How A Second Opinion Cost The IRS

Read More About Business

This is a war story. Joe, a 60-year old reader of this column, owned 100% of Success Co. He called me and wanted to know which of two estate plans he should choose.

Here are the significant facts: Joe's wife Mary is 53 years old. His only child Sam "31 years old" has worked in the business since he was 12. Sam owns one share of Success Co. stock; Joe owns all the rest of the stock: 199 shares. The business is worth $4 million and has enjoyed about a 10 percent growth in profits in each of the past five years. This growth should continue into the future. Joe's total net worth is $10 million including a residence, various investments (mostly the real estate leased to Success Co. and a portfolio of stocks and tax-free bonds) and $950,000 in a profit-sharing plan.

The two estate plans Joe asked me to review ("Give me a second opinion"' in his words) follow. At the core of both plans was a $4 million life insurance policy on Joe's life. Plan #1. The life insurance policy would be owned by Sam. Joe would gift Sam the annual premiums. At Joe's death Sam would buy Success Co.'s 199 shares from Joe's estate for $4 million. Plan #2. Success Co. would own the $4 million in life insurance keyman insurance and would redeem the 199 shares from Joe's estate. In the end, the final results would be exactly the same: Sam would own 100 percent of Success Co. and the estate would have $4 million in cash instead of $4 million in stock.

First, the good news:

(1) Joe's estate would owe no income tax on the sale of the stock. Why?... Because the estate would get a raised basis equal to the fair market value of the 199 shares on the date of Joe's death.

(2) No estate tax because the $4 million of insurance proceeds will wind up in Mary's trust and receive the benefits of the 100 percent tax-free marital deduction.

Sounds pretty good. Joe loved it.

Yes, it is a good plan. Certainly better than no plan at all. As a matter of fact, either of the plans outlined above""or some variations""is the most popular way of transferring a business to the next generation.

Now the bad news: two problems always cause us to turn thumbs down on any such plan:

(1) Joe's team of professional advisors forgot that Mary did not need the income that would be produced by the $4 million of insurance proceeds. The other $6 million of assets owned by Joe is more than enough to take care of her lifestyle needs.

(2) When Mary passes on, the IRS is guaranteed a big payday; 55% of the $4 million, that's right, the IRS will get $2.2 million and the family only $1.8 million.

Plus a huge undeserved bonus to the IRS of 55% of the after-income tax balance on the income in(1) above, which is explained in the following paragraph. An outrage!

Continuing with (2) above, watch this tax disaster unfold. Mary is a healthy 53-year old with a normal life expectancy to age 83. Her grandparents, on both sides, all lived to age 92 or older. Good genes.

Mary's mom and dad are in their late 70s, healthy and lead an active lifestyle. Let's say Mary lives to age 85. That's 32 years of earnings on the $4 million in her trust. Let's use a conservative after-tax earnings of 4%. Have you any idea of how much that $4 million will grow to in those 32 years? Would you believe $16 million?... Really that's the number.

And what do you think the IRS's bite would be?... An amazing $8.8 million.

Lousy planning! Yet, that's the way most business owners, on the advice of their professionals, do it. What should you do when your facts are the same or similar to Joe's facts?

Here's the four-step plan put in place for Joe:

Step #1. Success Co. elected S corporation status. We recapitalized the company so Joe wound up with 99.5 percent of the voting stock"100 shares"(So Joe could keep control of Success Co. for as long as he lived.) Then, Joe sold the non-voting stock "19,900 shares" to an intentionally defective trust (IDT). The non-voting stock, under the tax law, is allowed to take various discounts. So, the value of the Success Co. stock Joe sold to the IDT, for tax purposes, was only $2.4 million (actually almost all profit, because Joe started Success Co. 31 years ago with $12,000, most of it borrowed.) The IDT trust is a wonderful creature under the tax law that allows Joe to collect the entire $2.4 million (plus interest) tax-free. Also, the IDT takes Success Co. out of Joe's estate, avoiding another big tax loss to the IRS.

Step #2. We initiated a strategy called retirement plan rescue (RPR), using the $950,000 in the profit-sharing plan, to acquire a $4 million second-to-die life insurance policy on Joe and Mary. We created an irrevocable life insurance trust (ILIT) to own this policy. Because of the RPR and the ILIT, none of the $4 million in insurance proceeds will be subject to income tax or estate tax. Every penny will be tax-free.

Step #3. Joe decided to invest a portion of the funds in the profit-sharing plan in senior settlements (SS) to help pay the life insurance premiums in Step #2. SS earn an average of 15.82% per year without market risk (created by a public company that sells on the NASDAQ).

Step #4. We created a family limited partnership (FLIP) to hold Joe's investments and started an annual gift-giving program to give interests in the FLIP to Joe's and Mary's other two children (neither are in the business). The four-step plan we substituted for the original proposed plans will increase the amount of wealth Joe and Mary will leave to their family by an estimated $5.5 million (increasing every year Mary lives and growing to over $14 million if Mary lives to age 85, as explained above) more than the original plans.

Joe was right: He sure needed a second opinion.

Article Source: http://depositarticles.com/

Irving Blackman is a very experienced CPA and lawyer. He is the founding Partner of Blackman & Kallick, the largest independent CPA firm in Illinois. He is also the founding Chairman of the Board of New Century Bank of Chicago. He is the author of 8 books and is currently being published in 59 business trade publications in the USA. His web site is www.taxsecretsofthewealthy.com . If you want to contact Irv, please call 888-278-3623.

Please Rate this Article

Not yet Rated

Click the XML Icon Above to Receive Business Articles Via RSS!

Additional Articles From - Home | Business

Our other websites
All about SEO
Beauty Tips Forum

	Print This Article
	Post Comment
	Add To Favorites
	Email to Friends
	Ezine Ready

Submit Articles
Member Login
Link Us
Submission Guidelines
Ezine Notifications
Article RSS Feeds
Sitemap

New Stuff
About Us
Developer
Good shopping portal
Link to Us
Contact Us
Privacy Policy
Terms of Service