Get a Second Opinion

Joe and his wife Mary were planning a three-week trip to Europe, and he wanted to make sure his potential estate tax liability was covered in case of a fatal mishap on the trip. Joe asked his CPA to compute his estate tax liability based on his current wealth. The CPA prepared a worksheet detailing all of Joe’s assets, the expected estate tax liability ($3,227,000), the liquid assets Joe had available to pay the tax ($766,100) and the shortfall ($2,460,900). Based on these figures, the CPA recommended that Joe buy a $2.5-million term life insurance policy on Mary, which Joe would own, to pay the expected estate tax.

Joe, age 61, and Mary, age 58, had a typical, traditional estate plan in place that consisted of pour-over-wills and A/B trusts, which was drawn up by a lawyer specializing in estate planning. 

Joe’s CPA was well-meaning, but Joe really needed a second opinion. There are common errors that closely held business owners like Joe make in their estate planning, and these errors can amount to missed opportunities to save on estate taxes. They can cause the Joes of the world to lose millions of dollars of their wealth to the IRS.

So we took a closer look at Joe’s personal wealth. His total taxable estate was valued at $16.7 million, including $9.5 million in various investments (mostly real estate with $2 million in mortgages); Success Co., his business worth $4.6 million that nets about $950,000 per year after Joe is paid his $275,000 salary plus liberal fringe benefits; $1.8 million in a 401(k); $800,000 in miscellaneous assets; and, finally, a $2 million life insurance policy Joe owns on himself.

Discounts and Freezing Major Assets
There is a loophole in the tax law concerning the value of certain assets: A particular asset 
retains its real, fair market value, but has a lower, discounted value for tax purposes. The 
following chart shows typical assets and the strategies that can be used to get the oh-so-wonderful discounts:

Asset Class	Strategy	Discount
Business	Non-voting stock	40%
Investments	Family limited partnership	35%
Residence	Split ownership*	30%

*Typically, 50 percent of a residence is owned by the husband’s A/B trust and 50 percent by the wife’s.

We implemented these three strategies for Joe and tallied up discounts totaling $5.565 million, bringing the value of his taxable estate down from $16.7 million to about $11.2 million.

Another important tactic in cutting tax liability is to freeze one’s major assets. In Joe’s case, gifts to his three children were the weapon of choice. We used the annual exclusions of $14,000 per donee ($28,000 for Joe and Mary combined) as well as a portion of the lifetime credit of $5.25 million ($10.5 million for both). An intentionally defective trust (IDT) also was used to transfer Success Co.’s non-voting stock to Joe’s kids tax-free.

Insurance
To really take advantage of this strategy, you must know the laws, understand the life insurance products available in the marketplace, keep the policy proceeds out of the insured’s estate and minimize the cost of premiums. 

Joe’s estate included a $2 million policy on Joe with annual premiums of $15,349 and a cash surrender value (CSV) of $52,000. A second-to-die policy on both Joe and Mary was a better option, however, because no estate tax is due until both husband and wife have died, and it requires a lower premium of $10,521. Joe dropped the old policy and pocketed the $52,000 CSV, and a new $2 million second-to-die policy was purchased by an irrevocable life insurance trust to keep the death benefit out of the estate.

Because of the changes we made to Joe’s estate plan, the $2.5 million policy on Mary recommended by the CPA was no longer needed to pay estate taxes. But because insurance premiums can be paid by an IDT, we had the trust buy a $2.5 million second-to-die policy on both Joe and Mary for the benefit of their kids and, of course, structured it to be estate-tax-free.

Life insurance, in general, might be the most messed up area of estate planning. Errors can include wrong type of policy, overpaid premiums, proceeds subject to estate taxes, over-insurance and under-insurance.

The following list will help determine if you need a second opinion on your insurance coverage:

1. You are married and have a single life insurance policy (typically on the husband). A second-to-die policy will give you more bang for your premium buck.

2. Your policy is paid up and you no longer pay out-of-pocket premiums. This is guaranteed to enrich the insurance company instead of your family. Use a tax-free exchange to significantly increase the death benefit and still pay no premiums.

3. You have a CSV of more than $350,000 or $3 million in coverage, or your policy is more than 10 years old. Updating old policies can result in higher death benefits for the same premiums.

In general, it is smart to have your insurance policies reviewed by an independent set of eyes every three years.