Create Tax-Free Wealth While Legally Sidestepping the IRS

A restaurant near my Florida home serves up a “fusion” menu, combining various foods, spices and sauces. I’m going to borrow from this concept to create the tax-fusion concept, or T-fusion. The typical T-fusion candidate (Joe, married to Mary), is fortunate to have one or more of the following asset situations:

1) Excess cash—enough cash or cash-like assets to maintain their lifestyle, with an excess to invest.

2) Own income-producing assets such as a closely held business, rental-income, real estate or stocks and bonds.

How T-Fusion Works

Here’s an example of how T-fusion works. Let’s say that Joe owns real estate worth $5 million that produces 7 percent net (or $350,000) of rental income. Joe (age 70) and Mary (66) could purchase second-to-die life insurance for an annual premium of $14,452/$1 million of death benefit, if both were healthy. Unfortunately, medical issues cause the premium to rise to $24,617/$1 million of coverage. They decide to purchase a policy with a $5.5-million death benefit with an annual premium of $135,394.

In the real world, all documents needed to create a T-fusion are completed simultaneously, but here I’ll explain the overall plan in four steps. For convenience, some numbers have been rounded.

Step 1: Create a family limited partnership (FLIP)

Joe and Mary contribute their $5 million of real estate to the FLIP, receiving back a 1-percent interest as general partners and a 99-percent interest as limited partners. The transaction is tax-free, but under U.S. tax law the limited partner’s interest receives a 35-percent discount, or $1.75 million (supported by a professional appraisal). So, for tax purposes, the real estate is worth $3.25 million.

Step 2: Transactions with the intentionally defective trust (IDT).

Joe and Mary create an IDT, intentionally defective for income-tax purposes, and sell their limited-partnership interest to the IDT, receiving a $3.25 million note in payment. The terms of the note are interest-only at 5 percent (or $162,500/yr.) for 15 years, when the note comes due. Of course, this transaction is tax-free.

The exact terms of the note can vary on a case-by-case basis to fit the needs and plans of the IDT creator (Joe and Mary). The key to the transaction is the 35-percent discount on the FLIP interest allowed by the tax law. The amount of the note is not based on the real intrinsic value of the real estate ($5 million), but rather on its fictitious (for tax-purposes only) value—$3.25 million. The discount causes a cash-flow surplus in the IDT, computed thusly:

The IDT cash flow easily covers the required interest and premium payments. When Joe and Mary have gone to heaven, the IDT will immediately receive the $5.5 million policy proceeds, tax-free—no income, gift or estate tax.

There is one more big tax benefit for Joe and Mary: The annual interest ($162,500) they receive is tax-free under the IDT rules. Note: the IDT cannot deduct the interest paid against its taxable rental income ($350,000). Typically, Joe would contribute a portion of the tax-free interest received to help pay the IDT income-tax bill.

Step 3: The IDT buys the $5.5 million second-to-die life insurance policy on Joe and Mary.

The trust is the owner and beneficiary of the policy. What if Joe or Mary (or both) are still alive in 15 years when the note becomes due? A few options exist: The note could be paid partially or in full (using other assets they own; or, the note could be paid with a new note (interest-only or including principal payments), due down the road.

Step 4: Create a family bank.

Joe and Mary can tailor the terms of the IDT to accomplish their financial goals and help fulfill their dreams for their family members. Remember, the $5.5-million death benefit will come to the IDT tax-free. Some of the funds can be distributed immediately; some when the kids/grandkids reach a specific age; and some can be set aside to fund the needs of future generations.

Technologies: Management

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