A Tax Marriage Made in Heaven
I often write separate articles about the tax magic of irrevocable life-insurance trusts (ILITs) and intentionally defective trusts (IDTs). Now get ready for the wedding ceremony joining ILITs and IDTs.
An ILIT allows the death benefits of the life insurance it purchases to be received tax-free—no income tax and estate tax. A fly in the ointment: Necessary gifts each year by the trust creator to pay premiums kicks up a gift-tax problem. Marrying an ILIT to an IDT eliminates the problem, and also creates a host of tax-free and wealth-building opportunities.
An IDT—also irrevocable—is defective only for income-tax purposes. In all other respects, it is the same as any other irrevocable trust. An IDT is the perfect strategy to transfer income-producing assets such as a family business or real estate from parents to children, and the transfer is tax-free. For example, when transferring a closely held business, the tax savings run about $200,000 per $1 million of the stock value.
Before we tie the knot between ILIT and IDT, let’s discuss the concept of arbitrage—the purchase and sale of the same or equivalent security in different markets in order to profit from the price discrepancies, profit being the key concept here. What makes the marriage work? Anyone that owns an asset earning a rate of return exceeding today’s low interest rates can use the arbitrage profit to pay insurance premiums, creating tax-free wealth while avoiding any losses to the IRS.
Crazy American tax law provides for various discounts, such as a discount for lack of marketability and a discount for minority interest, that reduce the real market value of an asset in the 30- to 40-percent range for tax purposes, increase the arbitrage profit and make the tax-savings a slam dunk.
Here’s how to initiate and complete an arbitrage ILIT.
Step 1. Create the arbitrage ILIT. A lawyer must create the trust defective for income purposes, combining the ILIT an IDT in one document. Joe, our tax hero in this example, will be responsible for personally paying the income tax due on all trust earnings, because the trust is ignored for income-tax purposes. The basic facts: Joe is married to Mary, and both are 65 and in good health. An insurance consultant quotes the cost of a second-to-die policy at $11,832 per $1 million of death benefit. Joe owns Success Co. (an S corporation worth $6 million), run by his son Sam. Joe and Mary want Sam to own Success Co. A major concern is how to treat their two nonbusiness kids equally—aside from Success Co., they have $5 million of other assets; about one-half is liquid.
Step 2. Select the asset to sell to the ILIT. Typically, the creator of the ILIT will sell one of three types of assets to the ILIT: 1) Stock of a closely held business; 2) An interest in a FLIP (family limited partnership), which owns real estate and/or securities; or 3) an interest in an LLC (usually holding real estate). Regardless of the asset selected, the transaction is arranged so Joe keeps absolute control of the asset for as long as he lives, even though the asset is out of his estate.
Joe decides to sell all of the nonvoting stock (10,000 shares) he owns in Success Co. to the ILIT, keeping all 100 shares of the voting stock. So, Joe gets Success Co. out of his estate while keeping control.
Step 3. Have the asset sold to the ILIT professionally valued. Ask an expert to determine the discount of the asset, which is almost always a) about 40 percent for the nonvoting stock of a family business, so $1 million of stock is worth only $600,000 for tax purposes, and b) about 35 percent for a limited partnership interest in a FLIP, so $1 million of such an interest is worth only $650,000 for tax purposes.
Success Co.’s 10,000 shares of nonvoting stock are valued at $6 million as its fair market value, but the appraisal expert applies a 40-percent discount, making the stock worth $3.6 million for tax purposes. Note that future earnings of Success Co. are estimated at $1.2 million/yr.
Step 4. Pay for the assets sold to the ILIT. The ILIT pays Joe in full for the 10,000 nonvoting shares with a $3.6 million note with interest at 4 percent.
Step 5. Purchase the life insurance. Remember, the ILIT’s income is estimated at $1.2 million/yr. The ILIT purchases $6 million of second-to-die life insurance on Joe and Mary; cost per year is $70,992 ($11,832 X 6).
Step 6. Operation of the trust. The trust will use the dividends from Success Co. (say $1.2 million) each year to pay the insurance premiums ($70,992) and the interest due on Joe’s note (about $144,000 the first year and the balance to pay down Joe’s $3.6 million note.) The arbitrage profit is huge—the difference between Success Co.’s profit and the interest.Step 7. The final curtain. In 5 to 8 years, depending on company profits, Joe’s note will be paid in full. Using the income stream from Success Co., the ILIT will continue to pay the policy premiums, and the three children will share the balance of the income. When Joe and Mary die, the ILIT will receive the $6 million death benefit, tax-free. The 10,000 shares of Success Co. nonvoting stock will be distributed to Sam and the $6 million insurance cash (plus other assets left by Joe and Mary) will be used to treat the three kids equally. MF
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