CHICAGO — By any definition, Joe was a “success,” and so was his business, Success Co. Although Joe was a planner, after he died, his estate plan and business succession plan turned into an economic and tax tragedy—for son Sam, wife Mary and the rest of the family.
Fortunately, the 100% marital deduction (everything to Mary, except $2 million to the family trust) spared Joe’s estate from any tax due at his death. But the entire family, especially Mary, was shocked when their lawyer told them the loss to estate taxes would be in the $10 million range (the exact liability could not be determined because the estate tax rate depends on the year of death) when Mary died.
Here’s the final blow: As explained earlier, Sam must earn $1.7 million and pay $700,000 income tax (state and federal) to have $1 million to pay down the note. Joe is socked with a capital gains tax (15%), leaving $850,000. Estate tax on the $850,000 in Mary’s estate (when she dies) will be about $300,000. Then, only $550,000 remains. What is the full lost-to-taxes picture? For each $1 million of the note, Sam must earn $1.7 million for the family to wind up with only $550,000!
For the entire $12 million, Sam must earn more than $20 million for the family to receive $6.6 million. That’s lousy tax planning.
The Other Two Children
They were forgotten in the plan, until Mary died.
What Joe and Mary Should Have Done
Lack of space prevents me from covering every point, issue and possibility. But following are the most important strategies that would have allowed all of Joe’s $27.7 million to go to his family with all taxes paid in full.
- An intentionally defective trust (IDT). First, there is a recapitalization of Success Co. (100 shares of voting stock kept by Joe and 10,000 shares of nonvoting stock to be sold to the IDT). Now, the discount is 40%, resulting in a price to Sam of only $7.2 million. The entire transaction is tax-free to Joe—no capital gains tax, no income tax on interest received. What’s the cost to Sam? Zero. Profits (cash flow, really) of Success Co. are used to pay the $7.2 million note.
- Life insurance. Since Joe and Mary were insurable in 2005, our advice would have been to purchase about $11 million (set up to be tax-free) in second-to-die life insurance. The 401(k) funds would have implemented a strategy called “retirement plan rescue” and purchased $6 million of life insurance, while the IDT would purchase $5 million.
- Family limited partnership (FLIP). The “investment” assets total $12.1 million, but only $11 million would be transferred to a FLIP. The IRS allows a 35% discount, making the FLIP assets worth only $7.15 million for tax purposes.
- Gifting program. Joe and Mary’s three children have a total of eight grandchildren. The maximum tax-free gift in 2005 was $11,000. So, Joe and Mary together could make a $22,000 gift to each nose, or a total of $242,000 per year.
Every strategy listed here is easy to implement and, when done correctly, accepted by the IRS.
When your professionals are finished with your estate plan (you must include a succession plan if you own all or part of a closely held business), ask them to show you how the plan passes all of your wealth—intact—to your heirs.
For example, if you are worth $5 million, the entire $5 million will go to your heirs. All taxes, if any, would be paid in full. Just substitute your own numbers.
If 100% of your wealth is not passed intact, get a second opinion!