Published 5/13/2010

The Risk of an Outdated Estate Plan

This is the story of two brothers: Joe and Moe. One created an estate plan, and the other did not. Here’s how the dust settled.

Irvine Blackman, Brian I. Whitlock

Joe, 68, did the right thing by creating his estate plan at an early age, monitoring it and updating it as necessary. On the other hand, Moe, 72, was a champion procrastinator. He did very little estate planning, and what he did was out of date. However, when it came to business, Moe was on the ball. He had a knack for spotting problems, solving them quickly and multitasking.

In the late ‘60s, the brothers started a business (Little Co.) in a rented two-car garage. They struggled in the beginning, yet the business grew in sales and profitability. Market share increased almost every year. Joe and Moe were a rich success by any standard.

From the very beginning, Joe insisted on a buy/sell agreement for Little Co., funded by life insurance. The stock was valued every year, and additional insurance was acquired to fund the increased value of Little Co. This buy/sell agreement ultimately saved the day.

Before I explain the importance of the agreement, here is a little background information about the family and the company. Two of Moe’s five children, Sid and Sam, work for Little Co. and will someday own it. Joe has three kids, but none of them ever worked for Little Co.

Although Joe and Moe took exactly the same salary, their individual net worth was significantly different. Aside from the value of Little Co., Joe was worth $23 million. He watched and managed his personal wealth, often seeking professional help. Moe, on the other hand, was worth only $15 million, plus his interest in Little Co. Moe simply did not pay attention to the millions of dollars he drew out of Little Co. over the years.

The only semblance of an estate plan for Moe was his 22-year-old will, which left everything he owned to his wife, Molly. From time to time, Moe would talk about doing a comprehensive estate plan (similar to Joe’s), including transferring his share of Little Co. to Sid and Sam. Unfortunately, Moe died before he did this. Procrastination and the IRS were the clear victors.

This is where the buy/sell agreement kicked in and saved the day. According to the agreement, Little Co. had a value of $23 million—$11.5 million for Moe’s 50-percent share. The insurance on Moe’s life was $11 million. A few days after Little Co. received the $11 million in insurance proceeds, which was tax-free, Little Co. redeemed (bought) Moe’s stock for $11.5 million, for cash.

Molly (age 76) was now worth $26.5 million. No estate tax was due at that time because of the marital deduction, but when Molly goes to the big business in the sky, the IRS will get its many pounds of flesh (the exact amount depends on the estate tax rates when Molly dies).

Another sad footnote: Molly—somewhat of a health nut—became uninsurable about a year before Moe died. The most basic estate planning strategy would have been a large second-to-die life insurance policy on Moe and Molly (both of whom were healthy—and very insurable—until near the end of this drama). The policy in an irrevocable life insurance trust (which was part of Joe and his wife’s plan) would have yielded millions of dollars of estate tax-free insurance for Moe.

After Moe’s death, Joe owned 100 percent of Little Co. Sid and Sam were ready to take over running the company, but they did not own stock. Uncle Joe wanted to do the right thing, so he sold half of his Little Co. stock to an intentionally defective trust (IDT) for $11.5 million and made Sid and Sam the beneficiaries of the trust.

Under the tax law rules, the $11.5 million (plus interest) to be collected by Uncle Joe from the IDT will be tax-free. This means no income tax or capital gains tax. How will Sam and Sid pay for the stock, which they will receive from the IDT after Uncle Joe is paid in full? The IDT is a sort of tax miracle worker. Sid and Sam will not pay one penny. The cash flow of Little Co. will be used to pay Uncle Joe.

When the IDT is done (Uncle Joe paid and the stock is distributed to Sam and Sid), Moe’s sons will own 50 percent of Little Co. (25 percent each) and Uncle Joe will own the other 50 percent.

The buy/sell agreement was updated, with appropriate language, to accommodate all possibilities—disability, death or any type of transfer—for Sam, Sid and Uncle Joe. Life insurance was acquired for Sam and Sid.

Of course, the intent of the new buy/sell agreement is that someday when Joe joins Moe in heaven, Little Co. will redeem Uncle Joe’s stock and his two nephews will own 100 percent of Little Co. Also, Joe was still insurable, so additional life insurance was acquired to cover the then fair market value of Little Co.

Remember: If you have a comprehensive estate plan like Joe, the IRS will not become a partner in sharing your family’s wealth. However, failure to keep your estate plan updated guarantees the IRS a big payday when you die.