Joe and Mary create an IDT, which is intentionally defective (means will be ignored) for income tax purposes. Then they sell their limited partnership interest to the IDT, receiving a $3.25 million note in payment. The terms of the note are interest only at 5% (or $162,500 per year) for 15 years, when the note is due. Of course, this transaction is tax-free. Please note that the exact terms of the note can vary on a case by case basis to fit the exact needs and plans of the IDT creator (here Joe and Mary).
The key to the transaction, at this point, is the 35% discount on the FLIP interest allowed by the tax law. The amount of the note is not based on the real intrinsic value of the real estate ($5 million), but it’s fictitious, for tax-purposes only, value ($3.25 million). The discount causes a cash flow surplus in the IDT, computed as follows:
Rent income $350,000
Less – Note interest $162,500
Policy premium 135,394 297,894
The IDT cash flow easily covers the required interest and premium payments. When both Joe and Mary have gone to heaven, the IDT will immediately receive the $5.5 million policy proceeds (See Step No. 3). Tax-free, no income, gift or estate tax.
Wait! There is one more big tax benefit for Joe and Mary: the annual interest, $162,500, they receive is tax-free under the IDT rules. But sorry, the IDT cannot deduct the interest paid against its taxable rental income, $350,000. Typically, Joe would contribute a portion of the tax-free interest received to help pay the IDT income tax bill.
Step No. 3: The IDT buys the $5.5 million second-to-die life insurance policy on Joe and Mary. The trust is the owner and beneficiary of the policy.
What if Joe or Mary, or both, are still alive in 15 years when the note becomes due? There are a few options: The note could be paid partially or in full (using other assets they own). Or the note could simply be paid with a new (interest only or include principal payments) note, due down-the-road.
Step No. 4: Create a family bank. Joe and Mary can tailor the terms of the IDT to accomplish their precise financial goals and dreams for their kids, grandkids, and even future generations. Remember the $5.5 million policy death benefit will come to the IDT tax-free.
Some of the funds can be distributed immediately, some when the kids/grandkids reach a specific age. Yes, some funds can be set aside to become a “bank” to fund the needs of future generations: down payment on a first home, start a business, pay emergency medical bills and on and on.
You could create what’s known as a dynasty trust, by setting aside enough funds to buy new life insurance policies, on the older beneficiaries of the IDT. When those insured beneficiaries go to the big business in the sky, a new tax-free, cash benefit will enrich the trust to bank future generations (to be repeated forever).
If you or someone in your family is fortunate enough to own the type of assets — almost any kind of income producing investment or ownership in a family owned business — needed to do a T-Fusion, then you owe it to yourself and your family to check out the tax-fusion concept.
It should be pointed out that no attempt is made in this article to cover all the variations to structuring a T-Fusion plan. One warning: When you decide to do your own plan, work with an experience professional.
Want to learn how a T-Fusion can work for you and your family? Please send me the following information via fax to 847-674-5299: your name, address and all phone numbers (business/cell/home); a personal financial statement (include your spouse, if married); and your birthday (if married, also your spouse). Mark "Tax-Fusion concept" at the top of the page. If you have a question, call me, (Irv) at 847-674-5295.
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.