Year after year, our office is asked to give a second opinion on the completed estate plans of owners of family businesses. It is rare to analyze the life insurance policies of a real-life client and find that all is as it should be. Typically, we find the wrong kind of insurance. Wrong ownership. Wrong beneficiaries. Wrong tax consequences. It goes on and on.
This is a big deal. We are talking about big money. Typically, the IRS gets 50 cents to 55 cents of every life insurance dollar. Imagine owning a $1 million policy and the IRS gets $550,000 but your family only gets $450,000. It happens all the time. A needless tax travesty.
Let’s review the three biggest mistakes business owners make concerning life insurance.
Mistake No. 1: A corporation should never own insurance on the life of a shareholder, particularly a majority shareholder. Why? The trouble starts as soon as the shareholder dies: The policy proceeds are subject to the claims of corporate creditors. Worse yet, in a C corporation, the proceeds can be subject to the alternative minimum tax (AMT), which can steal up to 20% of the proceeds. The net proceeds (after the AMT) can only get into the hands of your family by paying a second tax via a taxable dividend.
If yours is an S corporation, the proceeds (although not subject to the AMT) are still locked in and can only be paid out tax-free if all old C corporation surplus is fIRSt paid out as a dividend (a lousy and tax-expensive idea).
Mistake No. 2: You or your spouse own the life insurance policy. You just guaranteed the IRS a big payday.
Mistake No. 3: The policy (with cash surrender value) is old and the cash surrender value is half or more of the death benefit. You no longer have a life insurance policy but an investment. In most cases a bad investment.
What should you do? Here are the typical recommendations we give to our clients, so that, you and your family keep the money.
Mistake No. 1: Transfer the policy from the corporation to your name, paying the corporation only the amount of the cash surrender value (usually a tax-free transaction). Next, transfer the policy to a wealth creation trust (an irrevocable life insurance trust that eliminates all income and estate taxes).
Mistake No. 2: Transfer the policy to a wealth creation trust.
Mistake No. 3: If you are insurable, dump the old policy and replace it with a new cash surrender value policy to be owned by a wealth creation trust.
Often the best answer for all the above mistakes is to use one or all of the following strategies:
Split-dollar insurance (a way to use your current cash or cash-like assets — in or out of your corporation — to create tax-free wealth.)
Use a VEBA (voluntary employee’s beneficiary association) to deduct your life insurance premiums.
Use a subtrust (in effect, the IRS pays your premiums out of your profit-sharing plan or rollover ira or other qualified plan to create large amounts of tax-paid wealth).
Here’s an easy way to get started: List the policies on your life, whether owned by you, your corporation, a trust or otherwise. Then ask this question about each policy on your life: What is the ultimate tax cost — income and estate — while I’m alive? When I die? When my spouse dies? The answer should be zero. If not, do what is necessary to make it zero.
Pump up your retirement plan
Do you think that qualified retirement plans — pension plans, profit sharing plans, iras, 401(k) plans, etc. — are the best thing since sliced bread? If so, you have lots of company. After all, a current deduction for contributions to your plan, plus tax-deferred accumulation of earnings could never be a bad move, right?
The clear answer is it all depends. On 1) whether you need the money and, in fact, do use your plan funds for your retirement (a great tax deal); or 2) you turn out to be rich (my definition of rich is you are in the highest income tax bracket — 40% — and the highest estate tax bracket — 55%).
If you are already rich or become rich in the future, all your qualified plan money, in the end, will be caught in a huge tax trap. You face a tax disaster. Simply put, you made a lousy tax investment.
Why? How can this be? Well, let’s look at $100,000 (substitute your own number) in your profit-sharing plan or other qualified plan: The IRS will get 73%, your family only 27%.
Here’s how the tax law robs your dollars. As the funds are distributed to you from the plans, each distribution is socked by 40% in income tax. You watch our $100,000 turn into $60,000 after the first $40,000 tax bite. When you go to heaven, the IRS feasts again on the remaining $60,000; this time it’s the 55% estate tax. Another $33,000 is swallowed by the tax collector. So, your family ends up with only $27,000. Sorry, but that’s the law.
In an evil sort of way, the IRS gives you a second chance. If you die before distributing all of your qualified plan funds, your heirs still get hammered for the same 73% double income tax and estate tax.
So, if you’re rich (by my definition), or likely to become rich, you are probably wondering if there is a way out. Here’s a way: the annuity/insurance strategy.
For example, suppose Joe has $1.75 million in his qualified tax plan. Joe (60 years old) is married to Jane (also 60). Suppose Joe has the plan trustee buy a joint and survivor annuity (continues to pay as long as either Joe or Jane is alive) that pays $130,000 per year. The income tax would be $52,000 ($130,000 times 40%), leaving Joe and Jane with $78,000. They use $25,000 to make an annual gift to an irrevocable life insurance trust (ILT) that buys a $2 million second-to-die policy (on Joe’s life and Jane’s life). After both are gone, the ILT will hold $2 million free of taxes for Joe and Jane’s family. Not only was the full $1.75 million in the qualified plans replaced, but an additional $250,000 in tax-free wealth was created.
Remember $1.75 million is only worth $472,500 (27% of $1.75 million) to Joe and his heirs. This strategy turns $472,500 into $2 million. Plus, Joe and Jane will receive the $130,000 annual annuity payment as long as either one of them is alive.