Blackman on Taxes
When Your Professional Says,
I’ll bet the farm that this article will save many business owners who want to transfer the family business to their kids a ton of taxes.
Let’s set the stage by quoting an e-mail a reader sent to me: “Mom is 82 with an estate worth about $20 million. Included is an S corporation valued at $1 million for IRS purposes. My dad started the company and ran it until he died two years ago.”
“Sam, my brother, and I, Larry, are the only heirs and want to continue to run the company. You state in your articles that the estate tax can be avoided completely. Mom has excellent tax attorneys and CPAs who say it can’t be done with an S corporation…they have done what they can…but my brother and I will end up with a $7 million tax bill payable over 15 years.”
Let’s set up the problem the way it comes up most often (the business owner is married), what most professionals get wrong, and finally the solution.
Here’s the typical problem: Joe (married to Mary) owns Success Co., which is worth $10 million. Steve, Joe’s son, runs Success Co. The plan proposed by Joe’s professionals is for Steve to buy Joe’s stock for $10 million, to be paid over 10 years.
Steve must earn about $16 million and pay $6 million in income tax to have the $10 million to pay Joe. Joe must pay about 1.5 million in capital gains tax—only $8.5 million left. So, Steve must earn $16 million for Joe’s family to keep $8.5 million. That’s nuts.
Lesson No. 1—A sale of all (or even a portion) of your stock to your kids is a lousy idea for tax purposes.
Sometimes professionals use various strategies (most likely a stock redemption or stock purchase agreement) requiring insurance on Joe’s life as a means to move the company stock to Steve. Better than lesson no. 1, but the IRS will collect estate taxes on every dime of that life insurance (roughly $4.5 million to the IRS on $10 million of insurance using 2009 tax rates). In most real-life cases the insurance is either too much (stock was gifted to Steve while Joe was alive) or too little (Success Co. just kept growing in value).
Lesson No. 2—Life insurance can play an important part in your estate planning, but never use it in a business succession plan to move your company stock to your business kids. You’ll always guarantee the IRS a big pay day when you die.
Now, let’s give credit to the professionals Sam and Larry’s mom are using. They avoided the pitfalls in lessons 1 and 2. True, there would be an unnecessary $7-million estate-tax bill, but they jumped on Section 6166 of the Internal Revenue Code, which allows certain business owners to pay their estate-tax liability over a 15-yr. period, plus a low rate of interest (not deductible) on the amount of estate tax due. Never in my 50-plus years of practice have I used Section 6166 as part of an estate plan, because it cannot save a penny of taxes and just stretches out the time of payment.
In every case, my network of professionals has been able to pass all of each client’s wealth (whether worth $5 million or $50 million—or more) to their heirs 100 percent intact (no tax or all taxes paid in full).
Lesson No. 3—Never use Section 6166 as part of your overall estate-tax plan. Instead, create a comprehensive plan (as described below) to eliminate the estate tax.
Now let’s turn to the solution for the typical family business owner who wants to transfer his business to his kid(s). Most business owners have four kinds of assets:
1) The business (Success Co.);
2) A residence (often two or more);
3) Funds in a qualified plan (for example, an IRA, 401(k), profit-sharing plan or similar plan); and
4) Investments (like real estate, stocks, bonds cash, CDs and other investments).
The solution (really a system to create a comprehensive plan) requires two plans: a traditional will and trust (one for Joe and one for Mary). This is really a death plan. It cannot save you a dime in taxes. It just defers the estate tax until both Joe and Mary die.
The second plan—a lifetime plan—beats up the IRS legally. Let’s look at the lifetime-plan strategies most often used in practice. The system uses strategies that are implemented during your life and are based on the assets you own.
1) Your business—We use an intentionally defective trust (IDT), which means the trust is intentionally defective for income-tax purposes. What does this accomplish? The transfer of the Success Co. stock (typically nonvoting stock, while Joe keeps the voting stock and control) is tax-free. The tax savings, compared to selling the stock to the kids, usually are $456,000 per $1 million of the value of Success Co. ($5,016,000 for Sam and Larry’s mom; $4,560,000 for Joe).
2) Residence(s)—The most common strategy is called “50/50.” We transfer the title of each residence by having 50 percent owned by Joe’s traditional trust and the other 50 percent owned by Mary’s trust. Tax result? We get about a 30-percent discount for estate-tax purposes (for example a $600,000 house is only valued at $420,000 in the estate). Larry’s mom cannot take advantage of this strategy (her husband is gone).
3) Funds in qualified plans—These funds are double taxed. Sorry, but the IRS winds up with about 70 percent, the family only 30 percent. For example, $1 million in a rollover IRA will only yield $300,000 to the family. Ouch! We use strategies like a subtrust or retirement plan rescue to boost that $300,000 to the $2 million to $7 million range (all tax-free) depending on age and health of the business owner (and spouse if married).
4) Investments—A family limited partnership (FLIP) is almost always the strategy of choice. Joe transfers his investments to a FLIP (could be more than one FLIP). Immediately the value of the assets transferred to the FLIP are discounted about 35 percent for tax purposes. Hey, $1 million of intrinsic value is worth only $650,000 for tax purposes, yields estate-tax savings of $158,000. Works for Joe and Larry’s mom too.
5) Still an estate-tax liability—Often 1 through 4 above kills the estate-tax liability. But what if it doesn’t? We fall back on one of about 20 life-insurance strategies to create tax-free wealth. Easier if you are married, like Joe and Mary, because you can buy second-to-die insurance, which costs much less in premiums than single life to pay the estate tax.
What if the business owner is uninsurable (and so is his wife, if married)? We then use a strategy called a charitable lead trust (works very similar to life insurance) to create tax-free wealth for the heirs. That’s exactly what Jacqueline Kennedy—who was uninsurable—did to earn her heirs about $250 million tax-free.
Lesson No. 4—The system as described above always works (kills the estate tax) whether you are young or old, married or single, insurable or uninsurable.If your professional does not eliminate all of your estate-tax burden, get a second opinion. MF
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