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The Five Biggest Estate-Planning Mistakes that Enrich the IRS Instead of Your Family

Sunday, April 01, 2012
 

Mistakes in estate plans can cause tax dollars to be lost to the IRS, automatically reducing your children’s inheritance. Recently, I reviewed the estate plan of a well-to-do reader (Joe, age 65) with a net worth of $20.8 million. The plan, unfortunately, included all of the five biggest mistakes described here.

Mistake #1—Not creating the right succession plan

Joe owns 100 percent of Success Co. (an S corporation), which is run by his son Sam. The company is worth $9.7 million, grows 5 to 10 percent in revenue almost every year, and profits increase accordingly. Joe’s original plan left Success Co. to his wife (Mary, age 64) and, after her death, to Sam. This is a mistake, because the potential estate-tax liability grows along with the increasing value of Success Co.

Now is the time to transfer Success Co. to Sam. Joe should recapitalize Success Co. (create voting stock (say 100 shares) and nonvoting stock (say 10,000 shares)—a tax-free transaction. Joe keeps the voting shares and absolute control for as long as he lives. Under the tax law, the nonvoting shares are entitled to a deep discount of 40 percent, so for tax purposes these shares are worth only $5.82 million.

Next, Joe should transfer (sell) the nonvoting shares to an intentionally defective trust (IDT) for $5.82 million, taking an interest-bearing note as payment. According to tax law, the entire IDT transaction is tax-free to Joe—neither capital-gains tax nor income tax on the interest to be received while the note is being paid. Even better, Sam does not pay even one penny for the stock. Instead, the cash flow of Success Co. (via S corporation dividends to the IDT) is used to pay the note, plus interest. When the note is paid in full, Sam–as the trust beneficiary–receives the nonvoting stock, tax-free.

Mistake #2—Not avoiding the double tax on qualified plans and IRAs

Between Joe and Mary, they have $1.9 million in the Success Co. 401(k) plan and various IRAs. Left alone, these funds will be clobbered with a double tax (income and estate tax). Using 2013 tax rates, the IRS winds up with 70 percent of these plan funds and the family a paltry 30 percent.

To avoid this mistake, Joe should use a strategy called retirement-plan rescue (RPR) and purchase $5 million of second-to-die life insurance on himself and Mary. The policy should be purchased and owned by an irrevocable life-insurance trust (ILIT). The beneficiaries of the ILIT are Joe and Mary’s three nonbusiness children (Sue, Sy and Sid), treated equal to Sam. Because of the ILIT, Sue, Sy and Sid will receive every penny of the $5 million tax-free.

Without the new plan, the kids would receive only $570,000 (30 percent of $1.9 million).

Mistake #3—Not putting investments into a family limited partnership (FLIP)

Joe and Mary have $8.1 million in cash, CDs, stocks, bonds and income-producing real estate. They created two FLIPs: one for their real estate and one for their other investments (holding $2 million to be used in Mistake #4). So, the amount put into the FLIPs is $6.1 million. A FLIP, when properly structured in accordance with tax law, is allowed a 35-percent discount, reducing the $6.1 million to $4 million for tax purposes and saving estate taxes on $2 million.

Joe and Mary immediately give separate gifts of $1,026,000 each to Sue, Sy and Sid, including $13,000 from Joe and $13,000 from Mary—the annual gift exclusion allowed without any gift-tax consequences. The additional $1 million each used a portion of the $5.12 million one-time gift maximum allowed per person (or a total of $10.24 million for a married couple) for 2012. (Note: This drops to $1 million per person starting January 1, 2013).

A warning: If you are in the financial position to make large gifts to your kids and grandkids, you have until December 31, 2012 to use your $5.12 million ($10.24 million if married). This window of opportunity is closing.

Mistake #4—Not taking advantage of life insurance as a tax-advantaged investment

There are dozens of core life-insurance strategies and hundreds of variations that allow investors to beat Wall Street and the tax collector at the same time. Joe used three of the core strategies as follows.

Strategy 1—Referring to Mistake #1 above, Joe uses a portion of the funds received each year by the IDT (for its share of Success Co.’s S corporation profits) to purchase a $3 million second-to-die life-insurance policy on himself and Mary. The $3 million death benefit, along with the other second-to-die policies described in the following two strategies, will be used toward giving Joe’s three nonbusiness children their fair share of the estate.

Strategy 2—Refer to Mistake #2, where a strategy is described that acquires $5 million of second-to-die insurance on Joe and Mary.

Strategy 3—Refer to Mistake #3, where $2 million was held back to be used in this strategy, called single-premium immediate annuity strategy (SPIAS).

In a nutshell, here’s how the SPIAS works. Joe and Mary purchase a joint and survivor single-premium annuity for $2 million. As long as one of them remains alive, every year (starting immediately) they will receive an annuity payment of $109,304. IRS regulations make a portion of the annuity received tax-free, so after income taxes they will have a net amount of $96,362 every year. Joe and Mary use that to pay the annual premium on another second-to-die policy for $7,268,294. Actually, the policy was purchased and is owned by an ILIT. Sue, Sy and Sid will receive the death benefit tax-free.

Mistake #5—Not having a comprehensive estate plan

A comprehensive plan dictates that you have two plans: a lifetime plan (the real tax-saver and wealth builder) and a death plan. Of course, the two plans must dovetail.

As you can see, the first four mistakes described above all are part of your lifetime plan. Your comprehensive plan deals separately with each significant asset owned, getting those assets out of your estate for estate-tax purposes while allowing you to control each asset for as long as you live. Properly done, your plan should completely eliminate the impact of the estate tax.

If your estate plan does not at least accomplish all that is discussed in this article, you owe it to yourself, your business and your family to get a second opinion.

And finally, a warning: This article does not attempt to cover every possibility, exception and potential tax trap. Only work with advisors who can explain exactly how your plan accomplishes each of your goals and eliminates your estate-tax liability. MF

 


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