Second Opinion Eliminates Taxes

This is a true, sad, tax-war story. A business owner (let’s call him Joe), has just completed his estate plan and his plan to transfer his business to his kids.

After examining the documents and reviewing the plans, it became clear that the plans, taken as a whole, were a tax disaster. Here’s the story: Joe is 63 years old; his wife, Mary, is 60. Joe has five key goals:

1. Have a flow of income to maintain his lifestyle for as long as he (and Mary) live.
2. Transfer the business, Success Co., to Sam, his son, who runs the business.
3. Treat his non-business children fairly.
4. Provide for Mary if he dies first.
5. Minimize death taxes.

Joe is worth about $3,500,000 alive—$2.5 million is the approximate value of Success Co., and he has $0.6 million in investment real estate, and $0.4 million (almost all non-income producing) in other assets. Most are owned jointly with Mary. But get this: Joe is worth $5 million dead. Success Co., a tax-paying C corporation, owns and is the beneficiary of a $1.5 million insurance policy on Joe’s life. Joe intends to slow down (work about 10 hours a week) when he reaches age 65, but draw a salary of $90,000 (plus almost $15,000 in fringe benefits) instead of $100,000 (a reasonable salary when he was working full time) for as long as he lives and is able to work.

Before continuing, jot down your own transfer/estate objectives and your fact pattern. You may find many similarities.

The wills were almost useless because of the joint tenancy. If Mary dies first, the two non-business affiliated kids share about $1 million, while Sam gets the rest of the estate, not “fairly” as Joe desired. Sure, Sam would own the business—but as a great tax cost. Success Co. would get hit with an alternative minimum tax of about $275,000 on the $1.5 million insurance proceeds. And what about the estate tax? There would be no tax when either Joe or Mary died, but the estate tax liability would skyrocket to about $1.5 million after the second death (assuming 2006 or after). The reasons for this tax mess are complex. But suffice it to say that, if done right, it is easy to eliminate both alternative minimum tax and the estate tax.

What should Joe do? First, Joe must get the insurance out of the corporation and into an irrevocable life insurance trust. Then, get one half of the joint property into his name and half into Mary’s name.

Also, Joe should elect S corporation status. Then he could avoid paying about $6,000 a year in payroll taxes, increase his Social Security benefits, and avoid an IRS attack for unreasonable compensation. S corporation dividends would provide him with a tax-advantaged flow of income.

In addition, a grantor retained annuity trust (GRAT) was used to transfer Success Co. to Sam, but Joe kept control by retaining all the voting stock (the nonvoting stock went to the GRAT). A family limited partnership (FLIP) was created to hold the real estate and transfer the nonvoting FLIP interests to the non-business kids.

What was Joe’s mistake? He took some advice from his accountant, some from his lawyer, and some from his insurance agent. No one person coordinated the entire plan. The results—good wills, once the titles were changed; good insurance, once ownership was changed to an irrevocable life insurance trust; a good corporation, once S corporation status was elected and the GRAT was in place. Joe’s situation was easy to fix.

The point? If you don’t have a transfer/succession plan and an estate plan, get them in place now. If you have plans in place, but are still faced with an estate tax liability, get a second opinion.