Turn estate tax disaster into a wealth bonanza

I've written more than 1,000 articles over the years. But never has the response been greater phone calls, letters and faxes by readers than two recent items in the column that are sort of kissin cousins. The subjects? Income in respect to a decedent (ird) and subtrusts. Not exactly the kind of stuff youd think is that exciting. Single business owners have special tax problems all bad when compared

I've written more than 1,000 articles over the years. But never has the response been greater — phone calls, letters and faxes — by readers than two recent items in the column that are sort of kissin’ cousins. The subjects? Income in respect to a decedent (ird) and subtrusts. Not exactly the kind of stuff you’d think is that exciting.

Single business owners have special tax problems — all bad — when compared to their married counterparts.

Now, however, that we know the interest level of these subjects, this article presents the problem (ird) and the solution (subtrust).

So, if you have (or someday may have) about $200,000 or more in a qualified plan such as a profit-sharing or pension plan, 401(k) plan, rollover ira and most other such plans, this article is must reading.

First the problem: Say you have $1 million (substitute your own number) in a qualified plan. Every dollar you take out of the plan is subject to income tax. Unless you spend it, the balance is subject to estate tax. In the highest brackets (40% income tax and 55% estate tax), your family gets only 27%, $270,000, out of that $1 million. The irs gets 73%, $730,000. Of course, your home state usually gets a piece of the action, further reducing your family’s share.

Now suppose you die with $1 million in your plan. The irs gives you a second chance to get clobbered with double taxes. Your heirs, in effect, pay the same amount you would have paid if you had withdrawn the funds during your life. A horrible confiscatory tax!

Now here’s the solution: subtrusts. A subtrust allows you to use a certain portion (normally up to 50%) of your plan funds to buy life insurance. You can purchase insurance on your life (single life) or on you and your spouse (second-to-die). At your death (or you and your spouse if second-to-die), the policy proceeds are free of the estate tax.

A few real-life examples are the best way to drive home the huge savings and wealth-creation possibilities of using subtrusts.

A single client, age 60, with $1 million in his plan purchased $7 million of life insurance in his subtrust. Every penny will go to his heirs, tax free.

A married client, age 56 with a 53-year-old wife, had $212,000 in a 401(k) plan, which is receiving annual contributions of about $11,000 each year. He purchased $2 million of second-to-die insurance in his subtrust.

If you have an estate that will need a big chunk of cash when you (or your spouse) go to the big business in the sky, you should consider a subtrust. It is capable of taking a potential tax disaster and turning it into a wealth-enhancing bonanza.

Tax planning for singles

Single business owners have special tax problems — all bad — when compared to their married counterparts. During life, no joint return; only a $10,000 gift exclusion per year donee (instead of $20,000 when married). At death, no marital deduction to stop the estate tax cold when the first spouse dies; only $625,000 estate tax free (instead of $1.25 million) in 1998.

Well, here comes a true tax tale of a single business owner. Let’s call him Joe. He came all the way from Portland, Ore., to Chicago to get a second tax opinion. (I should note that when there’s that much distance between the business owner’s home and my office, the second tax opinion consultations usually occur via phone and fax instead of starting with a plane ride.)

Joe (a vigorous 68 years young) operates his business (a C corporation, Success Co.) with his only son, Sam. He has three daughters — none in the business. Aside from Success Co., Joe’s taxable estate includes these significant assets — land and building, which he leases to Success Co., and two life insurance policies — one for $500,000 owned by and payable to Success Co., and one for $600,000 owned by Joe and payable to his kids equally.

We divided Joe’s tax plan into two parts, lifetime planning and death planning. Following are the significant points of each.

The lifetime plan. Joe followed these steps:

Enter into a long-term lease for the real estate between Joe and Success Co.

The terms include raising the rent to fair market value and giving Sam an option to buy the property after Joe dies. Then transfer the real estate to a family limited partnership (flip).

Immediately gift voting and nonvoting control of Success Co. (via a tax-free creation of voting and non-voting stock) to Sam. Joe is comfortable with this action, and it greatly reduces the value of Success Co. for estate tax purposes.

Every year gift $10,000 of Success Co. stock to Sam and an equal amount to each daughter of limited partnership interests in the flip.

Transfer the $500,000 life insurance policy from Success Co. to Joe.

Next, gift both insurance policies to his daughters. This gets $1.1 million ($500,000 plus $600,000) out of Joe’s estate.

Elect S corporation status, so Joe can take tax-free dividends from Success Co. in excess of his salary, which will decrease as he continues to slow down.

The death plan. Not much to do here. We just wrote a simple will leaving Joe’s estate equally to the four kids. But appropriate adjustments must be made for the gifts completed during his life — the stock and the insurance — so that each of the kids is treated equally (to Joe that means “fairly”).

The final result of Joe’s tax plan will reduce income and Social Security taxes during every year of Joe’s life and probably will reduce an estimated estate tax liability of more than $1.5 million to zero. The most important part of this tax story is that the plans outlined above work no matter how large your estate might be and whether you are single or married.

If you’re not incorporated

What’s the biggest question unincorporated business owners, whether working out of their home or not, ask? “Should I incorporate?”

Although there are many reasons why you should or should not incorporate, the key reason revolves around the tax cost. Here’s the general rule: Profits mean you should incorporate. For the successful business, the simple fact of incorporation usually means immediate tax savings. For our purposes, let’s define a “successful business” as one having a bottom-line profit of $150,000 or less.

How does incorporation save taxes? The answer lies in the corporate tax rates for C corporations, which follow:

Income

Rate

Under $50,000

15%

Next $25,000

24%

Next $25,000

34%

From $100,000 to $335,000

39%

Over $335,000

34%

The individual tax rate starts at 15% and goes up to almost 40%. The best way to understand how the corporate and individual rates can be used in tandem to slash your tax bill is by a concrete example.

Assume Mary Entrepreneur operates a successful home business as a tax-paying corporation, called Things & Stuff Inc. Her husband, Sam, earns in excess of $200,000, which puts Mary and Sam in a solid 40% personal tax bracket. Last year Things & Stuff’s profit was $60,000. This kicked up only a $10,000 corporate tax ($7,500 on the first $50,000 plus $2,500 on the next $10,000).

If Mary had operated as a sole proprietorship, her $60,000 of Things & Stuff income would have been added to Sam’s income. This change would have resulted in $24,000 ($60,000 x 40%) in tax. The corporation saved $14,000 ($24,000 minus $10,000). Smart move, Mary!

This article does not attempt to cover every rule, benefit and problem of incorporating. Suffice it to say that more savings can be yours.

Irving Blackman is a partner in Blackman Kallick Bartelstein, 300 S. Riverside Plaza, Chicago, Ill. 60606; tel. 312/207-1040.