This article is the story of the typical owner (Joe) of a family business who decides it is time to get his estate plan done. Joe, age 63, organized a meeting with his long-time friend and CPA, Chuck, and lawyer, Lenny, who specializes in estate planning.
To start, all agreed Chuck should compute Joe's estate tax liability based on his current wealth. Chuck prepared a worksheet showing all the assets (and their values) owned by Joe, the potential estate tax liability ($4,080,000), the liquid assets available to pay the tax ($807,300) and the short-fall ($3,272,700).
Chuck and Lenny, at a second meeting, recommended and Joe bought a $3.5 million term policy on his wife Mary, age 57, (with Joe as the owner) to pay the potential estate tax. Lenny presented his plan: a typical traditional estate plan, pour-over-wills and A/B trusts.
Joe — a loyal reader of this column — was not comfortable. He called me for a second opinion.
I want to zero in on the most common errors I see closely held business owners, like Joe, make in their estate planning... Errors (these are really, missed opportunities to save estate taxes) that cause the Joes of the world to lose millions of dollars of their wealth to the IRS. Sadly, the missed opportunities are almost always a lack of knowhow by the professionals.
Let's start by taking a closer look at Joe's personal wealth. His net worth is $21.1 million: $10.4 million in various investments (mostly real estate); Success Co. (business owned 100% by Joe) worth $6.6 million and nets about $1.2 million per year after a $290,000 salary to Joe, plus many fringe benefits; $1.8 million in a 401(k); $.8 million in miscellaneous assets, and finally, a $1.5 million old life insurance policy on Joe (owned by him).
Loophole in tax law
There is a huge loophole in the tax law concerning the value of certain assets. These assets retain their real fair market (intrinsic) value, but enjoy a lower discounted value for tax purposes.
Following is a chart showing you the asset class, the strategy used and that tax-friendly loophole discount.
We used all three of the above strategies for Joe. The discounts totaled $6.52 million, bringing the taxable estate down to about $14.6 million (actually $12.6 million without the $1.5 million insurance policy, which we will deal with later).
Get major assets out of your estate
We created a family limited partnership (FLIP) to hold Joe's investments. Here gifts (to Joe's three kids) are the weapon of choice. We used the annual exclusions of $14,000 per donee ($28,000 for Joe and Mary combined), followed by using a portion of the lifetime credit (in 2015) of $5.43 million ($10.86 million for both).
An intentionally defective trust (IDT) was used to transfer the non-voting stock of Success Co. to Joe's kids tax-free for Joe and the kids. Important: Even though the assets were out of Joe's estate, he continued to control them. How? He kept voting control: the voting units of the FLIP and the voting stock of Success Co.
The go-to strategy
This takes knowledge. First, you must know the tax law; second, understand the life insurance products available in the marketplace; third, keep the policy proceeds out of the insured's estate; and last but not least, minimize premium cost. Sadly, few professionals know how to get the job done. Let's deal with Joe's two policies one at a time.
The $1.5 million policy on Joe's life
The annual premiums were $19,501 with a cash surrender value (CSV) of $64,000. A second-to-die policy for the same amount on Joe and Mary (really what they need because no estate tax is due until both have gone to heaven) has a lower premium of $16,023. The decision was easy... Drop the old policy. Joe pocketed the $64,000 CSV. A new second-to-die policy for $1.5 million was purchased by an irrevocable life insurance trust to keep the death benefit out of their estate.
The $2.5 million policy on Mary's life:
First, a fact: The policy was no longer needed to pay estate taxes, which were eliminated by the above planning. But when, I told Joe that the premiums could be paid by the IDT, he decided to have the IDT buy another second-to-die policy for $2.5 million (for the benefit of their kids) and, of course, it was structured to be estate tax free.
Some help with your life insurance planning
Can you guess what is the most messed up area in estate planning? Yes! Life insurance! Wrong type of policy; overpay premiums; proceeds subject to estate tax. Either over insured or under insured. Actually, I could write a book. But the following should help you determine if you are in insurance hot water and should get a second opinion:
1. You are married, have single life insurance (typically on the husband), but logic tells you second-to-die will give you more bang for your premium buck.
2. Your policy is paid up, you no longer pay out-of-pocket premiums. This is guaranteed to enrich the insurance company instead of your family. Simply use a tax-free exchange to significantly increase the death benefit, and still pay no premiums.
3. If you have: a.) more than $350,000 in CSV, b.) $3 million in coverage or c.) the policy is more than 10 years old, review the policies once a year. Also, get a second opinion before you buy. Typical result — significantly more death benefits for the same premiums dollar.
Want to learn more? Browse my website at www.taxsecretsofthewealthy.com. Call Irv at 847-674-5295. You can e-mail me at [email protected] with your questions or concerns.
Irv Blackman, CPA and lawyer, is a retired partner of Blackman Kallick 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.