IT IS RARE indeed that we look over the life insurance program of a business-owner client without finding a potentially expensive tax blunder — sometimes the income tax, sometimes the estate tax. Usually both.
What’s the most common mistake? Having the corporation own one or more policies on the owner’s life. Lousy tax planning! No, the insurance itself is not the mistake. But the way the policy is owned will enrich the IRS usually more than your family down the road.
The most common reason a business buys life insurance is for so-called key man insurance or to fund a buy-sell agreement. When you die, the corporation collects the insurance proceeds on your life, say $1 million. First, the good news: The entire proceeds are free of the regular income tax. Sorry, but the rest of the news is all bad. Very bad.
Suppose your corporation is a C corporation (a tax-paying corporation). Do you know that the corporation can be hit by an Alternative Minimum Tax as high as 20%, or $200,000 on that $1 million? Ouch!
Now that you’re gone, the family decides that your wife, Mary, should have the balance (now only $800,000 after the AMT) to live on. Sorry, but that payment is a taxable dividend. Mary must cough up about $300,000 more in income taxes!
If you operate as an S corporation, the results are a bit better. No AMT, so there is a full $1 million to distribute to Mary.
Wait! Did anyone ever tell you about this tax-horror rule? To the extent that your business has prior C corporation earnings, every dime of those earnings must be paid as a taxable dividend before the $1 million insurance proceeds can be distributed tax-free.
Put another way, if your corporation has $1 million or more in C corporation surplus, the entire payment to Mary will be socked with current income tax. About $400,000.
What can you do now? Whether you operate as a C or an S corporation, get the insurance out of the corporation and into your own name. Simply buy it from the corporation for its cash surrender value and have the ownership transferred into your name. Now, Mary can collect the entire $1 million and use it all, free of income taxes. Also, remember that insurance proceeds paid to a family member, instead of the corporation, are not subject to the claims of corporate creditors.
One more point: Now that you have the insurance out of your corporation who should own it? An irrevocable life insurance trust. This delightful tax-saving animal not only avoids the regular income tax and the AMT, it legally avoids the estate tax. Think about it. Your family gets every dollar of your insurance proceeds. The IRS gets none. Don’t wait. Get your insurance out of your corporation and into an ILIT.
Converting your taxable insurance out of your corporation into tax-free insurance is the single best tax move you can make. It’s easy to do. Do it!
The above discusses existing insurance owned by your corporation. Suppose you are about to buy a new policy. Who should own the policy to make the death benefit tax-free and to avoid the claims of creditors? There are four choices.
Choice No. 1: a subtrust. If you have a significant amount ($200,000 or more) in a qualified plan (like an IRA, 401[k] or a profit-sharing plan), a subtrust is usually your first and best choice. The plan, not you, pays all premiums. Result: You get a 70% discount on your premiums.
Choice No. 2: a family limited partnership. A FLIP has all the advantages of ILIT (Choice No. 4) for estate tax purposes, plus two more big advantages: You are always in total control and can change anything you want, including the beneficiary, without any problem.
Choice No. 3: an intentionally defective trust. An IDT is a wonderful discounting strategy for transferring your investments, including your closely held business, to your kids and/or grandkids. For example, you can transfer $1 million worth of stock (either a public company or stock of your family corporation) and use up only about $650,000 of your unified credit. Saving tax on the $350,000 discount is worth about $192,000 in estate tax savings. A good move.
Choice No. 4: an ILIT. Yes, we are back to our old friend, the ILIT. A worthy companion, whether you want to buy $1 million or less or $10 million or more of life insurance.
All of the above choices escape estate taxes and lock creditors out (including anyone who sues you or divorcing in-laws).
Every detail, nuance rule and possible tax trap of the above choices are not given. Make sure you work only with qualified and experienced experts.
Irving Blackman is a partner in Blackman Kallick Bartelstein, 300 S. Riverside Plaza, Chicago, IL 60606; tel. 312/207-1040, or via e-mail at [email protected].